Letter #7

The Dude

“Yeah, well you know, that's just, like, your opinion, man.”¹

Dear Boys,

Today I want to bring us back to the concept of risk and weave it together with our thoughts from the recent few Letters. If you remember, we formulated that:

risk exists if there is a chance of a bad outcome

We also discussed the idea that in the real world you can’t remove risk altogether because unknown unknowns are always lurking to bite you where it hurts. If that’s the case, the obvious question is then why bother bearing risk at all? Why not just fully protect what I have and not worry?

Well, as we covered in our discourse on spending vs. saving vs. investing, doing nothing isn’t good enough. The world is constantly moving. In the context of investments this means the value of assets that you own are always changing. There is no absolute. That’s critical for you to understand. As we saw, even the value of savings held as cash changes due to the effects of inflation. What you can buy with £100 today, or with £100 next year, will be different. Your goal with your investments is to grow them adequately so that you can increase your purchasing power. Whether for a specific objective, or ultimately just to sustain your ability to live from the investments themselves. You can’t do this if you spend the capital itself, as ultimately you will be left with nothing. Staying still means you are actually dropping behind.

Just like when we discussed jumping out of a plane in Letter #2, there is always a flip side to bearing risk, and that is the return, or benefit, you will get from undertaking the risky activity. If the return doesn’t outweigh the risk then you won’t do it, simple as that. Striving for returns means you have to take risk. So the process is not about removing risk completely, that’s not realistic. What is realistic is taking the least risk required for a given objective. There is a subjective assessment that takes place (hence The Dude’s pithy remark…) when one is considering a particular course of action that weighs together the upside (potential return) and the downside (potential risk). This is no different in the world of investments. The more risk you bear, the more return you require to outweigh that risk. But the problem comes in that (as we know) there is uncertainty around the future. The return that you require for compensation for bearing the risk isn’t guaranteed.

It is commonly assumed that bearing greater risk will automatically lead to greater returns. But nothing could be further from the truth. After all, as we have just seen, if the route to success was simply to take more risk, by definition it wouldn’t be risky, would it! A more refined observation would be to state: the more risk you expose yourself to

• the greater is the range and magnitude of the achievable outcomes;

and/or

• the greater is the likelihood of one of those potential outcomes having a negative impact.

This is a critical point for you to understand so let’s just deconstruct it for a second. The first part of the statement suggests that risk is related to the magnitude of outcomes. Losing £10 isn’t as bad as losing £1000, and therefore would be assumed less risky. Standing on a cliff edge is inherently riskier than standing on the edge of your sofa, even if the likelihood of falling off both is the same.

The second part relates to the idea that more risk means more likelihood of ending up worse than you started out. A 10% chance of losing £10 isn’t as risky a bet as having a 90% chance of losing the same amount, even if the magnitude of the negative outcome in both cases is the same.

The ‘and/or’ refers to the fact that in reality, risk is a combination of both magnitude and likelihood simultaneously. Even if the likelihood of falling from the cliff edge is very low, it is still a risky pastime to partake in (by just standing there). Conversely, gambling £5 on the 250-1 outsider at the Grand National isn’t really risky even though the likelihood of winning is extremely remote, because the magnitude of your loss is small. So the greater risk you bear, the greater is the return required to compensate for that risk. But the return isn’t guaranteed. It’s only a potential. And the greater risk induces a broader range of potential outcomes, with the extremes being worse as the risk increases!

Fortunately, one signal that provides information about the potential returns of any investment is the price. What you pay today will define the potential future returns from a given investment. The price also reflects the Market’s assessment of the potential risks associated with the investment. (We’ll talk more about ‘the Market’ in subsequent Letters, but for now, just think of the Market as all the people who are interested in buying or selling the said investment). Let’s understand that point a little more. Risk and return are two sides of the same coin.

We can use a simple example to work through the logic. Imagine ‘thing A’ has a price that has fluctuated over the last year between a low of £30 and a high of £40, and ‘thing B’ has a price that has similarly fluctuated over the last year, but by a wider range – from £10 and £60.

Also imagine that today you can purchase ‘thing A’ or ‘thing B’ for £35. Straight away you will have observed that ‘thing B’ has had a wider range of prices over the last year, and hence we can make an assumption that the risk of buying ‘thing B’ is greater than that of buying ‘thing A’. Simply because the range of ‘thing B’ is higher and the downside potential is higher. Makes sense, right? “But I can make more money with ‘thing B’, clearly”, I hear you say… “it might go back up to £60 again and then I’ll have made £25 profit, as opposed to ‘thing A’ which looks like it might only gain £5 if it goes back to £40”.

Assuming you are looking to maximise your gains then you might be inclined to choose ‘thing B’ simply because the potential range of outcomes, according to the historical data, is much wider than in the case of ‘thing A’. You’ve just made an assumption about the risk of ‘thing B’ vs ‘thing A’ due to their respective price performance. Additionally I could also think about this from the perspective of losing money… clearly ‘thing B’ has a chance of a greater loss (a bad outcome). I could get a lot more sophisticated around how to ascertain the risk but actually simpler is better in this case.

But how would things change if I could only buy ‘thing A’ today for £40, but ‘thing B’ for £15? ‘Thing B’ now looks like a much more appealing opportunity as it’s trading close to the low of its range (any further downside is limited), and has a greater potential upside (from £15 all the way back to £60²).

Of course, this is a simple example and the decision making process about ‘thing A’ vs ‘thing B’ will take many more factors into consideration to understand which is a better investment choice.. but the example serves the purpose of showing that higher risk is clearly not always the path to higher returns. But by making some simple observations about the potential risk of an opportunity using the price, you have been able to evaluate those opportunities and make an observation about which looks more appealing.

Here’s the thing though – taking risk doesn’t mean you have to be belligerent about it... in many areas of life, risk-taking done well can lead to excellent results. And in fact as we saw above... it’s a oxymoron to think that you must take large risk to achieve large returns. Buying ‘thing B’ at £15 may be much less risky than buying ‘thing A’ at £40, but in all likelihood, it will give you a better chance of achieving your outcome.

We’ve taken our first gentle step into thinking about the context of risk when it comes to the investment world today. We have identified that risk is a combination of both magnitude (how much can I lose?) and likelihood (how likely is it I will lose?) simultaneously. Using price allows you to assess quite a lot of information that can help you frame your perspective of the potential risks of a particular decision. Of course, we’re only just getting started. Next time, we’ll talk about the alignment of risk and return, to ensure we are being sensible with our risk taking. Stay tuned.

Yours,

D.

1. The Dude, The Big Lebowski (1998)

2. £60 is just an example of a potential price that the investment could revisit based on history. I’m not suggesting that it will revisit that price.