BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “UNDERSTANDING RISK”

For making any investment decisions, we have to be dealt with the future, which is uncertain in nature. So, that when there is an uncertainty, then there is an involvement of risk and we cannot escape from the risk. We must have to focus on asserting risk while making any investment decisions.

When we focus on the return of the particular instrument, then we have concentrated our focus on half of the movie and rest half will get completed with asserting risk in that particular investment.

Risk 01

Traditionally, we all have learned, that in making a higher return, we need to take an incremental risk.

But we think logically about the same that if we get a higher return for the taking of incremental risk than there should not be a risk. We get rewarded by the returns for taking a higher risk.

Risk 02

Traditional risk/return graph has communicated the positive relationship between risk and return but ignored uncertainty involved for making such returns. Additionally, traditional risk/return graph has shown a risk as similar to volatility, but not focused on the danger which is involved in the investment.

Many a times volatility cannot be an as riskier as compared to other dangerous events for our investment.

Risk 03

So, that risk is not a volatility in the price of stocks, but the real risk is the permanent loss of our capital. And we must have to be worried about the permanent loss of capital rather than volatility. We must have to focus on the understanding of the risk which could have the probability of erosion of our capital.

Many a times risk is not only limited to, permanent loss of capital or to volatility, some kind of risk are objective and personal in nature; such as-

1) Falling short of one’s goal

Many investors have a different need, goals and not meeting those by investment results can be the risk for the particular person.

If someone just requires meeting the routine expenses, then getting a fixed return from fixed return instrument might not be at risk for the person, but if someone who wanted to build capital for investment then such a lower return can be a risk for that particular person.

2) Underperformance

Such kind of risk is related to the investment manager. If the investment manager cannot able to generate higher returns compare to index than the investment manager might lose his clients.

Risk 04

3) Career risk

This is an extreme form of underperformance risk. Continuous underperformance can have resulted in the risk to the career.

4) Unconventionality

This risk is connected with a being different while making an investment idea. If unconventional idea got wrong, then there might be a risk to the career.

We buy metals, sugar stocks, etc. (at the worst time of the cycle). Instead of buying pharma, IT, Banking which is a darling of the industry. And if our stock picks up doesn’t work, then we have to face trouble and extreme risk of loss of career.

5) Illiquidity

This risk arises when investors need a money for some urgency and unable to break his investment.

Let me take an example of the cricket match for understanding a risk.

The main risk in the cricket match is to losing the match, series, etc. as similar to losing our capital in investment. If all the players play a poor game, then definitely team will lose the match and similar to an investment; if all our investment resulted in poor returns or more risk oriented than we might lose our capital or lose real value of capital.

As we have seen in Indian cricket history that Mr. Sachin Tendulkar, Mr. Rahul Dravid has played very well and created the record, they don’t always come to the ground for making a century or creating a huge score but always played well for protecting their wickets. Their focus on protecting their wicket helps them to play well for the longer period of time. And on against to them, many other players came to Indian cricket history and gone also; cannot able to stay for a longer period of time. They just have focused on making a score and sometimes due to the luck they can able to make good score but not always.

If players do not able to play well on a continues basis, then they will have lost the opportunity of staying with the cricket team (Career Risk). Also, we have seen that Mr. Mahendra Singh Dhoni has taken a many unconventional decision for the team during the match. Many of his decisions got success and many not. When he filled with his unconventional decisions, he has to face the anger of the people. This is as similar to our unconventional investment decisions and has to face anger from our clients if we filed into the unconventional decisions.

It is not necessary that we only can be incurred a loss by buying weak fundamental stocks. If we bought the comparatively lower fundamental company at a very lower price than that investment turns out to be a successful investment.

Sugar IT

We can see that if we have bought the comparatively lower fundamentally good stock at a cheap price than this stock has generated a higher return compared to the good fundamental stocks in last 5 years.

Also, not good macro environmental promises of safety. Because too positive news brings up prices at too high and any small adverse development can be enough for damages to our wealth.

People generally tend to associate with the things that are doing well. And that investment might be able to fulfill expectations for a while and thereafter small negative event can damage much higher. Such scenario having an involvement of higher risk.

So, that value investors believe in achieving higher returns from lower risk. We have to be ready with underperformance risk while we are buying bargains and market is in a heated bull phase. We need to accept it rather than incurring losses.

Risk 05

Investment is dealing with the future and the future is highly uncertain. And it’s impossible to know anything about the future.

Risk means more things can happen compared to what happened in the past. Understanding of risk requires a second level thinking and it’s not an easy task. The risk of losing money is observed by one that’s similar is not observed by another one.

Read for more detail: The Most Important Thing Illuminated by Howard Marks

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