Investing

Risk, Uncertainty and Volatility – Should you be investing?

Posted

Should we be investing now given the current levels of risk, volatility, and uncertainty in financial markets?

Confused about what investment option to take?

This was a question we were asked several weeks ago during a presentation. We shared our response to this question in our most recent monthly Portfolio Update – sent to those clients that have engaged our Individually Managed Portfolio service. Given the insight this gives to managing investments effectively, we have reproduced it below:

“Firstly let me clarify that there is a difference between uncertainty and risk. When investing, it is possible to have high uncertainty but very low risk. For example, when Bill Gates and Paul Allen started Microsoft, they did it with $50,000 in capital. While their uncertainty was astronomically high, they were only risking $50,000 so their risk was very low.

Now let me touch on the concept of risk. The world of academia has defined ‘investment risk’ as volatility (the amount of variance in share price movements). However, we do not see volatility as risk. To us, volatility may be a function of risk and is certainly something that should not be ignored but volatility in itself is not risk.

We have never had a client come to us and say that their main focus is on minimising volatility. However, all of our clients want to, at the least, preserve their capital. As such, AFF defines risk as the permanent loss of capital.

When we talk about managing risk, we are referring to our primary focus of avoiding permanent loss of capital, not minimising volatility.

If we bought a $100 face value bond for $50 and the price of that bond drops to $30, is that necessarily a bad thing? It is only bad if the drop is a permanent one or if you needed to sell during that time.

If we did buy the $100 bond for $50, academia would conclude that we must be taking on a large amount of risk as they believe that the only way to achieve high returns is to take on more risk. However, we would assert that we have considerably low risk in this instance because we were able to buy a $100 asset for $50. yet we would stand to make 100% plus cash flow.

…and this notion of price is perhaps the most important factor when it comes to investing. The price at which you buy an asset in reference to the asset’s value dictates risk and reward. History is littered with great businesses that people have bought shares in that have subsequently gone on to lose 90%. Why? Because they paid too much for the asset.

You asked about investment risk in the current environment and when you stop viewing risk as volatility and start viewing it as the risk of permanent capital loss you become fixated on price and value. Theoretically, if an asset increases in price by $1, unless the value of that asset increases by a corresponding amount, that asset has become riskier. Vice versa, if it drops by $1 and value has not changed, the risk of buying that asset has declined.

At the moment, investors are pricing assets as if there is very little risk. They are paying prices for businesses that we do not believe have increased in value and therefore we believe for these investors their risk is quite high. However, this does not mean you should not invest because, at times over the past several months, shares in some companies have dropped considerably and presented great buying opportunities. In these companies, we believe the risk is much lower now than before despite volatility being a factor”.