My previous article, Managing Individual Investment Portfolios Better, deliberated on the friction between individual perception of financial markets and investing in general versus, the actual behavior and nature of markets. This article delves into investment risks, its causes, and mechanisms to deal with such risks. Discernment of investment risks help build better portfolios and commit fewer mistakes.
Understanding The Sources Of Investment Risks
Risks in investing stem from the unknowable future. Investment risks arise from misjudging future earnings of a company, growth rate of economy, level of interest rates, investment and savings rates, productivity and similar metrics. Unfortunately, there are no prescient-individuals or individuals with prescient-models that predict these things accurately. A collage of underlying factors such as, economic, geo-political, climatic, cultural, legal etc shape the future; no one synthesizes the interplay of these elements all at-once with perfection.
Human Behavior Lays Siege To Models And Theories
Another factor that distorts a predictable future is the role that human behavior plays in influencing those earnings, growth rates, interest rates etc. Conventionally, the rational human is expected to make mathematically correct choices. Mathematically correct choices or topically called expected-values enhances utility; however, in reality, one often behaves in ways that only hurt one’s well-being. For instance consider the following two choices (a) a stock that has a 10% probability of returning 75% in a year or nothing, versus (b) a fixed deposit or a debt mutual fund that has a near-certainty of returning 8% in a year. Most investors in the real-world would choose option (a), lured by the high-return possibility, even though option (b) has a higher expected-value.
Economic and financial models and theories are built on the edifice of rational-expectations of individuals. These models and theories rarely accommodate the irrational behavior of individuals. Some of these are so axiomatic that it may need careful application. There may be an element of truth in Andrew Lo, a professor of finance at MIT, quip ‘…economics has ninety-nine laws that explain three-percent of the real world, whereas in physics, three of its laws explain ninety-nine percent of all phenomena’.
So how does one rely on these models, to help predict the future, which assume rational behavior of participants at its core?
Investing, nevertheless, concerns with the future and not the past. Often, good prediction reduces investment risk; portfolios can be suitably positioned to take advantage of or hedge against future events. The term prediction implies precision. That description suits natural sciences more than financial markets. In natural sciences a combination of certain inputs in certain proportions and under certain conditions gives fixed results: such as locomotion or combustion. Such fixed results rarely occur in financial markets – despite using the best models. Unpredictable individual behavior lends prediction a risky affair. As Sir Isaac Newton so aptly put it, ‘I can calculate the motion of heavenly-bodies but not the madness of people’.
Rather, Paint A Picture
To succeed in investing one must develop – for lack of better word – an intuition or feelabout the turnout of future events. Thinking about a range of likely future eventsis a better preoccupation to using rigid models. One could take into account historical behavior of variables under different scenario and construct future events; and complete the assessment by assigning probabilities to events. For effective construction of a range of likely events one may view with a degree of caution, the behavior of the underlying variables as applied in economic and financial theories.
Volatility Risk Versus Permanent-Loss Risk
In ‘modern’ finance theory, propounded by Harry Markowitz in 1952, investment risks entail variability of returns, thus laying emphasis on volatility as the prime investment risk. From the investor’s perspective, volatility that occurs before maturity of asset or redemption-date preferred by the investor, cannot be called a real risk as it rarely disturbs his utility. Chances of a permanent-loss after initiating an investment is a real concern for most investors. Such permanent- loss risks can be managed by building portfolios that respond appropriately to future events.
Strategies that purely use financial-models driven to articulate a target number (such as earnings-per-share, or share-price) fail to accommodate non-linear behavioral influences. Shaky investments, stacked into a structure that pay-off a fixed-all-weather-return, fail to account for idiosyncrasies in the real world.
Financial planning reduces the surprise element in financial exigencies. Volatility is a lesser concern when portfolios can handle such exigencies without stress. In conclusion, investment risks are unavoidable since the future is unknowable. Scenario-building, financial planning and appropriate portfolio construction help mitigate investment risks.