James Piccoli
October 08, 2024
Money Education Financial literacy Economy Commentary Weekly update Weekly commentaryWhat killer coconuts can teach us about risk
“Risk” is one of the most common words thrown around in conversations about investments. I think it’s used so much because, in an investment context, risk is fundamentally misunderstood.
The investment community’s definition of risk differs from that which is in an English dictionary. To understand risk in an investment sense, it’s helpful to understand the opposite, an investment that is “risk-free”.
While no investment is entirely “risk-free”, a low risk investment may consist of a short-term US or Canadian government bond, where your principal and interest payment are guaranteed by the government, and there is no reasonable chance that your return is more or less than the interest rate associated with the bond.
Now, let’s conduct a thought experiment. You have the option of investing 100 dollars in one of three one-year investments.
Investment A pays a guaranteed 103 dollars in one year’s time.
Investment B has a 50 percent chance of paying 110 dollars, but a 50% chance of paying 90 dollars.
Investment C has a 50 percent chance of paying 106 dollars, and a 50% chance of paying 100.
Which is the best investment? Well it obviously isn’t B, as the probability-weighted expected return is only 100$ and is less than both A and C. But would A or C be more appropriate?
Investment A is still the better investment. This is because even though the probability-weighted expected value is the same, Investment C’s payout is uncertain. A rational investor would require a risk premium, or a little bit of extra return, as compensation for the uncertainty of the investment.
The “risk premium” is the basis of the expected positive return in capital markets. In buying a stock over a low risk asset, a rational investor expects to be paid more than the low risk rate since their return will be uncertain. This is what “risk” is. It’s simply the fact that the outcome of your investment is not predictable or guaranteed, and it’s value may be more or less than expected over time.
Taking more or less risk just means that there can be more or less variation in the final outcome of your investment. Seeing the value of your portfolio rise and fall day-to-day may be uncomfortable, but it is fundamentally the reason why your investment is expected to grow in value over the long term.
Risk (and uncertainty in all areas in life) is an uncomfortable feeling for everyone, and humans are hardwired to be risk-averse. Fear what happens when this feeling gets out of control, and emotion overtakes rationality.
As part of our research process we try and identify opportunities in the market where investors are fearful. This is where opportunities may lie…it’s part of the human condition to have irrational fear, and we can use this to our advantage. We analyze probabilities with a rational perspective, and act accordingly.
Most people are understandably scared of sharks. It is an innate human response to be terrified. Sharks, however, only kill 10 people every year.
On average, coconuts kill 150. If fear was a rational emotion, people would be 15 times more scared of coconuts than they are of sharks.
I don’t know anyone who wears a helmet to the beach.
As it relates to which investments to choose; this is where the wisdom of Warren Buffett’s quote “be greedy when others are fearful” rings truest.
Risk is not something to be afraid of; it’s something that is necessary. In fact, attempting to avoid all risk, (i.e. only ever investing in low risk assets) after taxes and inflation, may erode your wealth over time. Though this feels safe, it can be a dangerous strategy.
After all, isn’t life only interesting because outcomes are uncertain?
Next week, I will relate this to what has been happening in the Chinese stock market.