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Risk is one of the largest pillars of investing. It’s abstract nature often involves asymmetric relationships that investors can capitalize on. Investor preference related to risk is oftentimes the leading pricing factor. Assets with riskier tendencies will not attract as much interest from investors leading to an lower price and higher returns. Treasury bills for example are often regarded as one the benchmark for a risk free investments, attracting investor attention, raising prices, and lower returns.
But what exactly is risk? In finance, it will depend who you ask. Most will have a different notion. The one I agree with the most comes from three sources - Howard Marks, Nassim Taleb and Warren Buffett. The three have very interesting views that will change your outlook on risk.
Howard Marks defines risk as the chance of permanent loss of capital. This is my favorite definition. I guess we can all agree that a risky situation is one where we have a high change of losing and not being able to retrieve our initial investment. Investors end up being in a undoubtably worse situation compared as before the investment
# Risk is not Volatility
What risk isn’t. Risk is not volatility. Now here is where it gets tricky. Some finance authors will fight me on this, even bare knuckles with a lot of grit. Most finance academics regard risk as volatility. A risky asset is one that has a large variance in it’s price, compared with the general market. A common used indicator for this is a Beta. Beta is the ratio of the stock’s covariance with the market returns with the market variance. This allows the investor to know how much the price of this stock is changing compared with the stock market. A value of two, for example, would mean that the stock moves twice as much as the broader market. Beta is largely used in some finance pricing models such as the Capital Asset Pricing Model (CAPM).
A few problems instantly arise from this concept that clash with value investing. If we imagine the situation were a stock has been tumbling in price, with heavy spike changes. This higher degree of volatility will classify this asset as riskier, however, if we assume that the fundamentals are unchanged, management is the same, and the core business model remains intact with equal earning power, most sensible investors would consider the stock to be less riskier. The odds of permanent loss of capital are now lower, entering an investment at a lower price point and earnings multiple has that effect.
The backward looking trap is also very present in this form of thinking, a great analogy is gauging the danger of a mountain climb by measuring how windy it was yesterday.
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This all boils down with the insistence that finance academics have had for decades on applying precise mathematical methods to a social science. It won’t work. While it’s handy to be able to give a number to risk, you can’t quantify an abstract concept.
Munger used to call this physics envy. We as investors are envy of physics exact nature and often want to replicate some of their models.
check out my source post [here](https://open.substack.com/pub/medismarketnotes/p/market-rambling-on-risk?r=35je77&utm_campaign=post&utm_medium=web&showWelcomeOnShare=true) for the rest of the article plus bonus resources