As a value investor it’s important that you always assess the downside risk of your investments, prior to purchase. Famed investors Buffett and Klarman are always speaking about the ‘margin of safety’ espoused by the grandfather of value investing, Benjamin Graham. One of the best articles on assessing the risk of an investment in the stock market comes from Howard Marks in his 2013 memo.
Here’s an excerpt from that memo:
Much (perhaps most) of the risk in investing comes not from the companies., institutions or securities involved. It comes from the behavior of investors. Back in the dark ages of investing, people connected investment safety with high-quality assets and risk with low-quality assets. Bonds were assumed to be safer than stocks. Stocks of leading companies were considered safer than stocks of lesser companies. Gilt-edge or investment grade bonds were considered safe and speculative grade bonds were considered risky. I’ll never forget Moody’s definition of a B-rated bond: “fails to possess the characteristics of a desirable investment.”
When I joined First National City Bank in the late 1960s, the bank built its investment approach around the “Nifty Fifty.” These were considered to be the fifty best and fastest growing companies in America. Most of them turned out to be great companies.. . just not great investments. In the early 1970s their p/e ratios went from 80 or 90 to 8 or 9, and investors in these top-quality companies lost roughly 90% of their money.
Then, in 1978, 1 was asked to start a fund to invest in high yield bonds. They were commonly called “junk bonds,” but a few investors invested nevertheless, lured by their high interest rates. Anyone who put $1 into the high yield bond index at the end of 1979 would have more than $23 today, and they were never in the red.
Let’s think about that. You can invest in the best companies in America and have a bad experience. or you can invest in the worst companies in America and have a good experience. So the lesson is clear: it’s not asset quality that determines investment risk.
The precariousness of the Nifty Fifty in 1969 — and the safety of high yield bonds in 1978 — stemmed from how they were priced. A too-high price can make something risky, whereas a too-low price can make it safe. Price isn’t the only factor in play, of course. Deterioration of an asset can cause a loss, as can its failure to produce profits as expected. But, all other things being equal, the price of an asset is the principal determinant of its riskiness.
The bottom line on this is simple. No asset is so good that it can’t be bid up to the point where it’s overpriced and thus dangerous. And few assets are so bad that they can’t become underpriced and thus safe (not to mention potentially lucrative).
Since participants set security prices, it’s their behavior that creates most of the risk in investing. This is true in many other activities as well, the common thread being the involvement of humans.
- Jill Fredston, an expert on avalanches, has observed that “better safer gear can entice climbers to take more risk — making them in fact less safe.” (Pensions & Investments)
- When all traffic controls were removed from the town of Drachten, Holland, traffic flow doubled and fatal accidents fell to zero, presumably because people drove more carefully. (Dylan Grice, Societe Generale)
So improvements in safety equipment can be neutralized by human behavior, and driving can become safer despite the removal of safety equipment. It all depends on how the participants behave.
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