As a follow-on to our recent Sunday Morning Coffee with Erik video contrasting market risk with valuation risk, we thought we would revisit an article Erik wrote in September 2015 which discusses the difference between liquidity risk and solvency risk. Risk is a key factor for any successful investor to understand, so it is worth being precise about what “risk” really means. The article finishes up with a list of five things an investor can do to reduce investment risk.
Risk is not, as academics and adherents to the Efficient Market Hypothesis believe, variance of returns. As investors with a directional view, we very much want returns to vary – just as long as the variance is in the same direction as our view!
Risk is not, as many investors believe, a three (or five or seven) percent loss in the S&P 500 index one day. A big down day in the markets can be unpleasant and frightening, but a well-capitalized, appropriately levered investor need not suffer any long-term ill-effects from such a drop. If she keeps her wits about her, the long-term effect of such a drop can be very positive indeed.
Risk boils down to one thing: Not being able to pay for something you need or want when you need or want it.
There are two manifestations of risk, one usually less serious than the other.
The lesser manifestation is “liquidity risk.” This is when you have plenty of assets, but for some reason, can’t or don’t want to sell them to fund a purchase. An example is if you want to take an around-the-world vacation next month, but all your wealth is tied up in restricted stock units that you are prohibited from selling until next year. Liquidity risk can usually be avoided by sensible planning ahead of the fact and can be ameliorated by borrowing money at the fact.
The more serious manifestation is “solvency risk.” This is when you do not have enough wealth or income to meet ongoing structural obligations.* An example is if you do not have sufficient retirement assets to live comfortably, pay medical bills, and so on after you are too old to continue working. Solvency risk is caused by making poor decisions. In an investing context, this means either: 1) not investing in something that would have ended up generating necessary wealth and 2) investing in something that ends up destroying wealth.
With a focus on this conceptual framework, it’s not a huge leap to see that the best way to reduce risk – the kind of risk that really matters – is to figure out how to consistently make good decisions. There are five steps to doing this:
- Understand how much value a company creates for its owners now and its potential to create value in the future (successful value investors value growth).
- Learn how to make insightful, testable estimates of a company’s value.
- Understand what incoming information would materially change your estimate of a company’s value and how to incorporate that information into your valuation estimate.
- Only invest in companies when you can do so for a price much less than the value the firm will likely create (see the video below for our improved take on “margin of safety”).
- Understand how to allocate investment capital prudently and how to measure and manage leverage so that you are not forced to make a bad decision due to a lack of liquidity.
Notice that there is nothing in the above list about avoiding market drops.
If you are invested in the markets, you are exposed to market drops. Yes, there are ways to “hedge” a portfolio using option contracts (protective puts), short sales, and holding bonds or cash in reserve, but all of these methods are in fact just elements of point five above. In addition, considering point four above, an intelligent investor should welcome market drops because it provides more chances to invest in companies that are trading at prices much less than their values.
In short, the best way to avoid risk is by developing a sound intellectual framework for making good investment decisions and by keeping your emotions in check during times of market stress so that your sound decision-making framework can work to your benefit.
Great investors are great because of the decisions they make when prices fall.
* Sometimes, liquidity risk can lead to solvency risk – we saw this with the demise of Lehman Brothers in 2008 and Long-Term Credit Management in 1998. When liquidity risk leads to insolvency, it is obvious that the person or company in question had taken on too much leverage.
A slightly altered version of this article originally appeared on Forbes.com under the title Five Steps to Reducing Investment Risk.