VALUE INVESTING, RISK AND
RISK MANAGEMENT

Part III

15 October 2000

...continued from Part II

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.

Warren Buffett, Preface to
Benjamin Graham, The Intelligent Investor

Given the information to hand at a particular point in time, the overall risk which inheres in a series of decisions cannot be minimised or even reduced. Quite the contrary: poor choices can increase total risk and thereby magnify the likelihood of loss. With the information at one’s disposal, the best that one can do is to ‘exchange’ a specific risk which is regarded as very salient or most undesirable for one which is regarded as less salient or less undesirable. Not just objective consequences but also subjectivist and ethical considerations are thus bound inextricably into one’s decisions.

We are now in a position to apply this framework explicitly to investment decision-making. The underlying analogy of a trial by jury remains useful as a means of clarifying key elements of the problem at hand.

Investing: Four Possible Outcomes and Two Inherent Risks

Assume that you are a one-man ‘jury’ and your task is to evaluate a series of ‘defendants’ (assets which are candidates for addition to your investment portfolio). Each asset either will or will not generate the stream of earnings which your assumptions and analysis ascribe to it; and each either is or is not available at a price which justifies its purchase. Accordingly, each investment opportunity either is or is not suitable for your purposes. Seldom if ever, however, can information from the past and present be assembled in order to shed incontrovertible light upon the results which a potential investment will achieve in the future. Adding to the difficulty is ‘delayed feedback’ –  i.e., the reality that the suitability or otherwise of each opportunity may become apparent only in several (let us say five) years’ time.

Clearly, then, you must make a series of investment decisions on the basis of imperfect and incomplete information about the past and present. You must also make assumptions about these potential investments in the face of an inherently uncertain future. Accordingly – and despite your best intentions – the odds are London to a brick that some percentage of your investment decisions will be mistaken.

Granting that the extent of an asset’s suitability to an investment portfolio can vary from one individual to the next, in five years’ time it will be apparent that each investment opportunity either is or is not sound; and today you must either act upon it or decline to do so. Four possible outcomes, set out in Table 1, therefore present themselves. Two are usually regarded as ‘good’: that in which a sound investment opportunity is grasped and that in which an unsound one is avoided. Let us regard the third outcome, in which a sound opportunity is not grasped, as ‘bad.’ And let us regard the fourth, in which an unsound investment is purchased, as even worse.

Table 1: The Investment Process:
Four Possible Outcomes and Two Inherent Risks

Table 1 shows that two risks inhere in every investment decision. The first is a ‘Sin of Omission,’ i.e., the possibility that a sound opportunity is declined and the investor foregoes a financial gain. The second risk is a ‘Sin of Commission,’ i.e., the possibility that an unsound investment is acquired and the investor eventually incurs an actual financial loss. The magnitude of these risks may vary considerably. ‘Sins of Omission,’ for example, may vary from the significant (i.e., foregoing the opportunity to acquire an asset which earns a compound return of 15% per annum) to the severe (i.e., foregoing the opportunity to invest in Buffett Partnership Ltd during the 1950s or 1960s or Berkshire Hathaway during the 1970s or 1980s). ‘Sins of Commission’ may also vary from the modest (i.e., acquiring an asset which returns less than that available from a ‘risk free’ government bond) to the catastrophic (i.e., investing large sums in an enterprise which collapses and becomes worthless).

Experiment #1

Consider now an ‘experiment’ which consists in you as an investor, 100 potential investment opportunities and 100 investment decisions. Let us say that you are perfectly prescient: your crystal ball can gaze five years into the future and determine with perfect precision which of the opportunities is (for my purposes) sound and which is unsound. Unfortunately for me, however, you do not give me the benefit of your knowledge. Assume that 50 opportunities are sound and 50 are unsound, that my ‘accuracy rate’ is 50% (i.e., my assumptions and analysis can ascertain the soundness or otherwise of each opportunity with 50% accuracy) and that my ‘acceptance rate’ is also 50% (i.e., given an assessment of a sound opportunity, the likelihood that I act upon it is 50-50).

The results in five years’ time of your and my investment decisions, if they were repeated over a large number of ‘experiments,’ would approximate those set out in Table 2a. As an omniscient observer, your decisions (the cells of the table labelled “100% Accurate”) would correctly identify each of the 50 sound assets and correctly ‘purchase’ them; similarly, they would correctly identify each of the 50 unsound assets and correctly refrain from ‘buying’ them.

Table 2a: Expected Risks Arising from a Series of Investment Decisions
With a 50-50 ‘Acceptance Rate’ and a 50-50 ‘Accuracy Rate’

But my decisions, remember, are fallible. At the aggregate level the true numbers of sound and unsound assets (fourth column) correspond exactly to the total numbers the numbers which I actually buy and decline to buy (bottom row). With respect to individual investment decisions, however, for various reasons I make mistakes. Given that each of my decision is, on average, 50% accurate (labelled “50% Accurate” in the table), I will tend correctly to purchase 25 of the sound investments but erroneously decline to purchase the other 25. Similarly, on average I will accurately decline to purchase 25 of the 50 unsound investments but mistakenly buy the other 25. As a result, the two investment risks come to fruition: one-half of the assets (25+25) are either wrongly purchased or wrongly declined. My investment results under these circumstances are no different from those which would occur if I simply tossed a fair coin.

Experiment #2

Assume that five years later I am faced with another series of 100 investment decisions. Given the results in Table 2a, I am chastened. I cannot be certain which of the 100 new opportunities is sound and which is unsound. During the past five years, however, I have learnt that the expected number of dud investments in a portfolio (and the magnitude of the earnings and investment capital lost) can be reduced by lowering one’s ‘acceptance rate.’ Let us say that I lower it from 50-50 to 20-80.

During the past five years I have also realised that one can reduce the total risk which inheres in a series of investment decisions by increasing the average accuracy of each decision. I have therefore increased the quality and quantity of the information which I use to make decisions; improved my ability to reason through and interpret this information; and reduced the extent of the psychological biases which mar my judgement. Let us say that these improvements have increased my average accuracy from 50% to 75%. (On an average three out of every four occasions, in other words, I am able correctly to ascertain whether an asset’s market price is safely less than its intrinsic value). Otherwise all else remains equal: you are omniscient and 50 of the 100 investment opportunities are sound.

The results of our decisions, if taken under these assumptions over a large number of sequences of 100 trials, would approximate those set out in Table 2b. As an omniscient observer, your decisions continue to identify each of the 50 sound investment opportunities and to act upon them; similarly, you continue to identify each of the 50 unsound investments and to avoid them.

Table 2b: Expected Risks Arising from a Series of Investment Decisions
With a 20-80 ‘Acceptance Rate’ and 75% ‘Accuracy Rate’

Again, however, I am not omniscient and therefore continue to make mistakes. Given my stringent 20-80 acceptance rate, I act upon just 20 opportunities; and given my 75% accuracy rate, 15 of these 20 are assessed correctly. I thereby invest correctly in 15 of the 50 sound investments – and mistakenly forego 35 others. On the other hand, I correctly avoid 45 of the 50 unsound opportunities and mistakenly accept the other five.

The assumption of a much lower ‘acceptance rate’ and a higher ‘accuracy rate’ thus has three fundamental consequences. I will tend to respond to far fewer unsound investment opportunities and thereby commit far fewer ‘Sins of Commission’ (5 in Table 2b versus 25 in Table 2a). On the other side of the coin, however, I will also tend to forego significantly more sound opportunities (35 in 2b versus 25 in 2a) and thus commit more ‘Sins of Omission.’ The first consequence is therefore that the distribution among the two competing investment risks changes substantially: there is a decrease in the occurrence of real financial losses and an increase in the forfeiture of hypothetical financial benefits. The second consequence is that the ratio of ‘sound’ to ‘unsound’ investments in my portfolio increases from 1-to-1 (i.e. 25:25) in Table 2a to 3-to-1 (i.e., 15:5) in Table 2b. Finally, given better standards of analysis and more stringent criteria of decision-making, total investment risk – i.e., my total number of erroneous investment decisions (25+25 in Table 2b, 5+35 in Table 2b) – falls from 50 to 40.

As with jury decisions, so too with investment decisions: the major difference between Tables 2a and 2b is that a subjectivist ‘trade-off’ of risks has occurred whereby many fewer dud investments are purchased but more sound investments are overlooked and foregone. One risk which Graham-and-Dodd value investors regard as completely intolerable, in other words, is willingly ‘traded’ for another which they regard as undesirable but nonetheless tolerable. This is the basis for Graham’s Two Rules of Investing. Rule #1 is that one mustn’t lose money. Rule #2 is that one mustn’t forget Rule #1.

...continued in Part III

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