Risk: Actual Versus Calculated

Risk is an often misunderstood concept. At the most basic level, risk is the likelihood (e.g., probability) that a particular event occurs and the impact of that event.  Another way to think about risk is threat multiplied by vulnerability multiplied by the asset value. 

In my experience, the ability to confidently and accurately calculate risk by anyone is suspect. Every assumption that went into the risk estimate is subject to error and abuse. In practical terms, I would have no way of verifying a variety of published economic numbers. Moreover, Jeffrey Gundlach, the Barron’s proclaimed “Bond King” has been repeatedly warning of economic numbers being revised downward since 2018, drawing into question the efficacy and reliability of the data. 

In practical terms, let’s explore the different types of risks that investors face with any given investment.

Strategic risk - threats to a company’s overall goals, direction and objectives. Typical examples include poor market research, failing to adapt fast enough to industry changes or a new disruptive competitor enters the market.

Operational risk - day-to-day issues that may arise simply from business as usual operations.  Typical examples include dislocated supply chains, cyber attacks, human errors and omissions, equipment failures. 

Financial risk - Capital loss exposures born from market fluctuations, liquidity or credit tightening. Typical examples include changes in interest rates, market crashes, and expanding open receivables.

Compliance risk - legal penalties, sanctions, fines, or reputational damage born from failures to adhere to law, regulations, and internal corporate mandates. Typical examples would be data protection standards being ignored and personal data being breached, environmental standards, health and human standards violations.

Despite publicly traded U.S. corporations from periodically disclosing their risks in SEC filings, the reality of idiosyncratic risks facing corporations today has never been higher. The increasing complexity and sprawl of the extended supply chains, co-sourcing and outsourcing arrangements, has made the risk picture even murkier. 

So in practical terms, the way I am gauging risk is through a subjective set of variables that I estimate for each of my asset classes and assets in my portfolio.

Liquidity, or the ability to sell at or near the current price quickly is one measure.  I like this measure because if I need to sell real estate, I know it is not a highly asset and would require time and/or deep discounts to the price to transact quickly.

Valuation method, or the way in which the price has been established, is another key measure.  If the price was set today through thousands of transactions in the open market, then I have confidence in the valuation. If on the other hand, the valuation is set by a private equity firm for an asset that has no recent comparable sale, then I have less confidence in the valuation. 

Idiosyncratic risk, or the risks unique to that specific asset is another measure. This has to do with the relative moat of protection and the circumstances that could impair a particular asset. Like weather damage to a coastal real estate investment or a regional conflict flaring up that disrupts operations (e.g., European corporations have faced these disruptions to operations in the past few years).

Ultimately, despite my best efforts to research and estimate risk, my confidence level in the accuracy and completeness of the risk rating is relatively low. Too many variables, assumptions, human interaction points, automated data collection methods, and competing agendas are at play for me to believe risk ratings calculated fully reflect the actual risk. Moreover, the risk level changes considerably day-by-day with changes in the global geopolitical arena, changes to technology and innovation, and changes to consumer preferences. My parents have warned of seemingly inoculated technology, like a camera that I am told was once ubiquitous across households and film developing services to produce the printed photos were once common place; today, mobile phones have built-in digital cameras so neither are stand-alone dedicated cameras frequently sold nor are the photos physically developed often today.  How can I, or any investor for that matter, practically assess the risk of companies earning and valuations with so many variables and the lack of consistent and verifiable data (e.g., how would we know the risk of tax laws changing in another country will impact the earnings of a company based in the US, or how would we predict the technology innovations that would make cameras and photos effectively free with digital imaging?).