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Updated: January 10, 2011 12:18 IST

Pay attention to hidden risks

D. Murali
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You can probably save a good-size forest by recycling academic papers on risk and diversification, suggests Vitaliy N. Katsenelson in ‘The Little Book of Sideways Markets: How to make money in markets that go nowhere’ (www.wiley.com). These concepts are drummed into students’ heads in academia, but their practical application is usually spoiled by long formulas awash in Greek symbols, he frets, in a chapter titled ‘Think different.’

Taking up two common approaches to risk – one from the perspective of volatility (a stock declining in price, or returns falling below one’s expectations), and the other as permanent loss of capital (as put forth by Warren Buffett and Benjamin Graham) – the author says the truth is somewhere in between.

What risk means to us is shaped by our time horizon, he explains. “If you are investing for the long run – at least five years – a permanent loss of capital is the risk you should be concerned with the most. The distinction here is that if you are armed with a long-term time horizon, volatility is a mere inconvenience (and often an opportunity, especially in a sideways market).” On the contrary, to those whose time horizon is short-term, and so do not have the time to wait it out, even a temporary stock decline results in permanent loss of capital.

Emotional impact

Another important, although less tangible, issue with volatility is that it impacts our emotions and makes us do the wrong things such as buy high and sell low, cautions Katsenelson. He adds that for a very rational computer-like decision maker this is not an issue, but since we are not computers we should not ignore the emotional element of volatility.

The antidote is to “make reasonable attempts to minimise its impact on the portfolio through diversification, and/or own stocks whose business you understand, so that you can be comfortable with their price fluctuations.”

Alternative history

An insightful section in the chapter is on ‘alternative history,’ where the author warns of the danger in evaluating decisions by focusing solely on the outcome. “Let’s say the CEO of a company that has all of its operations in Grand Cayman decided to save a lot of money by cancelling the company’s hurricane insurance, saying something to his constituents along the lines of, ‘Why waste millions of dollars on insurance when we can put it into R&D instead?’”

There was no hurricane the first year, and the company’s earnings went through the roof, marking the best year in its history, reads the narrative. The question that the author poses is whether the CEO should be given a huge bonus for saving millions of dollars for the company, or be fired.

Lady Luck

While hindsight analysis based on observed history would tell us to reward the CEO, such a conclusion would completely ignore other very probably alternative paths and risk that had not surfaced (the hidden risk), instructs Katsenelson. He informs that there is a 44 per cent possibility that a hurricane will hit Grand Cayman in any given year, based on a study of 133-year data set of historical observations from 1871 to 2004 which shows that a hurricane hit Grand Cayman about every two-and-a-quarter years!In this case, the CEO made a very blind decision that exposed the company to grave risk, and then just got lucky, the author reasons. “When evaluation of results is based solely on observed risk, success is often attributed to skills of an investment or a corporate manager, and not to Lady Luck, who really deserves it.”

Eggs and baskets

Towards the end of the chapter is a section titled, ‘Too many eggs, or too many baskets?’ opening with a quote of Warren Buffett, thus: “I cannot be in 50 or 75 things. That’s a Noah’s Ark way of investing – you end up with a zoo that way. I like to put a meaningful amount of money into a few things.”

The author highlights that investors holding hundreds of stocks incur the cost of ignorance, the condition of being uninformed, because a very large number of companies in investors’ portfolios makes it impossible for them to know these companies well. He rues that lack of knowledge leads to an inability to make rational decisions, which then causes investors to behave irrationally and hurts portfolio returns.

In Katsenelson’s view, a portfolio of about 20 stocks is manageable and provides an adequate level of diversification; for, at this level, the price of being wrong is not too high, but every decision matters. He also urges investors to stress-test their portfolios (that is, playing out different what-if scenarios) because the exercise can expose the weaknesses of the portfolios in the case of hidden risks rising to the surface.

Recommended addition to the serious investors’ reading list.

**

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