What is the biggest risk?
This is a regular question that I get asked at meetings with investors and mutual fund distributors. It is even more common today as markets have moved up to a record high and valuations have pushed significantly higher. This question presupposes that I have the skills to discern the risks in the market. Blessed as I am with a worrying & skeptical nature, I see risks all the time. But, the problem with risk is that the biggest and market disrupting risks are those that I cannot see. Worse they are the unknown unknowns. I don’t even know that they exist. I don’t even know that I must worry about them.
The usual stuff today is all rather well known – inflation, reversal in rate cycle or capital flows, a further spread of the virus etc. But to the extent that these are known risks they are likely already reflected in the market. Unless I have a significantly varying perception versus the consensus and I am right about the outcome, this risk may already be discounted by the market. As an example, I could argue that inflation concerns and an end to the down rate cycle are likely already embedded in the markets. However, if I expected a Consumer Price Index (CPI) of say 8-9% in India by the end of this year and a strong rate hike cycle then I would have a view at significant variance to the consensus. The markets would likely react sharply to such an outcome because such an outcome lies far away from the consensus that is discounted.
The biggest market moving risks are typically the things that were unexpected; not built into consensus or were something nobody had ever imagined. The Pandemic caused by COVID-19 was something that nobody had imagined except perhaps Bill Gates and a few others. Even the Global Financial Crisis (GFC) of 2008-2009 was a complete outlier, a true 6 sigma event for the markets because nobody expected the crisis to be so widespread and cataclysmic. By the way don’t think about risk as a one-way street. The only time I saw the market closed in an upper circuit was in May 2009 when the UPA won an election with an improved majority and the markets were super excited by the outcome. By the way those hopes were dashed over the next 4 years but on that day, it was enough of a surprise for the markets to close higher by nearly 17% on a single day.
There are many probable things that can happen in the future. Few may be good and few may be bad. But, just because they can happen does not mean that they will happen. In other words, the future can have different paths but the past has only one path and a specific outcome. More things can happen that will happen. And we may well be blissfully unaware of the existence of several risks.
A good investor has some sort of a risk model and can also evaluate various scenarios. In essence, all such models are pattern seeking and based on past experiences. However, as Gottfried von Leibniz, the polymath and philosopher said- nature does work in patterns, but “only for the most part.” The other part — the unpredictable part — tends to be where things matter the most. That’s where the action often is. So all the models in the world and knowledge of past cannot protect you from the future – both good and bad.
Unless you are perfect soothsayer you will never know for sure what the future holds. But, you can do something about the uncertainty. You could create a portfolio based on the fundamentals, valuations and level of diversification in the portfolio can navigate unexpected events and risks. That is the beauty of diversification - certain events in the future may be good for one industry/ company and bad for another. For example, just as the pandemic has been terrible for the travel, hospitality sectors it has accelerated growth & profitability for IT services. This is the first rule - diversification is the best way to protect your portfolio from the unexpected downside risks. Further the fundamentals (quality) of the companies you invest in also protect you against the unexpected. These principles work in both directions.
As the author and thinker Peter Bernstein describes it – ‘I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place. I want to make sure I’m exposed to it. Somebody once said that if you’re comfortable with everything you own, you’re not diversified’
When it comes to fundamentals it is slightly more subjective. An investment in a company that generates consistent cash flows and earns a high return on equity rarely goes bankrupt overnight. Diversification is insurance against such consequences - a bankrupt company could go to zero but a well-diversified portfolio (across companies with sound fundamentals) is hardly likely to go bankrupt. Of course, it could underperform benchmark indices that is a very different risk compared to a permanent loss of capital.
Many people think of risk management as an exercise to weed out all errors. But, in investing, it’s inevitable that some number of decisions that we have to make will turn out to be wrong. There’s just no way we can always make the right decision. So, what we need to worry about is the consequences of the decision if you turn out to be wrong more than just the probability of being wrong. Suppose this doesn’t do what I expected it to do, not just because it goes bad but even if it just doesn’t go up enough. What is going to be the impact on me? If it goes wrong, how wrong could it go and how much will it matter? But, you must think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.
So my response to those who ask me to forecast the biggest risk my answer is as follows
- No risk model is perfect - history and patterns tell you little about what can happen in the future
- Risk is more things can happen than will happen – good & bad
- Diversification is a survival strategy, it could also be an aggressive strategy
- When you think about risk - the consequences are more important than probabilities
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.