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One of the books listed in the Books section of this blog is Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk. In this book, Bernstein delves into the importance of risk assessment. It traces developments from ancient times to the modern financial era and emphasizes the critical role of risk assessment in decision-making and highlights how misperceptions can lead to sub-optimal outcomes.
When we are relatively new to investing, the tendency is to look at the potential return of our investments. Once we invest for a prolonged period, we realize that risk assessment is an important component of the investment decision making process.
Typically, most investors will have ‘what the heck’ thoughts when an investment implodes. Once we overcome these immediate thoughts, however, we should reflect on how/why we made a terrible investment decision. The purpose of these terrible investment decisions should reinforce the need to be humble and not greedy.
In several recent posts that are accessible through the FFJ Archives, I touch upon various topics that deal with the risk aspect of investing. In keeping with my focus on risk management, I share the following from Bernstein’s tome; reading this book cover to cover in one sitting is virtually impossible!
Focus on the Downside: The Importance of Risk Assessment
Bernstein underscores that while potential gains often attract attention, understanding and mitigating potential losses is paramount. This is exceedingly important when we are experiencing euphoric market conditions; you have to know that all is not well when the share price of TERRIBLE companies defy gravity.
The focus on the downside is essential because overestimating potential returns without adequately assessing risks can lead to a permanent impairment of capital. If we prioritize risk assessment, we can make more informed decisions that align with our financial goals and risk tolerance.
Investing can be emotional. Unless we focus on the downside, the emotions of fear and greed can lead to poor decisions.
By considering the potential downsides of different investments, we can gauge the extent to which we are prepared to assume risk. If we do not conduct a proper risk assessment, we are apt to enter into investments that pose far too much risk.
This applies to all forms of investing.
For example, a reputable real estate broker in the Greater Toronto Area (GTA) in Ontario, Canada recently recounted a situation in which two couples purchased a home together around late 2023/early 2024. The two males had been friends for many years, and therefore, proposed to their respective spouses that they pool their resources to buy a nice home versus purchasing two separate smaller and more affordable dwellings.
I think you can guess where this is going!
A year into the purchase, the employment situation of one couple takes a dramatic turn for the worse (ie. unemployed).
Now, one couple is unable to afford their share of all the costs associated with being a homeowner leaving the couple that is still employed to carry the vast majority of the financial burden of home ownership.
I don’t know the outcome of this story but given the current real estate market conditions in the Greater Toronto Area (GTA) in Ontario, Canada, a sale of this home is very likely to result in a significant loss.
This story demonstrates how improper risk assessment can destroy wealth.
Furthermore, I suspect the long-term relationship of these two friends is now severely strained.
Regression to the Mean: Distorting Performance Perceptions
The concept of regression to the mean suggests that extreme performances are likely to move closer to the average over time. Bernstein points out that investors often misinterpret short-term exceptional results as indicators of long-term trends which often lead to misguided expectations. If we recognize this statistical phenomenon, we can set realistic performance expectations and avoiding the pitfalls of chasing past successes.
When it comes to investing, investors often flock to recently strong performing investments under the assumption this trend will continue. Regression to the mean, however, suggests a stock’s recent extreme return is likely to gravitate toward the long-term average. This can lead to disappointment and losses for investors who buy high and sell low.
On the flip side, great companies periodically fall out of favor for various reasons and the stock prices comes under pressure. If a company falls out of favor because of ‘temporary’ circumstances, there is a reasonable probability the share price will eventually revert to the mean. When this happens, however, is difficult to predict.
A good example of investing in great companies when they temporarily fall out of favor is Intuitive Surgical (ISRG). In 2022, I wrote 3 posts in which I disclose additional ISRG share purchases because of the company’s attractive long-term outlook and surprisingly attractive valuation because of short-term headwinds; I also disclose my 2022 ISRG purchases in my monthly FFJ Portfolio reports.
Sometimes we can misattribute skill to luck. Could I have been lucky with my ISRG purchases? I am certain there was an element of luck.
I have also been extremely fortunate with some of my other investments. By no means, however, can I attribute this performance entirely to skill. If I were that skilled I would have committed far fewer errors of commission and omission over the past roughly 4 decades in which I have been investing.
The platform of one of my discount brokers reflects a 73.14% 3 year rate of return for the US component of one of the ‘Core’ accounts within the FFJ Portfolio. The rate of return over the same time frame for the much smaller Canadian component of the account is 30.92%.
I am under no illusion that I will generate these returns going forward. This is why I extrapolate the total value of my portfolio using a ~10% long-term annual rate of return. Applying the Rule of 72, I envision the total value of my portfolio doubling every ~7.2 years. This may be unimpressive to some but I choose to be conservative when trying to gauge future returns.
Overreacting to short-term share price fluctuations is especially common amongst ‘investors’ who base their investment decisions solely on share price behavior. If we understand our investments, we are less likely to make irrational investment decisions and are more likely to ride out negative short-term price fluctuations.
Do not underestimate the importance of long-term trends. Regression to the mean suggests the long-term average returns are a better indicator of future performance.
Diversification May Increase Risk
Diversification is a fundamental strategy aimed at risk reduction. The rationale is that a diversified portfolio will yield higher returns and pose a lower risk than individual securities or homogeneous portfolios. The concept of a diversified portfolio calls for holding different asset classes, such as stocks, bonds, real estate, and commodities, as well as different sectors, such as technology, healthcare, and energy.
Bernstein, however, notes that not all diversification leads to reduced risk. In some cases, increasing diversification might actually increase risk.
Naive diversification, where we invest equally across all available options without considering their individual risk profiles, can inadvertently increase a portfolio's overall risk. This naive approach may expose investors to assets that do not align with their risk tolerance or investment objectives. This underscores the need for strategic asset selection.
Take another example where an investor owns Exchange Traded Funds (ETF) that focus heavily on the technology sector. Adding shares in individual technology companies to the portfolio will increase and not lower risk.
Increasing diversification might increase risk if an investor invests in a large number of different asset classes or sectors. This increases the level of difficulty in tracking all investments and making informed buy/sell decisions. It can also lead to higher transaction costs if the practice is to regularly rebalance the portfolio.
To strike a better balance between diversification and concentration, I made a conscious decision in 2024 to reduce the number of companies to which I have exposure.
In my 2024 Year End Review, I disclose the number of holdings I have in the FFJ Portfolio and in retirement accounts for which I do not disclose details. In addition, I disclose the extent to which my top 10, top 20, and top 30 holdings make up my exposure. Although I made a few sales and purchases following that post and now have exposure to 48 US companies and 7 Canadian companies, my weightings are likely very similar to the end of 2024.
Some investors may argue that my heavy exposure to US companies is a risk. I recognize and accept this risk knowing that many of my US holdings are multinational.
Behavioral Biases Can Lead To Irrational Decisions
Bernstein explores the psychological factors contributing to irrational investment behaviors.
Cognitive biases, such as overconfidence, can lead investors to overestimate their knowledge and underestimate risks, resulting in excessive trading and potential losses.
Emotional biases, such as loss aversion where we have the tendency to prefer avoiding losses over acquiring equivalent gains, can lead investors to hold losing investments too long or sell winning ones too soon.
The following are other forms of emotional bias.
Herd behavior is the tendency to follow the crowd, even if we do not agree with the crowd's decision. This type of behavior occurs when we experience the temptation to invest in a company, even if we do not know much about the company or its prospects, because ‘everyone else’ is investing in the company. This behavior can lead us to invest in bubbles and overvalued assets.
Overconfidence leads investors to overestimate their abilities and knowledge. We may, for example, believe we are better at picking stocks than we actually are. This can lead to taking on excessive risks thus increasing the probability of suffering significant losses if our investments do not perform as expected.
As noted earlier, fear and greed can also influence our investment decisions. For example, out of fear we may be more likely to sell our investments during a market downturn - even if this unwise.
Loss aversion, where we have the tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain, is another emotional bias. An investor may, for example, be more reluctant to sell a losing stock, even if it is likely to continue declining, rather than realize the loss. This can lead an investor to hold losing investments for too long in the hope of a recovery.
Clinging to Bad Ideas
Clinging to bad ideas can result in disregarding contradictory evidence and failing to adapt to changing market conditions. This stubbornness can sabotage returns, as it prevents the adoption of more effective investment approaches. Awareness and acknowledgment of these biases are crucial steps toward more objective and successful investing.
Investors may persist with underperforming strategies due to ego and confirmation bias; confirmation bias is the tendency to favor information that confirms pre-existing beliefs.
Here are some specific examples of how ego, bias, and clinging to bad ideas can negatively impact our investment decisions:
- Overtrading
- Chasing Past Performance
- Failing To Diversify
- Ignoring Risk
- Holding Onto Losing Investments
When ego is involved, an investor tends to overestimate their abilities and knowledge. This can lead to overconfidence, where we believe we know more than we actually do and take on excessive risks. We might ignore advice from others, dismiss warning signs, and make impulsive decisions based on our gut feeling rather than careful analysis.
Whether we realize it or not, we all have biases that can cloud our judgment and lead us to make irrational decisions. For example, confirmation bias can make us seek information that confirms our existing beliefs and ignore information that contradicts them.
Sometimes, we develop an attachment to certain investment ideas, even when the evidence suggests they are not sound. This can be due to a number of factors, such as sunk cost fallacy (where we do not want to admit we made a mistake) or the fear of missing out (where we believe an investment will make us rich quickly).
Final Thoughts
The science of risk management sometimes creates new risks even as it brings old risks under control. We must, therefore, be wary of adding to the amount of risk in the system.
A good example of how our faith in risk management encourages us to take risks we would not otherwise take is the use of derivative financial instruments. These instruments may have been designed as hedges but they have also increased the temptation for some investors to use them as speculative vehicles which can magnify payoffs while also leading to the assumption of risks that no corporate risk manager should contemplate.
Against the Gods: The Remarkable Story of Risk is not light reading. Nevertheless, it is a worthwhile read to learn about the importance of a balanced and informed approach to risk.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
