Acceptable Risk: Is it Worth the Reward

Risk is often understood in markets in a very limited context. In fact, classical finance treats risk as synonymous with volatility. That is NOT because it is so, but simply because Volatility is statistically measurable and capable of being mathematically manipulated, while most other elements of risk are not.

In the risk-return trade-off, return is eminently measurable and managers have a good time in doing so. In any historical analysis, therefore, the return is remembered and recorded for posterity, but the risk is forgotten. So a Fund Manager may have used very high-risk strategies (that are bound to fail disastrously in the long run), hoping that his wins will be remembered (as they often are), but the risk he took will be forgotten. I have seen this spectacularly in multinational finance companies, where managers have taken break-neck risks, front-ending the returns, knowing that they would have moved on, by the time the chickens come home to roost (as they eventually will).

This flawed understanding of the nature of risk leads to peculiar, and repeated patterns of behaviour among investors. For example, whenever you hand over your money to somebody else, rest assured that his attitude to risk would be less conservative than yours. Especially in case of Institutional investors. Remember: everybody’s money is nobody’s money.

Investors, especially institutional investors in competitive markets, know that they are ALWAYS judged by the return they produce, NOT by the risk they took. That is why every bull market is ended by a scam or a bankruptcy brought upon by an institution taking excessive risk to produce ever-higher returns. It is an unwinnable race against expectations, which must inevitably come to grief. Rare is the Warren Buffet or George Soros, who returns investor funds because he refuses to stay in such a race.

Investors worry about losing money only when they have already lost it. That is when risk (or the possibility of losing money, which is its real definition) moves to the forefront of their “hierarchy of considerations”. Till such time, they are only focused on returns.

So what is an appropriate response to risk? Diversification is one, both at the level of the individual scrip and at the level of the asset class. This is where traders make their biggest mistake. Day-traders, for example, never have any Tier II capital, which is ever adequate to take care of Margin Calls in a crisis.

This ability (to be Last Man Standing) itself would be a differentiator for a day trader. After all, this more than any other business, is subject to the Rule of Last Man Standing. Returns in this business are always above-average, but only as long as the investor is getting them. During a market reversal, the key differentiator is to be able to stay in the market when everyone is exiting. This is why Buffet calls his (insurance) business a “Super Cat” business, ie, he is only a temporary trustee of the market’s wealth, holding it till the market chooses to take it back during a “super-catastrophe”. So the key, implies Buffet, is not the many winning trades he makes (in the re-insurance market), but his ability to survive the “Super Cat”. He could get a smaller return on his trades, and still have a very high return, provided he was able to reduce the probability of losing his shirt in the Super Cat. The problem in such businesses is that there are not enough “Super Cats” in one man’s lifetime, to get any real sense of how much (Tier II) capital is enough. 

Institutional investors must take on Tier II and Tier III capital on their books (and pay for it), reducing their returns. The low-tier capital must be parked in low-return avenues, while the major part of the earnings comes from the Tier I capital deployed in the high-risk avenues. Overall, on a weighted-capital basis, the return is not outstanding.

Individual investors (and corporates) have no such disability. By their very nature, they have potential access to capital (spare debt capacity, for example) which is not currently used in their mainline activities. This can serve as the Tier II capital.

A high-risk trading strategy could be outstandingly successful in such a scenario, delivering hundreds of per cent in returns on a small amount of Tier I capital invested in the business. The key, of course, is not to let the tail wag the horse, and invest ALL your capital into such a strategy. The ability to draw into your Tier II capital is the key to success, not the elements of the trading strategy itself. No business can fail if it has access to unlimited capital, in a manner of speaking.   

Properly understood and implemented, this kind of Treasury strategy has helped build very good companies among manufacturing companies. The key is honing the ability to access capital in doses that are way out of proportion to the operational needs of the company’s mainline business.

The actual asset-side investments may be in equities, bonds, commodities, forex, derivatives, even real estate. This apparent high-return asset actually derives its strength from the liability side.