THE DIFFERENCE BETWEEN RISK AND UNCERTAINTY Ambiguity Aversion

The Ellsberg Paradox offers empirical proof that we favor known probabilities over unknown ones. We stay away from uncertainty and try to give higher weight to known things. Risk means that the probabilities are known.

Uncertainty means that the probabilities are unknown to us. We can make calculations and decide either making bet or not while risk involved. But when uncertainty comes, we cannot make any calculations so decision-making becomes harder.

Only in very few areas where we can count on clear probabilities: casinos, coin tosses, and probability textbooks. Often, we are left with troublesome ambiguity.

Investment – We generally mixed up when we think about risk and uncertainty while investing. We tend to keep saying that we get higher returns where the risk is higher. But actually, we get higher returns where uncertainty is higher. When things started getting certain, valuation starts reflecting certainty, and chances of making good returns reduce.

COVID-19 pandemic is an uncertainty rather than a risk, and we can see that return comes after the pandemic event.

This entire series will be reviewed with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

Checklist about market cycle – 13 -MASTERING THE MARKET CYCLE

We cannot predict the future and cannot see the future so that can we prepare for the future? How can we be positioning our investments? Answers to these questions lie in the understanding of the cycle and at where we stand at the current cycle.

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It’s not always what we buy that matters but at what price we are buying that matters a lot.

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These checklists help us to an understanding regarding cycle and where we stand at the cycle. That understanding helps us with what we should do and what can be the portfolio positioning. These checklists also help us to remove some mistakes such as buying little when risk is low so that capital allocation decision also can be improved. The capital allocation also one of the key elements to becoming a successful investor.

We all see the everyday events which were covered by the media but we also need to put effort to understand that what it is going to indicate to us. These efforts help a lot to us. I got saved in recent market turmoil due to understanding of the cycle which I have practised after reading “The Most Important Things”.

MMC13 06-min

I want to quote my learning from the most important things here to explain this concept with a few additions.

The earlier scene in the year 2017-18

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The current scenario in the year 2019-20

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We need to focus on the current scenario what it is indicating to us, not to worry about the future. If the current scenario tells us to stay away and we are into the third phase of the bull market then we need to adjust our portfolio accordingly. And if the current scenario suggests the third phase of the bear market then we need to adjust our portfolio positioning accordingly. We cannot track each and every information flowing around the world but we need to understand which of them are important and help us to reach the conclusion.

When market and psychology of the investors flying then do not care for the valuations. People argue that old valuation techniques do not work in the current period. Another argument is that we should look at the business, not stock so that valuation does not matter. But what happens to this logic when bear take a charge?

Old technique again starts taking place. Higher P/E looks as an unhygienic for the health of the portfolio and low P/E tempted to the investors.

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We can see that during the bull period even non-qualitative companies also traded at the multiple of quality companies.

There are qualitative and quantitative two phenomena which we can study to understand where we stand in the cycle. We always need to ask the question to ourselves how the assets priced and how the investors around us behave? That means the quantitative part refers to the valuation of the assets. And qualitative part refers to the behaviour of investors around us & understand it.

MMC13 07-min

Example – one of the E-Commerce company of India

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When the market is booming, the psychology of investors is positive, economy growing, people are eager to make an investment then low-quality securities also getting issued by providing a better rating.

MMC13 08-min

We have to be contrarian, have to learn to go against the wind prevailing in the market.

When market falling, people tend to stay away from it. They argue that keep away from catching a falling knife. But when dust gets settled and we realize that the final bottom has made, a bargain will also be gone.

There is no way to know when and at what price exact bottom has made. We come to know about the bottom only after it has made.

MMC13 09-min

We should avoid buying with leverage money because when pendulum moves towards extreme pessimism then we cannot able to know where it will stop and we get a margin call, due to the leverage. We get a disastrous outcome of such an act.

John Maynard Keynes is reputed to have said: “The market can remain irrational longer than you can remain solvent.”

When the economy is in a troublesome period and investors psychology also negative then only, we get a good asset at a bargain price.

We have a two-risk scenario – one is a risk of losing money and the other one is a risk of missing out an opportunity. Investors have to make a balance between the risk. When market moving higher in the cycle, we have to focus more on the risk of losing money and when market-moving lower in the cycle, we have to focus on the risk of losing the opportunity. When there is a high chance of losing money then we have to play defensively and when there is a chance of missing out an opportunity then we need to play aggressively.

The cycle is going to happen and how we respond to it is the key matter. Successful investors are those who have survived under the different market cycle and that cycle makes them more thoughtful.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: Mastering The Market Cycle: Getting the odds on your side by Mr.Howard Marks

8 – THE CYCLE IN ATTITUDES TOWARD RISK – MASTERING THE MARKET CYCLE

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In a good time, people do not care for the risk. They believe that they will be able to generate a good return by taking additional risk. But what happens when bad time comes? Does this behaviour remain the same? No, in bad times, people change their focus on protecting wealth rather create it.

Investing means to build a portfolio position in a way that future development helps the potential profit generation.

But do we predict the future? Someone believes that they can. Since (a) investing consists of dealing with the future but (b) the future isn’t knowable, that’s where the risk in investing comes from. If we can accurately predict the future then would not be investing becomes so easy and everyone can perform it in a better way?

We do not even know what is going to happen with us in the coming few moments, then how we can predict the future of the corporate earnings and economy accurately. It is just a probability of occurrence of the events. The event may or may not occur, and if occurs then may not be on the time at where we have predicted. For becoming superior investors must have to understand, assess and deal with the risk. And without dealing with the risk, we cannot become a superior investor. It’s an essential element of investment success. How we behave with the risk is to decide investment success.

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It is overstated that the more you take risks, the more return you get. But if we take the higher risk then the outcome might be in lower or higher potential return. The concept should be, higher riskier investment should produce a higher potential return otherwise nobody will be going to invest in the particular assets.

 BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “UNDERSTANDING RISK”

If two investment avenue promises similar returns with differences into the risk scenario then we should choose the lower risk with assured return. Treasury bond and any other investment both promises same return then one should go with treasury investment.

Due to our risk aversion towards stocks, we remain careful while studying companies, keep a margin of safety, appropriate sceptical towards analysis, conservative to assumptions. For successful investing, we all need to focus on mentioned factors but not all perform these tasks and if perform then not every time.

MMC08 03

So, investors demand incremental returns forbearing of incremental risk. But when positive scenario plays out, people become less risk-averse than what they should. Now, they put less effort and less caution for performing an analysis. Not careful with a margin of safety, not demanding for the risk premium and resulting in it, prices of risky assets raise more compared to less risky assets. These reduce the incremental returns for the bearing incremental risk. The most unwise investment made during the good time rather in a bad time.

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So, the risk is higher when everyone feels that risk is lower. And the risk is lower when everyone feels that risk is higher. It’s all about temperament, comes with experience, no educational courses can teach it.

 Example – Maruti Suzuki – everyone bullish when marketing goods, majority of research reports indicated per capita car in India compared to others nations such as China, USA etc. but what happen when the euphoria has been wiped out then everyone has a threat of EV, disruption of business. We have to think that the country is the same, opportunity is the same. The scenario only changes from over-optimism to pessimism, liquidity has dries.

Cycle

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Just as risk tolerance had positioned them to become buyers of overpriced assets at the highs, now their screaming risk aversion makes them sellers— certainly not buyers— at the bottom. Here, people realize that they have made a mistake in selecting investment Avenue, selecting a particular stock, missed a few points in the analysis, etc. etc. But when the bull phase enters, they always made similar kind of mistakes which they realized during the bear phase.

We generally take more risks when we should avoid or behave in a risk aversion. And we behave risk aversion when we should take an incremental risk for incremental returns. We need to balance between too much and too little.

Such extreme behaviour tends to work as a cycle in the market.

MMC08 04

Risk arises when prices of the assets reaching towards high and started getting vague investment rationale to justify such a high price.

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If we want to save ourselves from the carefree market situation then we have to accept the lower comparative return during the carefree market scenario and have to look like an old-fashioned investor. This is only a way to save our reputation and wealth.

I have experienced the same in my investment career. I have mentioned many times in the past articles that I remain in huge liquidity position since the mid of 2017, and this has given me much rough and sarcastic behaviour from people. But now, they have lost their major part of the portfolio and I am searching for a good investment opportunity with a flat portfolio.

When a negative situation prevailing in the market, people tend to become more and unnecessary sceptical, they show risk-averse behaviour about the investment which they did not perform during the boom period. Such behavioural bias left them with a lower return with incremental risk. During the boom period, people have a fear of missing out an opportunity and during the negative period, they have a fear of losing the capital. When people have to show a risk-averse behaviour, they show a risk-tolerant behaviour and vice-versa.

MMC08 07

We always need to check; how much positive news is discounted into the price? Whether upcoming positive events already discounted into the price? Higher price compared to the intrinsic value left with a lower margin of safety. We have to be sceptical towards the decision making but sceptical in pessimism environment is for optimism and sceptical in the optimistic environment is for pessimism.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: Mastering The Market Cycle: Getting the odds on your side by Mr.Howard Marks

BIBLIOPHILE THE MOST IMPORTANT THING BY HOWARD MARKS

One of the books which have influenced me and my investment journey is “The Most Important Thing by Howard Marks”. This book teaches us the most important thing which we need to develop for becoming a wise investor.

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“The Most Important Thing” has many concepts which can help us to our investment journey. I have posted articles on the book. Now, I have compiled different articles into the one file for the ease of reading.

For, All in One Article click – BIBLIOPHILE THE MOST IMPORTANT THING BY HOWARD MARKS