Risk, Actually - from Perception to Reality.

Perceived vs Actual Risk

An important part of due diligence is to attempt to answer the seemingly simple question:

 

"what is the Actual Risk of this investment?".

Before discussing "Actual Risk", let's be clear about it's meaning. The Actual Risk is the exact chance of success or failure of an investment. Wouldn't it be great to know this? We could have our own guide-book to tell us exactly which investments fit our risk-reward profile and completely automate our wealth management according to a formula that all but guarantees success. It's not to do with minimising risk, rather it's all about understanding exactly what the risks truly are, but knowing it is clearly something worth striving for.

A brief reflection on risk

For many (not all) investors, preservation of capital is at least as important as the returns on the investment. That of course is why understanding the risk is such a big deal. Risk of poor performance is one thing, risk of losing your capital investment is quite another.

We have to deal with risks outside of the investment's control, such as hoped-for opportunities not presenting themselves or the occurrence of un-planned threats to the business, for example serious economic downturns or indeed a pandemic.

On the other hand there are risks at play within the investment's control which can lead to that investment going badly wrong, including the failure of the business to play to its strengths and of not addressing its weaknesses. Poor management, lack of integrity and openness from management, to name but three, can also come into play here too.

The less we know about something, the greater the potential risk to us.

The problem is, we can NEVER truly know the precise, actual risk of any complex activity like an investment until looking back at events when the party's over - by which time it is too late to invest. We can easily be wise after the event; "that was doomed to failure!"; "this was bound to be a success". More than one Hollywood movie has taught us it's easy to win big at the races with the help of a time machine!

When "near enough" is "good enough"

What we can do is reduce our uncertainty about the risk of possible investment outcomes by researching the investment as rigorously as we can economically do. I say economically because we all have a budget of time and money and the secret is to use them both wisely to investigating the right elements of the investment, with the right expert help, to give us the maximum cost-benefit for that time and money. Doing more and more research will usually result in diminishing returns (also known as Analysis Paralysis) and another skill is knowing where and when to stop : what is good enough.

Perceived Risk

When considering any possible investment, we all start with our own Perceived Risk: that is, our assumptions, our overall impression, our biases, combined with our initial lack of knowledge of the investment itself. We might at first be disposed towards it (eg. inspired and excited by effective salespersons), or shun away from it, based on those early judgements we rightly or wrongly form in our minds.

To keep things simple, let's ignore our various human biases and focus just on our knowledge.

Introducing the Risk Profile Pyramid

When starting to research an investment, the very extreme case, when we know nothing, the range of Perceived (or possible) risk is all the way from 0% (certain success) to 100% (certain failure). As we research, make discoveries about it and draw objective conclusions, we reduce that range. We hopefully find reassuring data (such as proclaimed security of capital) and perhaps disturbing information (such as lack of experience of the managers). This might eventually reduce that range to between say 40% and 90%.

The Risk Profile Pyramid
The Risk Profile Pyramid

Looking at the diagram, we suggest that every due diligence process starts at base of the pyramid. Here, the Perceived Risk is at its greatest: highly subjective, essentially our pure "gut reaction" when we first encounter our investment proposition. At one end of the base we have someone's rose-coloured view: so enamoured with the opportunity that to them the risk is negligible to zero and in effect sadly irrelevant to them. At the other end of the base is the opposite extreme: the perception that the (very same) investment is doomed to failure!

Of course the reality is very likely to be between those two extremes: somewhere on that baseline. The highly-desired Actual Risk that we can never truly know, is that single unattainable point at the apex.

The result of the due diligence we do is to improve our understanding of the risk, by researching all that is relevant and practical about the investment and the organisations behind them and to move us closer to the "Nirvana" of that unreachable place, the Actual Risk. So every piece of insight we gain, every background check, every tick or cross on our investment checklist, brings us closer to knowing the Actual Risk, but never there.

Some may say it is pessimistic to assume that Actual Risk can never be found. But we live in a practical world and that, whilst one can get close that's the most that we can hope for.

Climb as high as you can, and be humble

Here's the thing though. As we follow the Due diligence arrow in the diagram upwards from the base, the cost of moving a step closer to the summit gets more and more difficult. Imagine a mountain where the higher you climb, the thinner the air and the harder to climb.

The good news in all of this is that when we use our resources wisely, and focus our energy on the right activities, we can climb far higher on a budget with an efficient plan and a good guide.

With our pragmatic approach we as investors end up with is a much better insight than the majority who gamble with investments without that knowledge.

The signs of a pragmatic, successful investor is the alliance of a sense of adventure with the humility of knowing they are only human.

In the end

Our Due Diligence will NEVER give us 100% certainty of an investment outcome (good or bad) - this would need a time machine. It will not even let us fully know what the Actual Risk is because we can never be omniscient enough to factor in every possible eventuality! But, it helps to know that our research when done correctly and proportionately, reduces the range of possible risks (that is our uncertainty) to the point where for us, we know enough to make an informed decision about whether the investment risk suits our personal appetite.

It's not so glamorous when you don't reach the summit - and the bragging rights are fewer. But boy, the view is still incredible - and beyond anything that many will ever see.