How do you define risk?

December 18th, 2006

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The answer to this question depends on whether you are investing from the retail level or investing along with the legendary investors of excellence.

First, let?s look at the former case. In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time. Since volatility does not engender the feeling of safety and confidence, it is to be avoided as risk wherever possible. The root motivation of this kind of perception is fear?the fear of losing it all. To assuage such fears, the financial services industry came up with ideas like portfolio management and asset allocation, in which their aim is to structure investment portfolios for the purpose of ‘controlling’ volatility, and thus risk, for a given return. However, in truth, no one can control volatility as much as the thermometer controls the weather. The best that can be done is to reduce the effects of volatility using past volatility behaviour as a guide.

Now, if you want to achieve results of excellence in your investment endeavour, you have to see risk differently. As contrarians, we define risk in terms of the soundness of the underlying economic and financial state. This implies that in order to understand the risk of an investment, we have to really understand the fundamental nature of the investment itself. Thus, if we invest according to our understanding of the economic and financial soundness of the investment, we should not let its short-term volatility perturb us.

To further illustrate today?s point, look at our views on gold. For this year, the gold price had been very volatile. Thus, compared with cash, the mainstream would see that gold is more ?risky? than cash. But in reality, if you understand the nature of today?s monetary system and economic reality, you will see that cash is in fact far more risky.

Hence, know your stuff.

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