Savvy investors understand real risk

By DAVID MOON, Moon Capital Management
February 8, 2004

One of the most exciting experiences in investing is the thrill of seeing your money grow 20 or 30 or 40 percent in a given year. It makes you feel rich and powerful. Or even bullet proof. But as exciting as such returns can be, for most people, extraordinary returns are seldom the most important factor in creating long-term wealth. It is just as important (if not more so) to avoid catastrophic losses.

The first reason is simply algebraic. If you lose ten percent one year, then earn ten percent the following year, you haven't broken even over the two years; you've lost one percent. (If you don't believe me, do the math, assuming an initial investment of \$100. After losing ten percent, you have \$90. When you earn ten percent in year two, your return is based on the \$90 you have to invest, not the original \$100. You only earn nine dollars in the second year.)

If you lose 30 percent one year, you need to earn 43 percent in the following year to get back to even.

Since the stock market increases an average of ten or eleven percent a year, it doesn't take too many years of horrible returns to put someone in a seemingly insurmountable hole. Then the risk is that the investor will feel compelled to take even more risk in an attempt to climb out of the hole. This is not a good plan.

As Will Rogers said, the safest way to quickly double your money is to fold it over once and put it back in your pocket.

One of the culprits in this circuitous path to lost riches is an investment community that has adopted a useless definition of risk - a definition that is easily quantifiable, but lacks little practicality.

For years, many researchers in the academic community have argued that volatility in the returns of an investment equals or measures its risk. The higher a stock's historic volatility, the greater its risk. Volatility was a nice definition, especially since it can be easily calculated to seven decimal places, using simple statistical formulae for things like standard deviation and variance.

But just because it is easy to calculate doesn't mean it's useful. There is no research to suggest historic volatility has any predictive value. And isn't that what we want to know? What is my risk going forward, not in the past?

A better definition of risk isn't as clear as standard deviation; it can't even be calculated. But it can be estimated. What is the possibility that a particular investment will cause me to experience a permanent loss of any of my original capital? What is the chance I won't get all my money back? I really don't care what the historic relationship was between the price movement in a particular stock and some artificial stock index. I want an estimate of the likelihood of the worst possible outcome. Now that's risk.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).