Do not confuse fear and risk

By DAVID MOON, Moon Capital Management, LLC
September 15, 2013

Successful investing is, as much as anything else, about identifying and properly pricing risk.

Unfortunately, however, our industry does a disservice to its clients in the way we typically talk about risk.

We misdefine it, talk around it and subject clients to risks they don’t even know exist.

Since the 1960s, our industry has preached that risk equals the historic price volatility of an investment. Historic volatility is convenient. It is relatively simple and can be calculated with precision.

It is not, however, risk. Every investment managers has chosen not to buy something because the price might decline. I’ve never known one who refused to buy something because its price might move around.

Conventional industry wisdom suggests that in order to earn higher rates of return, investors need only assume more risk.

Common sense, however, suggests that if higher risk investments produce higher returns, they aren’t higher risk.

Many people confuse risk and fear. It is the inability to evaluate risk that creates fear.

And the inability to evaluate risk typically comes from a lack of information or experience.

My wife is afraid of snakes. I am not. I have been bitten twice by corn snakes and did not die either time. Getting bitten felt like being slapped by a strip of Velcro.

I have more experience and first-hand information about the dangers of snakes around my house than she does. Our risk of being bitten is about the same, but she has a greater fear.

Despite the effort of most of the investment community to argue otherwise, risk is not a simple issue. It is multifaceted and imprecise.

There are other types of real risks, none of which can be calculated to two decimal places like beta or standard deviation. There’s a risk that your expectations aren’t met. There is a risk that your investment will lose ground to inflation, or that you might need to liquidate your investment at a time when there are few buyers for it.

There is the risk of an outright permanent decline in the value of your investment.

People innately recognize these risks, even if their advisor can’t express them neatly in a two-digit statistical calculation.

Most investors, however, have no idea of one of the most prevalent risks of working with an investment advisor: career risk.

Howard Marks describes career risk as what happens when the person managing the money and the person whose money it is are different.

In order to manage money, investment advisors need money. The risk/reward ratio between manager over performance and underperformance is not symmetrical. That is, a manager loses more client assets for underperforming a benchmark or similar managers than he gains by outperforming them.

As a result, too many (or perhaps, most?) managers focus on making certain that neither their investment choices nor their returns differ much from those of the crowd. That’s how clients often end up with seven or eight mutual funds that expensively and unknowingly replicate the entire stock market.

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

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