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In the picture part I - Risk is less about price volatility than the uncertainty of an asset’s future path

19/11/2015

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

In our eagerness to celebrate ‘Back to the Future’ Day on 21 October – in honour of which The Value Perspective wrote both Time and again)  and Where we’re going … – we neglected to mark another significant movie anniversary. For a fortnight earlier – and we apologise if, as it certainly did with us, the news makes you feel old – Forrest Gump turned 21. 

That whole film was about serendipity as Forrest passes through a sequence of unlikely events, along the way proving Mrs Gump’s point that “Life is like a box of chocolates – you never know what you are going to get.” It is an oft-quoted line though no more so, regular visitors to The Value Perspective may sometimes feel, than our own view that the future is uncertain and nobody can predict it. 

When it comes to investing, the more technical term for box-of-chocolate uncertainty is of course risk, which has been described by London Business School professor Elroy Dimson as the idea that “more things can happen than will happen”. Unfortunately, in our view, many investors then try to better this brilliantly succinct line by reducing risk to a single number. 

In this context, what they mean by ‘risk’ is in fact ‘volatility’ but that is not how we like to think about risk on The Value Perspective. We believe investors should be less concerned about the extent to which share prices bounce up and down on any given day and instead think more about how uncertain future paths can be and how they might stack the probabilities in their favour to enjoy superior returns. 

Having started this piece with a couple of film references, we thought we would try and represent that idea in pictures and, to do so, we will stand on the shoulders of giants. Well, one giant anyway. In his book, The most important thing, Howard Marks, the chairman of Oaktree Capital and one of The Value Perspective’s favourite investors, combines two common ideas to produce something more unusual. 

The chart on the left below illustrates the idea – with which, for the reasons outlined in Basic mistake, we do not particularly agree – that in order to earn greater returns, investors need to take on more risk. The second, on the right below, is a classic probability distribution chart – in this case a ‘normal’ one – which plots the likelihood of various events happening around a midpoint.

 

Source: Schroders, November 2015. For illustrative purposes only.

From these, what Marks arrives at, as we also saw in Basic Mistake, is the following chart, which offers a better, if more conceptual, picture of how risk and reward interact. On the left-hand side of the chart, for example, you have the smaller range of possible outcomes one might expect from less risky investments and then the increasingly more uncertain range of outcomes as you move up the risk scale.

 

Source: Schroders, November 2015. For illustrative purposes only.

Now, clearly equities would tend to be towards the right of this chart and yet, here on The Value Perspective, we would argue an additional and important consideration is that, the longer the period of time for which equities are held, the more their returns should gravitate towards the average – in other words, the more the distribution curve will be condensed. In ‘In the picture II’, we will show how we build on this idea to reach a more pictorial representation of risk in value-oriented equity investing.

 

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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