Here on The Value Perspective we often talk about banks in the context of earning from them, but what about the potential for learning from them? After all, these are organisations that have to think about the financial ramifications of their actions every bit as much as investors so you would imagine we could pick up a few pointers– not least with regard to how they think about risk.
Different people have different perceptions of what constitutes risk in an investment. Some, for example, think in relative terms. This is how far their portfolio’s construction or performance diverges from a particular stockmarket index, respectively known as ‘benchmark risk’ and ‘tracking error’. Others fret about volatility, which is essentially how much the price of an asset or market fluctuates.
We view none of those as true risk, and neither do banks, nor their regulators. When banks consider lending money, they do not think about volatility and they certainly do not think in relative terms. Your bank doesn’t worry about whether Borrower A is slightly more or slightly less able to pay them back than Borrower B. The key risk-oriented questions occupying their minds are: what is the probability this borrower will default on our loan? And if they do default, how much do we lose? That is also the lens through which the banking regulator looks at financial risks to ensure the banking system is behaving appropriately.
This mirrors our own approach to assessing the risk associated with a potential investment. We ask ourselves what is the probability this company will go wrong? And if it does go wrong, how much do we lose?
This means we may buy a company even if there is a chance we will lose everything. We would, of course, want the risk of total loss to be small, and to be more than compensated for that tail risk* through attractive profits if the tail risk does not come to fruition.
This is precisely the reason why we construct diversified portfolios of 30 – 50 risk-adjusted positions. Given enough time, on average, there should be more stocks that recover strongly than those that do not. And of those that do recover, their positive contribution should significantly outweigh the negative effect of the disappointments.
*Tail risks include events that have a small probability of occurring and occur at the ends of a normal distribution curve.