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Two ways investors can cope with uncertainty and risk

23/02/2017

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

The lead character in Up may have coped with the randomness of life by travelling the world in a house powered by helium balloons, but investors can make use of a couple of more conventional techniques

 

“Daddy, why is the man crying in the hospital?” “Daddy, where has the lady gone?” “Daddy, why are your eyes watery?” These were all questions my son asked me as we watched the first 10 minutes of the Pixar movie Up. If you have seen the film, you will immediately know what I am talking about. If you haven’t, you can catch the clip here. Don’t forget to have a hanky ready.

The film’s opening montage deals with some of the most difficult issues we face in life – notably, serious illness, death and coping with bereavement. Not the most promising start for a light-hearted animation primarily aimed at children, you might think, but they are unusually clever people at Pixar – as can be seen from the thoughts of one of the company’s co-founders on the subject of dealing with randomness …

“Here’s what we all know, deep down, even though we might wish it weren’t true: change is going to happen, whether we like it or not. Some people see random, unforeseen events as something to fear. I am not one of those people. To my mind, randomness is not just inevitable; it is part of the beauty of life. Acknowledging it and appreciating it helps us respond constructively when we are surprised.” Ed Catmull, Creativity, Inc.

Catmull’s quote drills right to the heart of the complicated concept of uncertainty – of risk – that is such an important part of the world of investing. And, to echo Catmull’s last line, acknowledging the nature of risk is a crucial first step for any investor.

 

What is risk?

Many investors feel the greatest risk is how much a share price bounces up and down over any period of time — its volatility.  We think about risk differently. We focus on the risk that lies within individual businesses and specifically two ‘fundamental’ points:

  1. The true worth of a company’s assets
  2. How much profit a company can make (in normal market conditions)

The risk for us is if these two ‘fundamentals’ change permanently from where we expected them to be when we invested in a company. No one can predict the future; this is something we are keenly aware of.  Often these fundamentals do change, but our awareness that change happens  means we prudently plan for it.  

 

How to cope with risk and uncertainty?

1. Margin of safety

Margin of safety (or margin of error as some say) describes how much the fundamentals of a company can change before the price you paid for its shares proves to have been too expensive.

The great investor Warren Buffett has explained the idea of ‘margin of safety’ with the analogy of a bridge:

You’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle. If the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.

For a more detailed explanation this Business Insider article is a good read.

Translating this into investment, we want to ensure we purchase shares a low enough prices to allow for this uncertainty. The riskier we think the investment might be, the higher margin of safety will be needed.

 

2. Diversification

Most investors diversify – that is to say, rather than ‘putting all their eggs in one basket’, they create a portfolio from different types of asset. It is one of the more straightforward approaches to investing but also a tacit acknowledgement that you can never predict what is going to happen.

Building a single story around what might happen may make the future feel more certain but such an approach will leave you out of touch with reality and prone to making mistakes. For our part, since we are well aware we could be wrong, we only take small positions in companies. This diversification not only means the decisions we get wrong should not unduly hurt our performance – they should also be compensated for by the ones we get right.

 

To help drive home our philosophy I’ll leave you with another quote from Catmull:

“Fear makes people reach for certainty and stability, neither of which guarantee the safety they imply. I take a different approach. Rather than fear randomness, I believe we can make choices to see it for what it is and to let it work for us.”

The world is an inherently complex and uncertain place and so, as Catmull says, striving for certainty and stability does not guarantee we avoid risk. Up may tell us we can strap a load of helium-filled balloons to our house and the wind will blow us wherever we want to go. Its bigger and more important message, however, is that things do not always turn out as we planned.  It is how we deal with that which matters.

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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