On balance – Investors should not seek to reduce risk but weigh it up against potential rewards

While visitors to The Value Perspective could be forgiven for not sharing our taste in holiday reading material, they may well share our experience of the impact of small children on the odds of completing even one book by the pool. Fortunately, the first 50 or so pages of Risk by John Adams still provided plenty of food for thought.

Adams begins his book with a discussion of risk management, arguing the business of risk control can be split into two camps. The first is the formal element and encompasses everyone from government agencies and the emergency services to toxicologists, driving instructors and statisticians. They are, in short, “the authorities”.

“The work of this sector is highly visible,” writes Adams. “It holds inquests and commissions research. It passes laws and formulates regulations. It runs safety training programmes and posts warning signs. It puts up fences and locks gates. It employs inspectors and enforcers – many in uniform. Its objective is to reduce risk.”

The authorities do all this in the belief it is, first, possible and, second, desirable – and we will return to that point shortly. By far the larger camp in the business of risk control though is the informal sector, which is essentially the rest of us. However, while the authorities try to reduce risks, the informal sector attempts a different task – a balance of risk and reward. That, of course, should also be the aim of any investor.

Often when authorities try and minimise risk they only succeed in redistributing it – much like when you squeeze a long balloon in the middle and end up putting extra pressure on the two ends. Over the past 75 years or so, there have been many improvements in health and safety thinking with, for instance, commissions, inquiries and legislation all attempting to reduce the incidence of accidental and violent deaths. However, over that 75-year period, there has not been any reduction at all and the risk of being trampled by a carthorse, for example, has merely been replaced by the risk of being hit by a car. Risk reduced in some area has always found a new outlet.

To translate that into investment terms, back in 2007 some banks thought they could reduce their risk by packaging up bad debts and sharing risk. This belief enabled the banks to increase leverage, which actually ended up increasing the risk in the system.

Here on The Value Perspective we aim to balance risk and reward by adhering to the tenets of value investment and buying cheap shares with strong balance sheets. We are not looking to buy risk-free companies because they do not exist but, even if they did, all you would receive as a consequence of investing in them would be a risk-free return, which is less than attractive in today’s market.

Instead, each day, we unemotionally appraise how risky any business is versus its potential upside and then we buy the ones we believe are extremely attractive and ignore the ones we see as borderline as they do not offer a sufficient margin of safety.

One line from Adams that particularly resonated with The Value Perspective runs: “Learning to walk or ride a bike cannot be done without accident. In mastering skills, [young children] are not seeking a zero-risk life. They are balancing the expected rewards of their actions against the perceived cost of failure.”

That is precisely what value investors are looking to achieve. You do not try to buy things that have zero risk of failure, you try and buy things where, although there is a risk of failure, you are more than compensated for that risk and, within a portfolio of 40 or so stocks over the course of five or 10 years, you will be handsomely rewarded.

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