Here at PDV, we worry about risk of permanent loss of capital, rather than the risk of temporary or quotational capital loss. Permanent capital loss results from diminution in a company’s business value on account of deteriorating operations that are likely to persist over time, while temporary or quotational capital loss results from inevitable market fluctuations that generate “paper losses.” While less important in our view, the latter causes the most strain on people’s emotions, when they see the value of their investments and wealth gyrate with the vagaries of the market, often causing them to make investment decisions they later regret.
These different views of risk can be traced to the fact that for most people, risk involves some vague notion of the possibility of loss, but different people will ascribe varying meaning to the concept. Often omitted in the definition or analysis of risk is, for example, the issue of time horizon. Buying a high-quality stock at a reasonable price might be risky for a day-trader whose time horizon is only one day; the markets are so irrational and random over the short run that anything can happen to the price of a high-quality stock in a single day. Buying the same stock to hold for ten years or more makes the same purchase a lot less risky.
Marty Whitman, the legendary value investor, has one of the most intelligent ways of viewing risk. He thinks that the word “risk” should not be viewed in isolation, but one should always be precise in defining what type of risk one is talking about. Whitman therefore is careful to use adjectives to describe what type of “risk” he’s discussing, whenever he’s opining on this subject.
It may be surprising to some of you that there are in fact many different types of risk when it comes to investing. These risks are sometimes mutually exclusive; trying to avoid one would necessarily mean that you will have to assume another. For example, the risk of losing purchasing power is one of the most subtle and yet important risks that inflicts those who “safe-keep” their money in a bank account. With the eroding effects of inflation and taxes, depositors are in fact generally losing purchasing power over time after taxes and inflation.
Market risk is the risk that the publicly-quoted prices (but not business values) of your investments fluctuate along with the uncertain and unpredictable nature of the markets. It is mostly a short-term concern, as stock prices and underlying business values tend to converge over time. A long-term investor might welcome market risk, so that she can buy in at attractive prices.
As can be seen from these different types of risk, a simple notion of risk would not adequately capture the complex nature of risk trade-offs. One must be clear what exactly is the risk being managed. All prudent efforts to address or manage risk will usually require making conscious choices that will exchange one set of risks for another. Having these distinctions clearly in mind will increase the odds of success for investment decisions.
PDV would be happy to assist you in making decisions regarding what risk trade-offs to undertake.