The philosopher’s risk taking, the fool’s risk management

September 6, 2021
by Noriyuki Morimoto

The risk of stock price volatility is an unavoidable and involuntary risk when investing in listed stocks, but it is not a fundamental risk. The fundamental risk is the uncertainty surrounding the sustainable growth of the company’s net operating cash flow. Of course, these two risks are closely related, but at the same time clearly distinct.

Since short-term stock price fluctuations are usually regarded as an issue, and therefore the need for long-term investment is emphasized, it is misconstrued as if the essential risk-taking object of stock investment is stock price fluctuations. However, stock price volatility is merely an incidental risk inherent in listed stocks. In fact, private equities that are not listed do not have the attendant risk of share price volatility due to market factors.

In investing in corporate bonds, there is credit risk and interest rate risk. Invariably, then, investments will be inconsistent unless one is subject to intrinsic risk-taking and the other to risk management.

It is difficult to define what is intrinsic risk-taking and what is incidental risk. Even more difficult is to bring ancillary risks under control in order to carry out intrinsic risk-taking. Excellent investors and asset managers can achieve excellent results on a consistent basis because they are able to do this very difficult thing consciously.

In investment, failure is often not due to intrinsic risk-taking per se, but to the failure of rigorous intrinsic risk-taking due to disturbances associated with ancillary risks. As a typical example, failures in real estate investment are often caused by excessive financial leverage which is not related to the real estate itself.

Moreover, confusing the subject of intrinsic risk-taking with incidental risk often leads to the foolish consequence of avoiding intrinsic risk-taking in the name of risk management.

For the wise investor, the object of intrinsic risk-taking is always rigorously, clearly, and consciously defined. When an investor is wise and adheres to intrinsic risk-taking, he makes a profit, and when he is foolish and mismanages risk, he makes a loss.

 

[Category /Investment Professional]