What is Risk?

There are few things in the world of investing that are as often misunderstood as the matter of risk. In my career, time and again, I have found it an uphill battle to impress upon investors that they must figure out their risk appetite before anything else. It doesn’t help of course that various billionaire legends regularly pour cold water on the very notion of risk. “Where is the risk?” they ask. If you know what you are doing, there is no risk, right? And after all, who doesn’t know what they are doing?

Warren-Buffett
A popular internet meme reminding investors of Mr. Warren Buffets wisdom.

Plenty of people as it turns out.

It may well be that none of us really know what we are doing. After all, the success of our investments depends on the actions of millions of strangers about whose intentions we have no clue.

Several decades ago my main interest in life was an ATARI video game system that was considered state of the art at the time, though hopelessly obsolete by today’s standards. I was one of the few lucky kids in India who owned such a thing. While my consciousness was occupied with space invaders games, the household began investing in stocks. My dad had me look up the value of his shares everyday in the newspaper which sent my sense of self-importance soaring sky-high. Space invaders were forgotten. Our household investment committee (i.e. mom and dad) had concluded that companies manufacturing women’s silk sarees and farming equipment were attractive. A “saree” is a 5 yard long colorful silk cloth that multitudes of Indian women somehow manage to wrap around themselves. Our investment committee reasoned that since this garment has been worn for thousands of years, it carried little business risk. And farming is after all the mainstay of India, a primarily agricultural country. We could not go wrong.

However, the committee had not reckoned with Mr. Deng Xiaoping. As it turned out, the former Chinese premier was intent on modernizing his country’s economy in ways that were wholly antagonistic to our family’s portfolio. Today, the silk sarees sold in India are almost entirely made in China, along with the statues of Hindu Gods and other traditional Indian stuff. The thousand year old Benaras silk industry is defunct, with unconfirmed reports of erstwhile silk weavers trading their blood to feed their families. Talk about black swans. Meanwhile, Indian agriculture is a beleaguered sector, permanently lagging behind in a country marching to the beat of technology and manufacturing. Needless to say, the value of those stocks is insufficient to buy a single meal at Panda Express at this point.

If there is one thing I have learnt, it is that human nature is remarkably consistent across households and nations. One of the popular stocks these days is Tesla Motors (TSLA) in no small part due to the charismatic appeal of it’s CEO, Mr. Elon Musk. Many believe it is among those few firms representing the coming nirvana of electric cars, automation and smartphones. How can that go wrong? After all, Elon Musk is arguably one of the smartest people on earth.

Well, the thing is that there are many very smart people in the world and they do tend to try to outsmart each other. In the end, those who live by the sword of innovation tend to die by the same sword. This is not the first time that technological change has fostered the belief that the lessons of history no longer apply. But it is wise to remember the many companies that have fallen from grace over the years, all the way down to near-bankruptcy. There was a time when companies like Eastman Kodak, General Motors and Union Pacific railroads were considered the cutting edge of technology.

KodakAd
A turn of the century advertisement by Eastman Kodak, inventors of personal photography. Kodak struggled to compete with Japan’s Fuji in the post-war years, and then went on to be wiped out with the advent of digital technology. It filed for Chapter 11 bankruptcy in 2012.

To be honest I am not smart enough to know what might de-throne firms like Tesla Motors or Apple Inc. If I knew, maybe I would be right now working on building a better smartphone or electric car. But I am pretty sure that someday it will happen and in a hyper-globalized world these firms are likely to face far more technological competition than Kodak ever did. Maybe some Russian kid is building something better right now at Stanford’s graduate school, on the same stanford.edu server that launched Google in 1996 and obliterated the competition.

Risk takes many unexpected forms that seem obvious in hindsight. Risk is humility. It is the humble pie that must be eaten day after day by investors. Managing risk is knowing how much humble pie you can eat before you throw up.