In my opinion, most stock market investors fundamentally misunderstand risk and think about it in the wrong way. Most investors abhor risk and see it as their goal to minimise their exposure to it, to the maximum extent possible. They try to pick companies to invest in which have the most assuredly positive and low risk outlooks. They want strong businesses, and stable earnings/cash flows/dividends, and so abhor cyclicals. They want good management and pristine corporate governance. They want strong balance sheets, and they don't want any sort of uncertainty about the company's future, including risks from new competition or technological change. And they want to invest in countries where the macroeconomic and political outlook appears strong and stable. They want all these things because they want to avoid risk, because the absence of any of these factors does, in fact, increase the chance of subsequent investment losses. They don't mind paying a higher price, because it's all about investing with (seeming) assurance of a decent outcome.
Furthermore, just as important is how they react to the subsequent emergence of new, unanticipated risks, which is wont to happen from time to time. When such risks emerge, investors behave predictably: they dump the stocks en mass, and usually realise large losses when they do so. This is seen as justified, as 'the fundamentals have deteriorated'. This is not what they signed up for. They chalk the losses down to experience, and vow to be even more risk averse next time they invest. "No more investing in companies with off-balance sheet lease liabilities". "No more investing in retailers, period - the consumer is fickle and it's too hard to predict the emergence of new competitors". "No more investing in countries with unstable political systems". They move on, with an ever elongated list of companies that are uninvestable to them on account of unacceptably high risk.
An example is how many 'value' investors responded to recent political developments in Italy. Peters-Macgregor, for instance - who are smart guys and well above average investors - nevertheless having done extensive analysis on Italian stocks like UBI, Mediobanca, and Telecom Italia, recently abandoned all their positions and dumped them at depressed prices after the Italian election. The outlook was now more uncertain and risky, so they felt uncomfortable and exited.
I believe this approach to be fundamentally mistaken. Trying to avoid risk is to a large extent like trying to deny its existence - something human beings are very good at. Risk is an inherent part of life and is, to a large extent, unavoidable. Every day you run the risk of being diagnosed with cancer; seeing a loved one die in car accident; losing your job, or experiencing political/economic turmoil in the country you live in; or suffering from some other catastrophic, unforeseen event. Death is inevitable and awaits us all, given a sufficient passage of time. We ignore these risks because they are too depressing to think about. We are a generally optimistic species, as it is good for our psychological health and willingness to act in the world. But ignoring them doesn't make them go away.
In my view, instead of denying the existence of risk, or doing everything in your power to avoid it, a much better way to think about risk is in a manner analogous to how an insurance company thinks about it. Insurance companies don't seek to avoid risk - indeed they actively seek it out - but are only prepared to assume it when they are sufficiently well paid in order to do so (assuming the company is well run).
Stock market investors would do well to think about risk the same way - it would make their decisions around risk far more rational. Indeed, it is arguable that one of the most important roles of the stock market - besides its obvious role of intermediating between savers and users of capital - is to allocate and price risk. For any business to operate, someone has to be willing to take the inherent risks associates with running the enterprise, and the stock market is a market for the allocation and pricing of that risk.
People who say stock market investing is akin to gambling are partly right, but they are missing a very important point. In a casino, non-productive risk taking occurs. Risk is created that benefits no-one except the casino, and the very occasional, very lucky punter. In markets, productive risk taking occurs. Some one has to be willing to take a risk for any business to be funded. The risks exist and are unavoidable, and it is socially productive that someone take that risk, lest enterprise and innovation be stifled. Stocks markets allow for the efficient allocation and spread of that risk.*
The most important benefit of thinking about risk in this way is that it causes you to ask the right questions. Insurance companies don't ask, "Is there any risk of a hurricane? If there is, we might lose money on hurricane insurance, so we better not write it". Instead, they ask, "what is the probability of a hurricane; how much do we stand to lose; and how sure are we? And given those facts, at what price would it be sensible to underwrite those risks".
Similarly, in the investment world, the correct question is not, "is there risk associated with investing in a Turkish bank right now?". Of course there is. Lots of it. That's the wrong question. The correct question is, "is the return potential on offer sufficient to make assuming those risks sensible?". This is why there is a price for almost anything. Insurance companies don't prosper by avoiding making claims on any policy they write. They make money by getting well paid for the risks they take, such that profits on profitable policies outweigh losses on unprofitable policies.
The analogy is exactly the same in the investing world, and is why successful investing actually has nothing at all to do with avoiding risk or buying good quality companies. That is the equivalent, in this analogy, of refusing to underwrite hurricane risk, irrespective of price. Successful investing instead has everything to do with correctly pricing risk, and taking advantage of situations where the pricing of certain risks is excessive. And invariably, that will be in places/times in the market where people feel most uncomfortable because the risks are most visible to all (and often daily, headline news). In this respect, successful investing is fundamentally a risk-seeking enterprise, not a risk-avoidance exercise, and it is one where successful practitioners face limited competition on account of the incurable risk-aversion most investors suffer from.
If an investor or fund manager says, "we don't invest in commodity stocks, because we don't feel capable of predicting the commodity price", you know that they are thinking about risk in entirely the wrong way. Instead of accepting the existence of risk and trying to price it correctly, they insist on avoiding risk at all costs. This approach is likely to cost them a lot of money over time, both in the form of many missed opportunities, and in the exit of underperforming investments at firesale prices. And yet this type of thinking is extremely common - even amongst many self-described 'value investors'.
So don't avoid risk - embrace it. Just make sure you're being well paid for taking it. And when you think about risk in this way, it is actually quite easy to be "greedy when others are fearful". If you are disciplined about taking risk at sensible prices, rather than trying to avoid it, you will make a lot of money in the long term.
LT3000
*Incidentally, this is one reason why the role of investment banks is often misunderstood. The economic role of an investment bank is not to counsel caution and give clients unbiased advice - it is to encourage investors to take (productive) risks - something that is very good for the economy in the long term (although not always good for the actual investors). Investment banks are intermediaries between the suppliers of risk-capital, and the users of risk-capital, and investment banks fulfil the role of lubricating productive risk-taking.
It therefore ought not be a surprise that sell-side research generally has an optimistic bias - if investment banks were to caution investors against taking risk all the time, they would not be fulfilling their economic role, and they would therefore likely go out of business as a result. Their clients would love them and recommend their unbiased advice, but they would go broke. Darwinian forces therefore basically ensure that sell-side research will forever be positively biased.
