At Rydra, we define risk as a permanent loss of capital or value. This isn’t what modern finance defines as risk. Here is a quote directly from Investopedia:
‘Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk.’
Thinking of risk this way is complicated and equates risk to volatility, and to us volatility isn’t inherently risky. Rather, volatility should provide opportunities by either pricing securities too low or too high.
What we’re interested in is health of the underlying business and that our initial investment thesis is still intact. Therefore, we are interested in the risks that affect the health of our business, like new technologies coming into the market, increased competition, etc. There’s also the risk that we made mistakes in analyzing the business, maybe overestimating its competitive advantage and return profile. This could also lead us to paying too high of price – essentially destroying value right away.
No one is ever going to eliminate nor properly evaluate all risk, especially in the stock market. It’s not just too difficult a task – it’s impossible. There are a multitude of different events and circumstances that are either impossible to quantify or impossible to see. A lot of risk hides in our blind spots and we are not either going to see them coming.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.“
– Mark Twain
However, we are interested in is getting compensated for our risk. Not to say that taking on more risk leads to more reward, but to be paid appropriately for the risk that is being taken.
If return = risk then everyone would take on more risk to achieve more return. What we’re trying to do is lower our risk by paying a good price for a company/stock with durable competitive advantages, and it will be by lowering our risk that we actually achieve a better return.
