Investment Risk (Part 1/3): What Is Risk?

Investment Risk (Part 1 of 3): What Risk Is and How Much of It to Take

When Carpedia Capital considers investment opportunities, we always frame the potential for returns against the magnitude of risk we are taking to ensure this relationship is appropriately balanced.

To describe our view of this concept and means of implementing it in our investment decision making, we are writing a three-part series on investment risk. The first part discusses our view of what risk is and how much of it to take, the second describes how we take risk and the third discusses the difference between perceived and actual risk and how we mitigate risk.

Below is the first part to our series on investment risk:

What is risk? Carpedia Capital believes that risk represents the potential for:

[1] actual realized returns on our investments being below those required over a reasonable time period,
and,

[2] permanent loss of capital, such that an asset of ours cannot be converted, without a loss, into cash over a reasonable time period.
The potential for risk is influenced, from our perspective, by the duration of time between investment and expected realization and the potential for interim changes occurring in business-specific results, broad economic results, regulations, politics, currencies, interest rates, inflation rates, the availability of credit, liquidity in the market and investor sentiment.
We make specific note that one commonly (mis)used indicator of risk, being the degree of volatility in market prices, is not on our list of potential sources of risk. This is because, in our opinion, short-term adverse fluctuations in price create more opportunity for returns than are they likely to represent a permanent loss of capital, while short-term favourable fluctuations create opportunity to realize returns.

How much risk should be taken? With an understanding now of our view of what risk is, the next logical question is how to assess the capacity to take risk – which we believe is defined in terms of both willingness and ability. A willingness to take risk (evidenced by actions, behaviour and personality, more so than words) and an ability to forego access to immediate liquidity over a defined time horizon dictate how much risk can be taken during that period in terms of the proportion of our portfolio that is invested in risk-bearing assets. When both willingness and ability to take risk are directionally similar, a meaningful allocation to risk-bearing assets is appropriate.

Conclusion: Given the clear willingness and substantial ability of Carpedia Capital’s sponsors to take investment risk, our investing strategies are focused around optimizing how we take such risk (further described in Part 2 of this series) and being proactive to mitigate the actual impact of the risks we do take (further described in Part 3 of this series).
We welcome, enjoy and encourage feedback from our readers – on this or other investing topics. If you have a comment or would like to discuss further, please submit your perspective to capital@carpediacapital.com or contact us.