Investment Risk (Part 2/3): How We Take Risk

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 second part to our series on investment risk:

How do you take risk? Carpedia Capital takes risk (in its pursuit of returns) by investing in assets which may not be converted easily into cash in the short-term and for which the actual realized returns may be uncertain until a reasonable time period has elapsed. In implementing Carpedia Capital’s investment strategy, we own assets (in varying proportions) ranging from cash to bonds, real estate, public shares and private businesses and regularly evaluate new securities to add to these asset classes. In our view, the degree to which these assets exhibit the above risk characteristics should be directly related to that asset’s perceived riskiness – though the relationship may not be linear.

The following example highlights our view of the differences in perceived risk between different types of assets:

Essentially no risk is perceived when investing in short-term treasury bills with high credit quality as they are easily sold at par plus accrued interest at any time after the date of purchase, the rate of return is certain and the investment is expected to be redeemed at par for cash after a short period of time.

The certainty of cash contrasts to an investment in the shares of a private company where the return, being dividends and capital appreciation, is not known with certainty at the outset (despite the numerous and assuredly detailed projections for the magnitude and timing of both) and will not be clearly determined until several years have elapsed, at which point a process can be undertaken to sell the company and convert the asset into cash.

As a result, the expected return on private company shares should well exceed the expected return on cash as the perceived risk profiles (potential for uncertain returns, potential to lose money) are materially different. Similar comparisons between less starkly different assets, such as bonds versus real estate or publicly-traded stocks, lead to the same conclusion: that the perceived risk profile must shift from low to moderate to high in order for the returns to commensurately increase.

Can investing in risk-less or low risk assets be risky? Many people, when confronted with the above concept – that the degree of perceived risk taken must increase for returns to increase – often consider a “no risk” or “low risk” route as a means of avoiding uncertainty (perhaps because they overvalue certainty). However, defaulting to a such a strategy over an extended period of time, despite having an ability to take risk, is more likely to create risk for an investor than avoid it [recall from Part One of this series our two-fold definition of risk as the potential to underperform a required rate of return or the potential for permanent loss of capital]; in fact, such a strategy is almost certain to result in the investor’s wealth, 5 to 10 or more years hence, being materially below where it should have been had an appropriate allocation to risky assets been made.

This counter-intuitive conclusion becomes obvious when you consider cash to be a highly defensive asset and all risky assets as opportunities to generate cash. The virtue of cash, being a riskless asset, or other low-risk assets is also their peril given their near nil nor low real rates of return. Therefore, an investing strategy which incorporates a significant amount of cash on-hand and low risk assets actually creates risk (particularly during moderate to high inflation periods) as the returns on cash and low-risk assets are unlikely to prove adequate over time – with the likely result being an erosion of purchasing power and a needless foregoing of wealth accumulation. A good analogy to this investing concept comes from the sporting world: your best defense [against risk] is a good offence [that takes appropriate investment risk].

However, while it is efficient to remain as fully-invested as possible, cash does serve an important role in Carpedia Capital’s investing strategy as a safe haven in which we temporarily idle our productive resources in-between their being put to work. Though we make efforts to remain fully-invested in attractive opportunities, we never:
[1] are afraid of taking a profit (or a loss) and going to cash when the balance of upside reward to downside risk is well-tilted towards risk;
or,
[2] rush the deployment of cash for the sake of limiting the time spent being invested in cash.

Conclusion: With our philosophy for taking risk now defined, and it being clear that low-risk assets are not viable long-term opportunities, Carpedia Capital consequently focuses its investing strategies around optimizing how we take risk 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.