Sunday, January 18, 2015

Finding low risk & high uncertainty in the markets

There have been several mentions of the difference between uncertainty and risk in the value investing community especially by Mohnish Pabrai. He says that the best investments will carry high uncertainty but low risk of permanent capital loss. Which in other words means that in the likely worst case scenario the investment price should be low enough that it should not fall further. If some uncertain but plausible and possible events occur it makes some good money.



Uncertainty
Risk

Definition

Opposite of likelihood. Unpredictable.
The chance that an investment's actual return will be different than expected.

Efficient market theorists view

Probability modeled on normal or other distributions
Risk is proportional to return as per the efficient market theorists.

Value investor’s view

Uncertainty is a certain opportunity to pick up cheap companies as it leads to low valuations.
Risk is largely in the price. The lower the price the lower the risk.

Mitigation

One needs to analyze it and sometimes learn to live with it.
Risk mitigation technique is to buy at high margin of safety.

Overall it has been very difficult for me to separate the two. Before reading about value investing I always thought that the two were correlated. The rationale was that the lower my ability to analyse and predict the future the higher the risk. The truth is that risk is drive by the price. If the price is low enough the uncertainty only drives the upside and not the downside. 

This is a concept that helps analyse and take a decision on investments. I have not yet found a way to build a screen-er that can filter out high uncertainty companies. One can however pick them up via reading, horizontal industry analysis, news stories, events, moves in raw material prices, etc.

Some interesting articles on the difference between uncertainty and risk