Risques

The risk from the investor’s point of view

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According to mainstream financial theory (modern portfolio management theory), risk is mainly characterized by the variation in the price of assets, or volatility. In order to minimize the investment risk, it is conventional to minimize this volatility as much as possible. However, Paramed[1] describes risk not as the standard deviation of the price of an asset but as the possibility of permanent loss of purchasing power as a result of an error in judgment at the time of investment. In his work the snowball effect[2], Schroeder reveals Charlie Munger’s view of volatility’s definition of risk as: “hogwash and hogwash.” For Munger, the risk results from the money that the investor can lose and not from the volatility of an asset. According to him, volatility is the risk of the short-term speculator and not of the investor. marks[3] follows the same reasoning by stating that risk is not volatility but the probability of a permanent loss of capital. Short-term price movements should be used for the short-term speculator, but the variation of these prices does not constitute the major risk for the long-term investor.

A significant divergence between the Chicago school and the investors influenced by Graham’s texts is found here. Modern Portfolio Theory or MPT gained Nobel recognition in 1990 with its principal authors, Sharpe, Markowitz and Miller, for their work on efficient market theory as well as for their research on the measurement of risk. an investment through volatility[4]. For the Chicago school (pioneer in quantitative analysis), the risk of an investment can be defined by the standard deviation of the price of the asset, while for investors in fundamentals, the risk is between the purchase price and the intrinsic value of the asset. Assuming a risk assessment by the standard deviation of the price of an asset, a period of speculative bubble will not be detected, however, an 80% drop in price of an asset will not allow an investment because the volatility will be too high, while this price may well be below the (estimated) intrinsic value of an asset.

In fact, the long-term investor concerned about the downward variation of his investments should probably move away from the simple observation of volatility or the various traditional indicators such as the Sharpe or Treynor ratio. The reading of the Sortino ratio seems the least incompatible with a long-term vision because the interest of this ratio is that it only takes into account the downward standard deviation. That is, the Sortino ratio actually shows the volatility of negative returns, and is not influenced by positive volatility.

This is where the main difference in investment philosophy lies between neoclassical economists and quantitative investors on the one hand, and subjectivist economists of the Austrian school and investors in financial fundamentals on the other (value). This fundamental discordance implies an even deeper notion. That of the difference between a short-term investment and a long-term investment and therefore of the ethics of investment by its fundamentals or by price variation. The growth in the use of purely quantitative and/or technical criteria in the investment industry may call into question the ethics of this type of activity. Beyond the extra-financial qualities of a company, the investment behavior of the portfolio manager must correspond to a certain responsibility. Graham knew and strongly suffered the crisis of 1929 in the United States, it was then that he understood the responsibility of investment in the disruption of the real economy. The crash of 1929 due to a frenzied speculation of the actors of the investment had for repercussion one of the most harmful periods for the American population, that is to say the Great depression.

We have therefore understood the investor’s responsibility with regard to the fundamentals of the economy. However, the development of quantitative finance offers valuations that are sometimes decorrelated from economic fundamentals. It is through this divergence of interpretation on enterprise value that the “Superinvestors of Graham-and-Doddsville” can benefit from the irrationality of the markets, as well as by having another definition of what risk is. of an investment. Volatility is therefore an opportunity for an investor who relies on company fundamentals and not a major risk. The risk is indeed present with volatility, but only for the short-term player. Montier reveals that “in fact, the vast majority of successful long-term investors are investors” value which reject most of the precepts of the MCH and the MPT[5] “.

By attempting to rationalize risk through past volatility, the fund manager dangerously omits the unpredictability of human action. To illustrate this unpredictability, we can quote part of the BNP Paribas group’s 2nd quarter results press release, published on August 1, 2007:

BNP Paribas, thanks to the good quality of its goodwill and a prudent risk policy, is not directly impacted by the current “sub-prime” crisis or by tensions in the LBO market. The quality of BNP Paribas’ risk management was highlighted by the rating agency Standard and Poor’s on July 10 when it announced the upgrade of BNP Paribas’ rating to AA+. This rating places BNP Paribas among the six best-rated major banks in the world[6]. »

All this to then explain on August 9, 2007:

To preserve the interest and equality of unitholders in these exceptional circumstances, and in accordance with the regulations in force, BNP Paribas Investment Partners has decided to temporarily suspend the calculation of the net asset value and, consequently, the subscriptions/redemptions of the following funds: Parvest Dynamic ABS from August 7, 2007, 3 p.m. (Luxembourg time) BNP Paribas ABS Euribor and BNP Paribas ABS Eonia from August 7, 2007, 1 p.m. (Paris time)[7]. »

The oldest of the studies on the quality of stock market forecasts dates from 1933; it is the result of Cowles’ research[8]. In this study, the author shows that over a period of four and a half years, Wall Street professionals and forecasters underperformed the Dow Jones Industrial Averageand that their predictions were no better than chance (Figure 1).

Figure 1: Can stock market forecasters forecast (Cowles 1933)

More recently and in a study called Analyst Forecasting Errors and Their Implications for Security Analysis[9], Dreman and Berry compared 66,100 quarterly earnings estimates from Wall Street analysts. The period analyzed runs from the first quarter of 1974 to the first quarter of 1991. The conclusions are that on average, 56% of the estimates fall outside a 10% error range and ≈ 45% are outside a range 15% error. The authors conclude by stating that the mean error of BPA forecasts[10] is too high for investors to rely on consensus forecasts as a major determinant of stock valuation. Jones and Johnstone[11] studied the recommendations of analysts before the bankruptcy of 118 companies during the period 2000-2010 (Table 1). They found that 67.77% of analysts recommended either to buy or to hold at the time of bankruptcies. The results are even more unfavorable for American companies since the figure rises to 73.42%.

Table 1: Distribution of bankruptcies

A latest study by Dreman presented in Value Investing Today Brandes[12] shows that analysts on average predicted a growth rate of earnings about four times higher than the actual data observed between 1982 and 2002. Economists meanwhile predicted growth three times higher than reality (Table 2). All this can be explained by the fact that analysts offering an optimistic outlook are more likely to be promoted.[13].

Table 2: Comparison of analysts’ and economists’ forecasts with reality[14]

Moreover, it is possible to highlight the lack of understanding on the part of certain investors as to the existence of the link between investment risk management and the fundamental responsibility of the investor. In short, volatility is an opportunity for the long-term investor, it is a risk for the speculator. The risk for an investor results in two points; commercial risk, valuation risk. Business risk can be defined as the possibility that the business you buy will lose quality. Valuation risk results in the thickness of the margin of safety, ie the price paid in relation to the intrinsic value.

References

[1] Garcia Parames, F. (2018). Invest for the long term. Valor Editions. p. 196.
[2] Schroeder, A. (2010). Warren Buffett: The snowball effect. Valor Editions.
[3] Marks, H. (2020). Master market cycles. Valor Editions. p. 20.
[4] Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, vol. 7, no. 1, p. 77-91.
[5] Montier, J. (2009). Value Investing: Tools and techniques for intelligent investing. John Wiley & Sons Inc. p. 17.
[6] BNP Paribas. (2007). Groupe bnp paribas: results for the 2nd quarter of 2007. Source: https://www.leguideboursier.com: https://www.leguideboursier.com/communique-groupe-bnp-paribas-resultats-au-2eme-trimestre-2007- 2007080115270.php
[7] BNP Paribas. (2007). bnp paribas group: bnp paribas investment partners temporarily suspends the calculation of the net asset value of the parvest dynamic abs, bnp paribas abs euribor and bnp paribas abs eonia funds. Source: https://www.leguideboursier.com: https://www.leguideboursier.com/communique-groupe-bnp-paribas-bnp-paribas-investment-partners-suspend-temporaiment-le-calcul-de-la- net-asset-value-of-funds-parvest-dynamic-abs-bnp-paribas-abs-euribor-et-bnp-paribas-abs-eonia-2007080910009.php
[8] Cowles, A. (1933). Can Stock Market Forecasters Forecast. Econometrica, vol. 1, no. 3, p. 309-324.
[9] Dreman, D., & Berry, M. (1995). Analyst Forecasting Errors and Their Implications for Security Analysis. Financial Analysts Journal, vol. 51, no. 3 pp. 30-41.
[10] EPS = Earnings Per Share
[11] Jones, S., & Johnstone, D. (2012). Analyst Recommendations, Earnings Forecasts and Corporate Bankruptcy: Recent Evidence. Journal of Behavioral Finance, vol. 13, no. 4, p. 281-298.
[12] Brandes, C. (2004). Value Investing Today. McGraw Hill. p. 23.
[13] Hong, H., & Kubik, J. (2003). Analyzing the Analysts: Career Concerns and Biased Earnings Forecasts. The Journal of Finance, vol. 58, No. 1, p. 313-351.
[14] Dreman, D., & Berry, M. (1995). Analyst Forecasting Errors and Their Implications for Security Analysis. Financial Analysts Journal, vol. 51, no. 3 pp. 30-41.

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