While I continue finalizing the 2011 update for the intrinsic value spreadsheets, updating the 2010 screen and my portfolio results, I’ve got a great guest piece for you today.

A short paper on risk and uncertainty written by my good friend Ernie. He also brought you How to Invest: Research and Valuation Process.

I believe this paper is his first revision, but it leads the reader into understanding the concept of risk and uncertainty applied to investing. I like it because it is very different to how main street and wall street define risk and uncertainty. To most, it is the same, but you and I know that it isn’t.

Here are some other posts related to risk you may also be interested in.

A Short Paper on Risk & Uncertainty by Ernie

Risk

Risk as it relates to investing is an event that unfolds to induce impairment or loss of capital.

There are many types of risk. To name a few, there are financial, market, economic, systemic and portfolio risk. Generally speaking, risk causes volatility in the stock market, but it doesn’t necessarily result in permanent loss of capital.

The risk that causes permanent loss of capital is the concentrated risk where multiple events combine together to form a negative lollapalooza. Much like a person carrying too many things with too much weight on his or her shoulders, sooner or later, they will fall to their knees impaired.

In the stock market, there are always two sides of the trade, one side will be right and the other will be wrong. There is always a reason why the seller on the other side of the trade is selling to the buyer. Both will assess risk to the investment differently so this means one will be right.

When a transaction takes place from a seller to the buyer, in effect, the seller is transferring risk to the buyer based on their own criteria of risk.

In other words, the seller is really thinking that “I cannot manage the risk anymore so I am transferring it to the buyer who thinks they can manage the risk better in this investment”. It is up to buyer to decide with their own sound reasoning and judgment that the risk can be managed to a profit.

The seller’s criteria of risk can be based on beta, some singular mandate or some flaw in their analysis and valuation which forces them to sell. The important thing to do is to differentiate the risk that causes volatility and the risk that causes permanent loss which is concentrated risk.

Uncertainty

Not far from concentrated risk is uncertainty.

Uncertainty as it relates to investing is the inability to assess the magnitude of a given outcome in which an event can take place.

Every event that unfolds has an outcome. These outcomes have varying levels of results because there are many different events that can transpire.

Uncertainty has a high and low.

When the strength of an outcome of an event can be fairly predicted, it is said that uncertainty is low. When uncertainty is low, capital has a very high probability of returning safely.

When the strength of an outcome of an event cannot be fairly predicted, then it is said that uncertainty becomes very high. When uncertainty is very high, capital has a very low probability of returning safely.

When concentrated risk is identified, bracing for uncertainty must be done. To brace for uncertainty, one has to take reliable information and reason out the possible outcomes using a kind of sensitivity analysis.

The kind of sensitivity analysis preferred is more of a qualitative than quantitative approach where a best case, base case and worst case scenario are determined. The point of doing a sensitivity analysis is to know generally what the security will be worth in each of these scenarios if concentrated risk that is identified were to play out.

In my opinion, risk and uncertainty cannot and should not be quantified. Risk and uncertainty should only be reasoned out based on sound judgment backed by information that has been reduced down to the reliable.

Risk and uncertainty go hand in hand, which means that both need to be managed together. The ability to identify concentrations of risk and knowing the magnitude of any outcome should profitably reward the investor for taking low risk.

When it comes to risk and uncertainty, there truly are no extra points for degree of difficulty.

The extra points go to those who don’t lose money since compounding works for them powerfully. It is absolutely imperative not to have a down year because the time value of money will go against you and you will lose the compounding power of your cash outlay.

It is far better to go for the easy money by stepping over the one foot bars and be rewarded handsomely than stepping over ten foot bars and be punished for it.

With regard to taking profit, it is absolutely imperative to understand that it is okay to leave some money on the table as long as this money is at the near top of the total move in a stock price. The reason being is that you are leaving it for someone else to take the last bit of profit for taking higher risk.

That person who pays a higher price for the last bit of profit has a higher probability of losing it all.