Most people think of risk and, of course, rewards when they talk about stocks. Returns are sometimes expressed as percentage increases or multi-baggers (x times growth, for example). But when it comes to risk, the emphasis frequently moves to possible losses, whether they are expressed as percentage drops or as the whole loss of the original investment.

Despite being the foundation of many quantitative measures, volatility is another often misinterpreted notion that is usually confused with risk. Although there are several ways to measure risk, none of them are completely accurate or flawless. Nevertheless, making wise investing choices requires an understanding of the underlying nature of risk.

One way to think about risk is as anything that has uncertain results. When there are several possible outcomes, each with a high probability of occurring, there is risk. This probabilistic aspect deviates from our anticipated or comparable result. In this sense, I like Howard Marks’ account of a gambler who consistently lost. He wagers the rent money after learning about a race in which there is just one horse. The horse bolted over the fence and fled halfway around the track.

Therefore, is risk defined by the outcomes themselves or by the sheer potential of the outcomes?

The first two are simple to understand. Only by experience can one learn the third, which is the most difficult. When we gamble or take a risk, we always know we’re taking a chance, but we can only learn from experience how that result affects us or how we respond to such circumstances. It may not be possible to reproduce that. Although most equities investors are aware of tail risks, such as the GFC and dot-com crash, they are often undervalued.

Based on my experience, I’ve discovered that investors’ risk tolerance varies. It varies according on the situation. As an example, I was speaking with an investor yesterday who had previously piled up shares of a faltering IT business in the hopes of a comeback. The stock surged years later, yielding enormous gains. Despite having formerly accepted the risk, he is now anxious due to sector-wide pessimism.

The change in conduct

is due to:

Loss aversion: Rather of seeking further upside, he is content to stick onto his current position and safeguard enormous winnings.

Recency bias: current events are more memorable and have a greater influence than his prior achievements.

Asymmetric risk perception: dread takes hold when the stakes are greater. Even while we are aware that the odds for the future are much greater, we nevertheless have a tendency to extrapolate from the views of the present.

Similar events occur during bubbles, but in reverse, when investors almost always reduce the likelihood of unfavorable consequences.

Diversification and patience are the two methods to mitigate risk.

Diversification: A well-organized portfolio lessens reliance on the performance of any one investment or asset. It ought to combine securities and assets with the fewest overlaps and/or lowest correlations. While total loss avoidance is not the aim, achieving results that are less than expected is. Naturally, too much diversity may result in “diworsification,” as Charlie Munger put it, which is detrimental to the portfolio rather than beneficial.

The well-known saying, “time heals everything,” may be applicable to volatility, particularly in the stock market. Long-term gains are made by equity investors (usually in portfolios), but if there are fundamental and governance problems, a single stock may experience a decline.

The strongest protections are time and diversity, but neither is infallible. Knowing risk isn’t about avoiding it; rather, it’s about planning for and making wise decisions in spite of it.

(Wealocity Analytics, where the author is a partner, is a

Info@wealocityanalytics.com is the email address of this Sebi-registered research analysis business.