What is risk?

I was recently asked how I managed risk in my own stock holdings, on a portfolio level. And I must admit that I was stumped for a moment. Because, you see, I don't manage risk on a portfolio level per say.

I am, at heart, a stock picker. And I manage risk by picking stocks/companies that I know the value of and which I know possess attractive risk/reward propositions. The logic behind that is that, if my individual holdings are attractive on a risk/reward basis, then my portfolio as a whole should enjoy the same characteristic.

A counter argument to this view is that there may be correlations amongst stock positions that may make the portfolio seem riskier than it appears. But clearly, there are two issues here - 1) how does correlation affect risk here on a portfolio level?; 2) is that an unsolvable issue?

On the latter, simple common sense will guide a reasonably prudent man to not hold all its positions in one sector for instance (e.g. real estate). So by construct, a reasonable man would naturally source for attractive ideas across a number of sectors, rather than just one.

So I do not set out to have a concentration in one sector (or not) for my portfolio. The construction of my portfolio is just a product of the ideas I have, at any point in time. If it so turns out that I am heavily weighted towards one, it is not necessarily a bad thing, as long as I have conviction that my individual ideas are good. But of course, I do consciously avoid betting my house on 1 single sector/factor exposure. Plain old common sense is what guides me here.

On the first point about correlation and risk, my reply is that it is largely an academic exercise. First, how do you measure correlations, other than stock price correlations. Is one able to realistically, with precision, break down each position into the factors that drive it and draw correlations across positions? That seems rather hard and way too many assumptions involved. The more assumptions you make, the more likely you will be wrong.

If so, then we are down to price movements as our last bastion of hope in measuring correlations and the implied assumption there is price movement - i.e. volatility - is risk. Risk is bad and as such, price volatility is evil.

And this is the juncture which I evoke the brilliance of Buffett, and which I absolutely agree with.

"I think volatility as a measure of risk is nuts. You should really try to understand the business instead, and try to understand the volatility of the business instead. Risk should be measured in terms of the quality of the business and the risk of permanent capital loss. That makes far more sense to me. It has nothing to do with volatility." - Buffett

As such, to manage risk, all you have to do is understand what you own and assess what your downside is (i.e. risk of permanent capital loss).