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Putting risk in perspective

Risk is fundamentally inherent to all investing. We believe one of keys to successful long-term investing is not to avoid risk altogether but rather to do all one can to manage risk prudently, avoid unnecessary risks and get compensated properly for the risks that one knowingly takes. In other words, every investment must be subject to a very diligent and stringent risk/return analysis.

It is very important for investors to maintain a proper perspective on risk. With stockmarkets down sharply from recent years&#39 highs, political tensions running high in various regions of the world and major economies still showing lacklustre growth, investors are understandably focused on risk avoidance.

However, we would argue that there are tremendous opportunities for long-term investors – not despite these apparent challenges but because of them.

There are basically two types of risk. The first involves uncertainty about the future, for example, global military conflict, economic growth and corporate earnings.

Then there is the risk for investors that the value of their investments will go down. This can be called portfolio-loss risk.

The ironic fact is that these two types of risk often interact with one another in an inverse manner. Extreme investor optimism can drive financial market valuations up to unsustainably high levels, ultimately resulting in severe portfolio losses for those not clever enough or fortunate enough to get out in time.

Conversely, severe investor pessimism and fear cause valuations to reach very depressed levels. Buying financial assets in this type of environment can actually involve far lower risk of future portfolio losses if prices already reflect all the uncertainty.

Three years ago, world financial markets reflected investors&#39 tremendously optimistic views on economic growth and corporate earnings. There was very little talk among investors (and most investment managers) about risk and uncertainty, as evidenced by their willingness to pay ever higher prices to own stocks.

This extremely optimistic mindset itself created extreme financial risks. Valuations reached levels that we all now realise contained enormous risk for investors.

Put in a different way, the financial markets were massively mispricing risk. Whenever financial markets of any kind massively misprice risk, it inevitably leads to misallocation of capital and creates enormous portfolio-loss risk for investors in that market.

Now take a moment to contrast that period with the circumstances of today. The risks and uncertainties are abundant and investors around the world are acutely focused on them. The risks are very real but are quite abundantly priced into financial markets. So investors should honestly ask themselves, which environment is truly a riskier one for disciplined long-term investors?

One in which massive and excessive optimism creates a perception that there is little or no risk and, in turn, extremely high asset prices? Or one in which the many real risks and uncertainties are quite fully understood by investors and thus abundantly reflected in valuations?

When looked at in this way, I believe it can easily be argued that the overall risks facing US stockmarket investors today are far less than they were just three years ago.

Does this mean we believe that the entire US market is extremely undervalued and should be bought aggressively in whole by all investors? Absolutely not.

Current valuations for the overall US stockmarket are definitely not particularly cheap in comparison with long-term historical averages.

However, amid the thousands of public companies, we do believe there are now several quite exciting opportunities to be found in individual stocks, certainly more so than at any other time in the past several years. It is our mission to find them, searching one by one across every sector and industry and across all capitalisation sizes of US stocks.

We believe a carefully constructed and well-diversified portfolio of US stocks today will handsomely reward those investors willing to own it for the long term.

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