Value Investing: Tools and Techniques for Intelligent Investment

Chapter 11. Clear and Present Danger: The Trinity of Risk^[11]

Despite risk appearing to be one of finance's favourite four-letter words, it remains finance's most misunderstood concept. Risk isn't a number, it is a concept or a notion. From my perspective, risk equates to what Ben Graham called a 'permanent loss of capital'. Three primary (although interrelated) sources of such danger can be identified: valuation risk, business/earnings risk, and balance sheet/financial risk. Rather than running around obsessing on the pseudoscience of risk management, investors should concentrate on understanding the nature of this trinity of risks.

• Value investing is the only investment approach (of which I am aware) that truly puts risk management at the very heart of the process. Ben Graham was deeply critical of modern finance's obsession with standard deviation (and I'm sure he would have laughed out loud at VaR). He argued that investors should concentrate on the dangers of 'permanent loss of capital.'

• Graham went on to suggest at least three broad risks that could result in such a loss. We have termed these: valuation risk, business/earnings risk, and balance sheet/financial risk. Valuation risk is perhaps the most obvious of our trinity. Buying an asset that is expensive means that you are reliant upon all the good news being delivered (and then some). There is no margin of safety in such stocks.

• Some markets display more valuation risk than others. For instance, the UK market is trading on ...