Can you explain your financial risk analysis approach – how you developed it? Why hadn’t anyone else thought about it this way?
I don’t think that my way of viewing risk is fundamentally very different from how others do it, or at least it shouldn’t be. However, there are two things that set my way of relating to risk apart from how many others do it.
First: When I take a risk, I want to know how large the risk is, and assess whether it is wise to take the risk – if I have the choice. I think many people would rather avoid thinking about risks than analyse them. Some even dismiss the issue of risk with platitudes such as “living is risky”.
Second: There are two types of damage that can occur. When the damage can be expressed in money (i.e. the damage is compensable), it is easy to understand and apply the following general definition: Risk equals the potential damage times the probability of its occurrence.
But there is damage that cannot be expressed in money, such as severe suffering or the loss of human life. In these cases, many people find it hard to apply the equation, which leads to a serious underestimation of risk – especially if the event is in the far future. Let’s say that we succeed in stabilising the carbon dioxide level in the atmosphere at 450 parts per million – which is far from a given at the moment. The probability of a 6 degree Centigrade increase of the average temperature (which would be catastrophic) would still be 1.6 percent. That may not sound so bad, but who would ever fly if one in every 63 planes crashed? And yet, in the plane example, only a limited number of people would die. In contrast, a 6 degree increase would be a serious blow to all humankind. It cannot be ruled out that such a temperature increase, due to threshold effects, could make earth uninhabitable. The damage would be infinite. And if the damage is infinite, the risk is infinite, as long as the probability of the event happening is non-zero.
When it comes to assessing the value of stocks and making investments, risk assessment mainly crops up in two contexts:
The first one is the required return on an investment. It is generally agreed that stock investments should yield a higher return than risk-free investments, and therefore a risk premium is added to the risk-free yield. But this risk premium varies, since different shares entail different risks. The market usually grades the risk level of stocks according to their volatility (the size of the variation in value). I myself prefer to grade the risk based on the forecasting uncertainty of the company. In practice, this means that you make two long-term forecasts for a company: One optimistic, based on the best case, and one pessimistic, based on the worst case. For example, you assess what the profit and return will be in ten years. The size of the gap between the two results determines the level of risk.
Never bet more than you are prepared to lose – or, as I like to say: Never confuse the improbable with the impossible.
The other factor concerns the loan-to-value ratio of a stock portfolio. On the one hand, you can always try to increase the return on an investment by financing part of the investment with borrowed money (if you believe that the return will be higher than the interest on the loan). On the other hand, this also increases the risk of loss, and, in the worst-case scenario, risks the entire capital.
My rule when it comes to this is never to bet more than you are prepared to lose – or, as I like to say: Never confuse the improbable with the impossible.
How much money have you made over the course of your career?
I made my first investment in stocks in 1966. I invested SEK 6,000. Half was my own, the other half was borrowed.
After six years, the capital had grown to SEK 100,000. That is when I left my job and began investing full time. In 1987, when I got out of my active stock investments, the capital was about SEK 250 million.
After that, I decreased the exposition to risk, and since then I have more or less only made long-term investments in a few low-risk real estate stocks. When I started the Global Challenges Foundation in 2012, my portfolio was valued to about SEK 1 billion [USD 110 million]. Since I started with a small capital, the rate of return has been good – about 30% a year for 46 years.