The return you see, the risk you don’t

While it may seem counterintuitive, successful investing isn’t about being right all the time. You can be wrong often and still do well if your losses are limited and your wins are meaningful. Conversely, you can be mostly right, but generate poor results if your mistakes prove very costly.

The quote often attributed to George Soros puts this concept succinctly:

"It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong".

A more accurate view on risk

While every investment involves risk, the concept itself is often not well understood.

Historically, risk has often been associated with share price volatility. Volatility is easily measured, often over a short time frame. However, volatility is simply a statistic, whereas genuine investment risk is fundamental and forward-looking. A stock experiencing significant price movements is not necessarily risky if it is expected to increase considerably in value over time. In fact, this is often a necessary element to achieving superior long-term returns.

Risk is also sometimes confused with uncertainty. While related, they are not the same. All investments we make involve some degree of uncertainty, whether around future product launches, management execution, or competitive dynamics, for example. But uncertainty is not risky if it is adequately reflected in a discounted share price.

Even less helpful is the view that risk equals deviation from a benchmark. While tracking error may increase an investment manager’s career risk, it has little to do with investment risk. Chasing momentum stocks can seem smart as prices rise — particularly when benchmarks are similarly skewed — but this can be dangerous. Avoiding risk in such circumstances may have the effect of actually increasing tracking error.

In our view, a better definition of risk is the likelihood of permanent capital loss. This risk is determined by two factors: the price paid for an investment, and the future performance of the underlying business. This fundamental definition shifts focus from superficial price movements to the potential for irreversible damage to an investor's capital.

Alternative histories

A key implication of the above is that while investment returns are readily observable, the risk taken to achieve them is not. Nassim Taleb, the statistician behind The Black Swan and Antifragile, illustrates this concept in Fooled by Randomness by introducing 'alternative histories'. This idea suggests that a realised return is merely one possible path among many that could have occurred. Our tendency to focus on successful outcomes often leads us to underestimate luck and to overestimate skill, and by extension, to ignore risk.

This dynamic likely explains much of the documented lack of consistency in investment manager returns. In strongly rising markets, the highest returns are often gained by those who accepted the most risk. However, these strategies can unravel when stock markets fall.

Our approach

While risk ultimately can’t be eliminated or objectively measured, it can be understood and managed. At Canopy, our job is to distinguish between short-term share price volatility and true investment risk—namely, the risk of permanent capital loss. Our risk management process is designed with this in mind. We focus on buying quality companies at attractive prices, where we believe the odds are meaningfully skewed in our favour. We sensibly diversify, to guard against unforeseen shocks, typically holding between 20-40 stocks. And we monitor and cap common risk exposures across the portfolio, while always remaining mindful of the risk you don’t see.