How Should You Think About Investment Risk?

Hedge fund manager Seth Klarman argues that conventional wisdom is misguided

You may have heard of Seth Klarman. He is the founder of the hedge fund firm the Baupost Group. He is also the author of a cult classic—maybe the only cult classic—in the world of investments, Margin of Safety.

The book has been out of print for decades, but because of its universally accepted wisdom, used copies often sell for $1,000 or more on Amazon. Below is one of my favorite quotes from the book:

“Others mistakenly equate risk with volatility, emphasizing the ‘risk’ of security price fluctuations, while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments…Risk simply cannot be described by a single number…I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security.”

This is an important point. Modern Portfolio Theory, which equates volatility with risk, is an interesting framework. And it did win a Nobel Prize. But in my opinion, it is more a textbook theory than a practical tool for managing portfolios.