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*The risk that matters most is the risk of permanent loss [of capital]. - *Howard Marks
The many varieties of risk
"Risk" is a funny word. In the context of investing, it is used constantly; however, if you ask somebody to define what he or she really means, you are likely to be met with plenty of hesitation. "Risk" is one of those words we all use every day without giving too much thought to what it actually means.
When I think about risk, though, one definition towers over and above all the other ones. To me, when investing, "risk" is mostly, but not exclusively, about the risk of permanently losing your capital. Whichever of those silos above you think offer the best description of risk, in almost all cases, the risk of a perman…
da-kuk/iStock via Getty Images
*The risk that matters most is the risk of permanent loss [of capital]. - *Howard Marks
The many varieties of risk
"Risk" is a funny word. In the context of investing, it is used constantly; however, if you ask somebody to define what he or she really means, you are likely to be met with plenty of hesitation. "Risk" is one of those words we all use every day without giving too much thought to what it actually means.
When I think about risk, though, one definition towers over and above all the other ones. To me, when investing, "risk" is mostly, but not exclusively, about the risk of permanently losing your capital. Whichever of those silos above you think offer the best description of risk, in almost all cases, the risk of a permanent loss of capital hovers above it. In the following, I will talk about how the risk of that can be minimised.
How to measure risk
When professional investors manage risk, two measures of risk tend to dominate:
- (equity) beta; and
- value at risk (VaR).
Allow me to spend a minute on how to define the two terms. Equity beta is a measure of the sensitivity of a stock (or portfolio) relative to movements in the equity market. If you assume the equity market is represented by S&P 500, an equity beta of 1 suggests the stock in question will move in line with S&P 500, whereas an equity beta suggests the stock in question is more (less) volatile than S&P 500.
The beta can be measured against other benchmarks as well – doesn’t have to be against the equity market. If, for example, you wish to measure the sensitivity to commodity prices, you calculate the commodity beta, etc, etc.
VaR is a bit more complicated. It is a measure of the maximum expected loss over a given time horizon and at a pre-defined confidence level (typically 97.5% or 99%) *assuming normal market conditions *. The latter is a very important assumption.
The primary problem with both of those measures is that they are akin to rear-mirror viewing. One cannot be sure that history will repeat itself, and both measures depend, to a significant degree, on historical patterns being repeated. That said, there isn’t much you can do to improve the analytical outcome. One option is to introduce a Month Carlo model when calculating the VaR, which will eliminate the dependence on history, but that won’t protect you against every possible outcome.
Every day, we calculate the equity beta on every single holding in our fund, and we calculate the portfolio VaR. In terms of the latter, we work with a self-imposed limit of 3%; i.e. we aim to keep the portfolio’s 97.5% 1-day VaR below 3%.
How you should manage risk
Most private investors don’t have the tools, nor the time, to spend hours every day on risk management, so a more pragmatic approach is warranted. I suggest the following approach: identify a handful or two of indicators which, historically, have led to the party coming to an abrupt end. To me, the ten most important ‘end of secular bull market’ indicators are listed in Exhibit 1 below.
Exhibit 1: End of secular bull market indicators
Sources: The Felder Report, Absolute Return Partners LLP
I work with these indicators in a rather simple way. Essentially, the more boxes I can tick, the more likely, I believe, it is for the secular bull market to come to an end rather soon. Now to the serious part: All ten boxes are currently ticked off! That tells me that the end might not be that far away. Three caveats:
1. Secular bull markets rarely end ‘just’ because equities are expensive. Some sort of catalyst shall be required.
2. When going through this exercise, you may end up with a different set of indicators than me but that matters less. Choose those that you are comfortable with and that have worked for you over the years.
3. Timing is the most difficult part of an exercise like this, and it is easy to be (too) early – in fact so early that it poses real career risk to professional investors, and that is probably why many prefer to stay on the train until it is too late to get off without an injury or two.
Re the last point, I learnt in 1990 when Tokyo Stock Exchange crashed, and again in 2000 when the same happened in New York, that most investors prefer to participate in the party to the very end, knowing very well that they may end up with plenty of (rotten) egg on their face.
Nothing has convinced me that investors have changed even the slightest. Momentum continues to drive markets forward, whatever asset class you look at, and the crowd mentality is stronger than ever. That is sort of a "if my neighbour got rich on gold, why shouldn’t I do the same?" mentality, which is very dangerous.
Allow me to finish this month’s Absolute Return Letter by sharing a chart from Goldman Sachs (GS) which shows how abundant speculative fever currently is (#5 on the list above). The chart was produced last October, i.e. it only provides 2025 data through September, but there is no reason to believe that anything happened in 4Q25 which would change the picture.
Exhibit 2: Price return on various US equities (Note: 2025 to 30 September)
Source: Goldman Sachs Global Investment Research
Now to my point: If Nasdaq stocks with no revenues delivered the highest return to US investors in Q1-Q3 last year, and if unprofitable Nasdaq stocks came joint second, isn’t that about as strong a signal you can get that speculative fever is ample?
I could indeed provide plenty of other charts to support the issues I listed in Exhibit 1 but will only do one more – leverage is high (#8). Exhibit 3 below is testament to the fact that it is not only retail investors who get carried away from time to time. As you can see, in recent years when equity returns have been particularly strong, what have hedge funds done? Piling on ever more leverage, is the answer. This can only end in tears.
Line chart showing Hedge fund borrowings by source from 2013 to 2025.
Source: Apollo Global Management
Final few words
In the fund we manage, we are, at least to a degree, caught in the same dilemma. It is easy to see (many) equities are overvalued, but by going too conservative you risk missing out on returns. Consequently, we remain nearly fully invested but with a defensive twist. We hold large positions in low beta equities and in certain commodities which tend to do much better than equities when stocks decline. Most importantly, we hold plenty of gold.
Rather surprisingly, our ‘defensive’ approach still led to extraordinary returns in 2025. We finished the year delivering +29.24% net to USD investors. That is obviously very pleasing; however, at the same time, I find it uncharacteristically worrying. If you deliver almost 30% to your investors, do you in fact take more risk than you think you do? Finding the answer to that question has kept us very busy in January.
Niels
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Important Notice
This material has been prepared by Absolute Return Partners LLP (ARP). ARP is authorised and regulated by the Financial Conduct Authority in the United Kingdom. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance. Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.