Risk vs Uncertainty

For those of you interested in interviews with famous value investors I would recommend the Value Investing videos on Youtube hosted by Steve Forbes. Tonight I was listening to an interview with hedge fund manager Mohnish Pabrai. If the name sounds familiar it is because Pabrai made headlines when he bid $650,100 in 2007 for a lunch with Warren Buffett.


During the interview Pabrai mentions the difference between risk and uncertainly. Often we are taught that to achieve high returns we need to have high returns - "High risk, high return." Value investors however believe that Low Risk, High Returns are possible. In fact when you purchase a stock for less than it traded yesterday, assuming future prospects have not changed then the risk has actually decreased. 


Pabrai uses his previous entrepreneurial background and a story about Microsoft's Bill Gates as an example to illustrate the point. Firstly he states that although entrepreneurs are seen as high risk takers, successful entrepreneurs actually take all steps to lower risk. 


Pabrai explains that he has founded three businesses during his career. The first was low risk and generated huge capital - a huge success. The second he invested a large amount of capital and suffered major losses. The third was founding a hedge fund which was low risk with potential for high payoffs. So far the third business has been a success.


According to his research successful billionaires such as Richard Branson and Bill Gates also followed the low risk, high return approach. He explains that Microsoft has never required more than $50,000 of initial capital to fund it's business growth and success. Microsoft founders Bill Gates and Paul Allen had low risk, but they did have high uncertainty. High uncertainly allowed for a range of possibilities from Gates and Allen going broke on one extreme to them becoming billionaires on the other extreme. 


High uncertainly does not necessarily mean high risk - a key point the investors need to remember. Although an investment may have high uncertainty as long as the risks are sufficiently low then it could still become a runaway success. Pabrai calls it the "Heads, I win; tails, I don't lose much" approach. In investing speak 'minimise the downside risk, and the upside will look after itself.'