Process / Philosophy · Series: Managing Investment Risk · Post 2 of 6
August 15, 2026
By Rob Nicoski, CFA · Disciplined Growth Investors · dginv.com
In our first post, we introduced Alex Honnold — the free solo climber who became an unlikely teacher on the subject of investment risk management. His secret wasn’t fearlessness. It was clarity. Honnold understood precisely what he was up against before he ever touched the rock. That clarity made it possible to prepare, to mitigate, and ultimately to succeed where lesser preparation would have been fatal.
The same principle applies to investors. Before you can manage risk, you must understand what it actually is. And this is where much of the investment industry goes quietly wrong.
Sound risk management starts with a risk mitigation plan that carefully considers the specific risks associated with an activity or endeavor. That appreciation for the specific risks flows from a clear understanding of fundamental truths about risk and uncertainty. We’ll cover two of those truths here and explain why getting them right — or getting them wrong — has significant consequences for every investment decision you make.
Voltaire once said, “Doubt is not a pleasant condition, but certainty is an absurd one.” His was a brilliant observation on not just the folly and arrogance of professing certainty about future events, but also the immutable nature of uncertainty in human affairs in general. Uncertainty is a fact of life that we must all accept. It guarantees the consequences of our actions cannot be exactly known or fully defined in advance, because all practical endeavors have an element of unknowability or unpredictability.
Generally, the more complex the system, the greater the degree of uncertainty. This equates to a much broader range of possible outcomes. For instance, the spread of potential outcomes for the level of the stock market one-year out is quite wide based on historical experience. This is because the market is a highly complex system driven by the independent decisions of millions of participants — leading to a dizzying array of possible outcomes. This is why we waste no time trying to predict future stock market levels or highly complex systems in general.
As a first step in building an understanding of risk that can allow us to eventually more effectively manage it, we find it helpful to think of risk as any outcome that falls below a “minimal acceptable result.” Think of this as the threshold at which an effect begins to represent risk. For an everyday activity like driving a car, the minimal acceptable outcome might be making it to the target destination without injury or damage to the vehicle. Any result that falls short of a safe arrival would constitute risk.
Humans intuitively grasp the notion of risk. We recognize that even though our behavior may be geared to elicit a positive outcome, negative consequences are generally likely as well. We have come to associate the gamut of potential unfavorable outcomes with the concept of risk. The specifics of these adverse consequences may conjure varying images in each of our minds, but humans generally concur that risk is the potential for harm or loss.
In the same way that risk is any outcome below the minimal acceptable result, risk is actually a subset of uncertainty — that portion of uncertain outcomes that carry the potential to cause harm. Uncertainty encompasses the full range of possible outcomes: good, bad, and indifferent. Risk is only the slice that can hurt you. The minimal acceptable outcome is unique to the decision maker. For investing, it may vary considerably based on each investor’s particular goals, liquidity needs, and risk tolerance.
This distinction — between uncertainty and risk — is not semantic. It is foundational. And it leads directly to the most important practical implication: uncertainty in its entirety generally cannot be managed, but risk can. Those investors who lump the two together will likely make faulty risk management decisions, thereby creating opportunities for those who properly separate them.
Risk is also a highly dynamic variable, arguably more volatile than uncertainty itself. This can be seen in activities where even subtle changes in context have the potential to meaningfully alter risk exposure. Such a change can shift the range of potential outcomes and/or modify the likelihood of different outcomes occurring.
A concrete example: In 2021, valuation risk in the equity markets was excessive according to our work; by late 2022 valuation risk had been reduced and largely removed from most publicly traded companies. This rapid shift in investor perception precipitated a sharp decline in market prices over the course of 6–9 months and led to an entirely different risk profile for stocks.
An ability to assess shifts in context and the impact on risk is a function of expertise, self-awareness, and a willingness to acknowledge changes in circumstances and adjust accordingly. We get a glimpse of this with Mr. Honnold. Over the course of his practice runs on El Capitan, he recognizes that he does not want to be on certain parts of the climb when the sun is at the wrong angle, as it will sap his stamina and increase the odds of a fatal mistake. He chooses to start his climb before dawn to avoid this potentially risky change in circumstances.
The story of risk management in the modern investment industry begins with an academic theory conceived in the 1950s that ascended to industry dominance in the 1980s: Modern Portfolio Theory, or MPT. The result of this framework is to make investment risk synonymous with volatility. Volatility, or beta, refers specifically to the relative short-term volatility of the price of a security. What this means in practice is that if the price of Fred Corp. stock fluctuates more on average than the price of Rob Corp. stock, Fred Corp. stock is a “riskier” investment.
The crisp mathematical conclusions volatility offers are a textbook example of a psychological bias called the “Streetlight Effect.” The Streetlight Effect is captured by an apocryphal tale of an inebriated man crawling on the ground under a streetlight. A police officer walking his evening beat approaches the man, who explains that he is looking for his car keys. The police officer joins him in the search with no success. Eventually the officer asks the man if he is sure that he lost his keys in this area. The man confesses he lost his keys in the park two blocks away. The confused officer asks why he is looking here. The drunken man answers, “Because the light is better here.”
The Streetlight Effect captures our tendency to look where “the light is best” — to favor ease of measurability over relevance. Volatility embodies this phenomenon perfectly in that it can be measured and manipulated with exacting mathematical precision. However, its relevance and effectiveness in understanding and mitigating risk is not supported by evidence. In fact, it can just as easily obscure risk (e.g., Bernie Madoff) as expose it. The moral of the story is that we jeopardize our ability to accurately assess risk if we choose ease of measurability over predictive relevance.
The consequences of misidentifying risk are not merely academic. When volatility is treated as a stand-in for actual risk, margin of safety — the cornerstone of sound risk management — gets applied to the wrong problem. Since risk is misidentified as volatility, the putative application of margin of safety is misapplied in a way that provides a dangerous false sense of safety.
There is a view regarding risk and risk management that dominates the investment industry today — a view constructed in the ivory towers of academia we refer to as the “Volatility View.” We argue that the Volatility View is fatally flawed. Even worse, it can lead investors into inappropriate types of risk mitigation plans. This is often the case because it violates the principles of risk management by misidentifying risk at a fundamental level. This mischaracterization of risk makes it impossible to properly apply the concept of margin of safety — a common and costly mistake for anyone adopting this risk management framework.
Getting the definition of risk right is the essential first step. But even investors who understand the distinction between uncertainty and risk — and who recognize the limits of volatility as a proxy — are not immune to getting it wrong. There is another source of distortion that operates closer to home, and it is one that no spreadsheet or model can fully account for: the investor’s own mind.