How investors can benefit from a 'mis-pricing' of financial risk

Most people would agree, any investment proposition must involve some consideration of risk and return. A good investment idea is one that sees an attractive return profile without commensurate downside risks.

In my experience, most equity investors tend to start with the return side of the investment equation because there is a natural bias towards looking for the upside. However, it is also possible to start with risk by investigating the things that can go wrong for a company, and how this might impact the valuation. Investment opportunities may present themselves when market expectations, as to the extent and likelihood of risks materialising, are out of line with the true fundamental risks. As an example, let us consider financial risk. The problem with financial risk is it tends to be...