For whatever reason, investors have a hard time dreaming of the high returns they can earn from an investment while also thinking about its risks. A deficiency in multitasking, I guess.
But it plays a big enough role in poor investment performance that Seth Klarman spent a chapter in his book explaining why risk management – avoiding losses – is the cornerstone of a value philosophy.
His explanation starts with the one thing we’re all terrible at, yet so many investors try to do it anyway.
One of the recurrent themes of this book is that the future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstance. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly, we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forgo some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.
Choosing to avoid loss is not a complete strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.
Investing is never without risk. There is always some risk to insure against and yet, we can never insure against every risk because its impossible to predict what happens next with any consistency.
So what’s an investor to do? How do you protect your money from the risks that cause the worst losses?
The first step is to stop focusing on returns.
Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating that you want to earn, say, 15 percent a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.
With investing, we’re compensated for the risk we take, hopefully, with an appropriate return. But that doesn’t always happen. Risk by definition means that what we expect to happen might not happen. A loss is possible. Other outcomes are possible too.
When an investor is dreaming of earning a high return, they’re not thinking about the equally high risk that comes with it. The latest IPO or crypto-coin might have huge potential upside but it has huge downside risk too.
So that “disciplined and rigorous approach” you choose should start and end with risk management:
Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.
Klarman is talking about asymmetric bets – where the upside is higher than the downside – that arise from inefficiencies in the market. It’s not the easiest thing to spot and act on for a reason. If it was easy, everyone would do it and the higher upside wouldn’t exist.
That doesn’t make risk management any less important. It still helps every investor avoid the temptation of high returns that often lead to devastating losses.
Source:
Margin of Safety
Related Reading:
Seth Klarman: Consistency in a Bubble
Seth Klarman on Risk Aversion
Seth Klarman on Absolute Returns, Risk, and Timing
