A big part of investing is understanding that every strategy moves in and out of favor. As the saying goes, the best strategies perform well over time, not all the time.
The second part to that is understanding that stock prices are in constant flux. The second you believe prices move in one direction is the moment you set yourself up for trouble later on.
History shows that for some reason – complacency, ignorance, panic, FOMO, greed, envy, whatever – many investors change strategies during a market cycle. Whatever strategy they were using, if they had one, is no longer good enough for the recent price action.
It’s that chasing of returns versus anticipating a change in those returns that lead to higher risk taking and uncomfortable endings.
The best strategy for you, is not only one that makes sense, but one you can stick with. – Joel Greenblatt
I was reminded of Greenblatt’s quote while re-reading something Seth Klarman said during a lecture. Greenblatt said it best, but Klarman offered a little insight into why he avoids certain strategies.
He offers a lengthy explanation on how he defines risk, being long, selling short, and why being comfortable is so important. That last part doesn’t get talked about enough (emphasis mine):
That most investors, especially these days when their clients are pestering them, “What is your risk control? How do you control risk?” And people ask us that. I think they want to think like we’re gonna pull out some computer and say, “Our risk is right here. Look. We got this model and we can’t lose money no matter what we do.” There’s no such thing. Or they want a quantitative number, “Our risk .7.” What the hell does that mean!
Risk is really simple. Risk is the way you think about it in your personal life. Risk is how much can you lose and what are the chances of losing it? That’s risk. And everything else is just, sort of, an academic-y kind of way of thinking about it, that they can start to measure something. But it’s not the same thing.
The simplest way to think about this is, if you want, look at Enron bonds. Enron bonds trading at 15 that we think are worth in the 30s. If they fell to 7 ½, if they fell in half, the world starts to think, “Oh my god. Look at the volatility of those. They’re really risky.” And all you have to do is say the name and they think they’re really risky. And the reality is at 7 ½ they’re just that much more of a steal. And that’s true for almost any kind of security. That the way we think about what a security is worth, if we think a stock is trading at $10 and it’s worth $20 and it falls, it’s gotten safer, not riskier because the amount you can lose is less. It’s very simple math. It’s closer to zero. And the upside is bigger. Instead of going from $10 to $20, you can go from $8 to $20 or from $6 to $20.
Now, of course, when a security falls you don’t just blindly buy it. You say, “Why’d it do that?” And the answer’s not always comfortable. Maybe it did it because there was an announcement about a hidden liability, or something went terribly wrong in the business, or they lost a patent or something. So then you reassess and it’s probably not worth $20 anymore. But if you reassess and you’re comfortable it’s worth $20, and it goes lower and lower, you back up a truck.
Now another thing – really important – people say, “Okay. You’re a value investors. What about selling short? Why don’t you sell short?” I don’t sell short because it’s not the mirror image of value buying. That if you buy a bunch of stock at $10, and it goes to $8 and buy more, it goes to $6 and you buy more, it goes $5 and you buy more, eventually you’ll own 51% – this is theoretical, you don’t actually do this – but eventually you own a very large stake. You, kind of, force the outcome. The outcome will be, all right, it’s really worth $20, let’s sell the company. Let’s spin off a subsidiary. Let’s do whatever and force the market to recognize that value. Or sell some assets and buy back a bunch of stock.
If, on the other hand, you’re short a stock at $40 that’s worth $20, and it goes to $50, and it goes to $60, and it goes to $80, you now are broke. That your position gets bigger and bigger, and you owe more and more as it goes against you. So, at least, if you are controlling risk and you’re short, you have to cover as it goes up. So you reduce your position as it goes higher and higher, locking in your losses, compared to being long where you don’t have to sell as it goes down. You buy more and turn the lemons of having overpaid initially, into lemonade by buying a lot lower.
Also, to put it bluntly, I don’t sleep well at night being short. That, if you’re long, you have very limited risk. You can lose, if everything goes hopelessly wrong, what you paid. If you’re short you can lose infinity. That’s not comfortable. I don’t like that skewing. So we’re not comfortable… One of the nice things about investing is there are many different disciplines that work. You should find one that you’re comfortable with. Don’t do one that you can’t sleep at night. It’s not worth it.
The lesson is not about avoiding short selling. Though, Klarman offers a great rundown on how value investors perceive risk and the risks of selling short. I would add Buffett’s reason on why he doesn’t sell short – the market is too unpredictable in the short term, making the risk too high.
Of course, the lesson is: do you understand the risks of the strategy? How much can you lose and what are the chances of losing it? Are you comfortable with the worst case scenario? Are you even thinking about the risks? Assuming you are, and that risk is uncomfortable, it’s best to avoid it.
Investing shouldn’t be a walk in the park, but it shouldn’t be a constant gut wrenching experience either because when things get unbearable is the moment where most investors give up.
Not surprising, around that same moment, the investors who have this figured out are doubling down on the strategy. Because in that instance, the investor turnover sows the seeds of that strategies return to form.
Unfortunately, saying this is the easy part. I doubt many investors find a strategy that fits on the first try. Finding out what works for you, and what you’re comfortable with, is something that comes with time and the experience of a full market cycle or two.
Seth Klarman on Risk Aversion
The Reminder of Mr. Market
Buffet’s Method of Success