đ 15th Anniversary Offer: On 9th July, Safal Niveshak turns 15. To celebrate, my books are on discount, individually, in combos, and as a complete set, till 15th July. Click here to buy.
“All of life is a management of risk, not its elimination,” wrote Walter Wriston, the former chairman of Citicorp. The more you think about this statement, the more you can strip away one more layer of the illusion that you can somehow control what markets will do.
Randomness is the fabric that weaves the interaction of everything around us. You can’t remove it from human affairs, and so you can’t remove the risk that comes with it either.
Peter Bernstein, in his book Against the Gods, put this beautifully when he wrote:
The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.
What does this mean for you as an investor? It means you stop playing the game of standard dice and start looking for the loaded die instead. In other words, you own those businesses and investments where your knowledge, your research, and your circle of competence make the environment a little less random for you than it is for everyone else.
By doing this, you are not trying to eliminate randomness, but rather shifting the odds, even if just slightly, in your favour.
Now, just pause a bit on this. The “loaded die” metaphor is often misunderstood by most investors. They assume it means finding a stock where you can predict the outcome with high confidence. That is not what it means, because a loaded die still has randomness in it. It just means the six shows up a little more often than one in six times.
That, my dear friend, is the entire game. You are not looking for certainty. You are looking for a small, durable edge, and you apply it again and again on enough decisions, for long enough, that it slowly compounds into something real.
And this is why temperament matters more than intelligence in investing. A brilliant investor who plays the loaded die game for six months and quits because three bets went wrong will end up worse off than an average investor who plays it patiently for fifteen years.
Anyway, there is also a second layer of randomness here: randomness in the business itself, and randomness in what the market thinks about the business.
You can get the business right and still lose money for years for reasons beyond your control. For instance, the interest rates may go up, or some unrelated panic may hit, and everything gets repriced downward, good and bad companies alike.
No amount of analysis can fix this kind of randomness, simply because the problem was never in your analysis. The only response to it is patience, and designing your portfolio and the broader investment plan in a way that you never have to sell during the bad stretch.
But the harder part here is that not every fall in price is this kind of “irrational” randomness. Sometimes the market is repricing a business because something in it is actually falling apart, and the numbers just haven’t caught up yet. Telling myself “the market is just being emotional, be patient” is comforting, and it’s also exactly what I would tell myself if I were wrong and simply hadn’t noticed yet.
The honest way I try to tell these apart is to revisit the original thesis at least once a year, using only new facts, and ask whether the reasons I bought the business are still true today, not whether I still feel good about having bought it.
Once you have taken care of the “which die to play” question, the second thing to remember is to minimise the impact when randomness strikes, because it will.
This is where the idea of âmargin of safetyâ comes in.
Ben Graham originally defined it as buying something worth X for a fraction of X, and he built an entire philosophy around this one idea. But as this idea has evolved over the years, it has moved beyond just being a valuation technique.
I see margin of safety as a confession of humility. It is you telling yourself, before the fact, that you might be wrong or unlucky about this business, about the management, or about the growth rate. And so, you want a cushion large enough to survive being wrong or unlucky without being destroyed by it.
Buffett explained this in the simplest words I have come across:
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety youâd need. If youâre driving a truck across a bridge that says it holds 10,000 pounds and youâve got a 9,800-pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if itâs over the Grand Canyon, you may feel you want a little larger margin of safety.
I want to extend that bridge metaphor a little further. The size of the margin of safety you need doesn’t only depend on how vulnerable the business is. It also depends on how bad the consequence of being wrong actually is for you personally.
Two investors can look at the exact same bridge and need different margins of safety, because one of them is carrying cargo he can afford to lose, and the other is carrying his family’s entire savings.
This is why position sizing is really another form of margin of safety that people forget to talk about. You can have a wonderful business bought at a fair discount to intrinsic value, and still blow yourself up if you put too much money into it, such that a random, unforeseeable event turns a survivable mistake into a permanent one.
Even with a real edge, betting too much of your money on one single outcome destroys you over time, because the math of compounding is unforgiving to large drawdowns. A 50% loss needs a 100% gain just to break even.
Randomness does not care how right you were on paper if the position size turned a temporary setback into a permanent one.
***
Nassim Taleb wrote about a related idea, which is the difference between fragility, robustness, and antifragility.
A fragile system breaks when random shocks hit it. A robust system survives random shocks without much damage. An antifragile system actually gets stronger from random shocks and disorder, up to a point.
Most investors think their job is to build robust portfolios, ones that survive the storm. But the more interesting question is whether you can arrange your portfolio so that volatility and randomness sometimes work for you instead of against you.
This is what a cash reserve does for an investor.
Randomness in the market, a crash, a panic, or a mispricing, becomes an opportunity rather than a threat, because you kept cash specifically for the day the loaded die would show up cheap. The same randomness that destroys an investor who is fully invested and/or leveraged becomes fuel for the investor who has built his portfolio to gain from disorder, instead of being hurt by it.
***
There is also a psychological trap hiding inside all of this that Daniel Kahneman’s work explained best. Once you build an edge through research, there is a very human temptation to believe the edge is larger than it actually is, and to start believing your results are pure skill, when part of it was just luck.
This is the illusion of control.
A few winning trades in a row do not mean the die got more loaded. They might just mean you got lucky within an environment where your edge was real but modest.
The practical discipline here is to judge your process, not your outcomes, in the short run, because in any short enough window, randomness dominates skill. Over a long enough window, skill starts to separate itself from luck, but “long enough” in investing often means years, not months.
***
Now, beyond all this theory of randomness, how do you put these ideas into real practice, with real money?
Here are a few things I practice.
Before buying anything, I try to ask myself whether this is an area where my research and understanding genuinely create an edge, or whether I am simply creating false patterns out of a good story.
The test I use is simple: Can I explain, in plain language, why I understand this business better than the average person looking at the same stock. If the answer is that I don’t, that is a regular die, not a loaded one, and I should either do the work to load it or walk away.
But I’ve learned this test alone isn’t enough, because a wrong thesis can sound just as convincing as a right one, especially to the person holding it (confirmation bias). So I add a second test: Can I name, in advance, the specific fact or number that would prove me wrong? If I can explain my edge well but can’t say what would falsify it, that’s usually a sign I have a story and not an edge. And this means I should either sharpen the thesis until I can name that falsification point, or walk away.
Second, once Iâve decided the die is loaded in my favour, I work out my margin of safety not just from the business’s vulnerability but from my own uncertainty about my analysis. If I am less confident in my growth assumptions, I demand a bigger discount to intrinsic value before I buy. I try not to let a good story feel like conviction, and stand in for margin of safety.
Third, while I size positions loosely, unlike a professional money manager would, I try to size on how bad the worst case is for me, not just on how good the opportunity looks. A 10% position that would terrify me into selling at the bottom is worse than a 3% position I can hold through the storm.
Fourth, I try and keep some capital deliberately unemployed (in my savings account and liquid funds). And I donât do this with the idea of timing the market but to prepare for randomness to hand me a gift at some point. This is the antifragile piece. It costs you a little in the good years and pays you enormously in the rare years that matter most.
Fifth, and this I think is the most important piece of my âhow to deal with randomnessâ arsenal, I judge myself purely on process. I also keep a simple written record of why I bought what I bought. Six months or three years later, this lets me honestly check: was I right for the reasons I thought? Right for the wrong reasons? Or wrong, but saved by luck? This I think is the only real defence against the illusion of control.
You see, in investing as in life, randomness is not the enemy. It is the water you are swimming in, and it always will be. The entire craft of investing well is learning to build a boat, and a habit of mind, strong enough to survive the water’s unpredictability.
đ 15th Anniversary Offer: On 9th July, Safal Niveshak turns 15. To celebrate, my books are on discount, individually, in combos, and as a complete set, till 15th July. Click here to buy.
Leave a Reply