Investing is a loser’s game and not anyone else but the investor, with his unforced errors, beats himself all the time. That’s why even an average performer can win this game by being consistent in avoiding mistakes. Focusing on what can go wrong has long been a hallmark of sound investing.
An investor needs to do very few things right as long as he avoids big mistakes. ~ Warren Buffett
If you don’t lose money, most of the remaining alternatives are good ones! ~ Joel Greenblatt
We are big fans of fear, and in investing it is clearly better to be scared than sorry.~ Seth Klarman
Superior returns are mostly earned through minimizing mistakes than through stretching for yield. ~ Howard Marks
Warren Buffett isn’t particularly prone to superlatives, so it’s high praise indeed that he calls two chapters in Benjamin Graham’s The Intelligent Investor – one on stock market fluctuations (chapter 8) and the other on margin of safety (chapter 20) – “the two most important essays ever written on investing.”
In the first, Graham introduces the concept of a manic-depressive “Mr. Market,” whose mood swings can lead to equity mispricing. In the second he describes how to manage risk by investing only when there is “a favorable difference between price on the one hand and appraised value on the other.” This margin of safety, Graham writes, “is available for absorbing the effect of miscalculations or worse-than-average luck.”
Focusing on what can go wrong has long been a hallmark of sound investing. Baupost Group’s Seth Klarman put it succinctly in an investor letter –
We are big fans of fear, and in investing it is clearly better to be scared than sorry.
But chances are that even the most avowed pessimists can have their attention to risk dulled by long periods of generally favorable market conditions and low volatility – becoming oblivious, as Klarman writes, to “off-the-radar events and worst-case scenarios.”
Many fund managers have unimpressive careers, not because they haven’t had any multi-baggers. They might have quite a few 10, 20, even-50 baggers, but along with those home runs they also have too many losers which end their careers too soon.
And yet they don’t learn from each other because you can still find many of them swinging for fences with every bet they make.
Asking ‘how much you stand to gain if your bet turns out favourable’ is not as much important as asking ‘how much you can lose if things don’t turn out the way you expected’.
That’s why risk comes from not knowing what you’re doing.
If you ask any investor, “Which do you care about more, making money or avoiding losses?” Chances are most people will show their preference for both the options. The only problem is that it’s not possible to focus on both, profit making and loss avoidance, at the same time.
Howard Marks illuminates this idea beautifully in his book The Most Important Thing using an analogy from sports. He writes…
Given anything other than an outright winner by an opponent, professional tennis players can make the shot they want almost all the time: hard or soft, deep or short, left or right, flat or with spin…The pros can get to most shots their opponents hit and do what they want with the ball almost all the time. In fact, pros can do this so consistently that tennis statisticians keep track of the relatively rare exceptions under the heading ‘unforced errors.
But the tennis the rest of us play is a ‘loser’s game’ with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost.
Professional tennis players can be quite sure that if they do A, B, C and D with their feet, body, arms and racquet, the ball will do E just about every time; there are relatively few random variables at work. But investing is full of bad bounces and unanticipated developments…
So much is within the control of professional tennis players, that they really should go for winners. And they’d better, since if they serve up easy balls, their opponents will hit winners of their own and take points. In contrast, investment results are only partly within the investor’s control, and investors can make good money – and outlast their opponent – without trying tough shots.
The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defence – significant emphasis on keeping things from going wrong – is an important part of every great investor’s game.
The part on amateur tennis sounds so similar to how small investors invest.
Most wealth destruction happens owing to those unforced errors – hitting into the net or out of bounds, and repeating double faults at service (while making buying decisions).
So, not anyone else but the small investor beats himself all the time!
Howard Marks shared a brilliant insight in a talk that he recently delivered at Google. He gave an example of a fund manager whose fund consistently remained between 27th percentile and 47th percentile for 14 consecutive years. That sounds like a boring average performer, right?
But here’s what would confound even the smartest data scientist. At the end of 14 years, in spite of being an average performer for each of those years individually, the fund’s cumulative record secured it a place in the top 4th percentile. How come?
That’s because many other funds who were in the race and were at the top for few years (short term) blew up somewhere in between and blew up so bad that they disappeared altogether.
Here is an example to illustrate the point using some numbers. The performance numbers (for 10 consecutive years) for two funds are –
• Fund A – 12%, 11%, 12%, 13%, 12%, 11%, 13%, 13%, 12%, 13%
• Fund B – 15%, 15%, 15%, 15%, 15%, 15%, 15%, 15%, -50%, 15%
If both funds start with initial sum of Rs 1000, which one do you think wins at the end and by how much margin?
In spite of Fund B winning in 9 out of 10 years, Fund A
That’s how an average performer wins this loser’s game by being ruthlessly consistent for avoiding mistakes.
How many times have you heard a statement like this – “If you want to be in the top 5 percent, you should be willing to land in bottom 5 percent also.”
Nothing can be further from truth, when it comes to investing. Landing up in the bottom 5 percent (even couple of times) can throw you out of the game permanently.
It’s like saying, if you want to live a long life, you should be willing to experience severe illness couple of times. No! That’s an insane thought. A severe illness can kill you also. Your focus should be on avoiding all kinds of severe illnesses.
Perhaps Charlie Munger was thinking something similar when he said, “All I want to know where I am going to die, so that I will never go there.”
So the idea is that you need to search hard for the places where you can die i.e., things that can go wrong and then leave no stone unturned in avoiding those things.
Value investing is not as much about doing smart things as it is about not doing dumb things.
Investing can become a winner’s game for you only if you work towards reducing those unforced errors – errors in picking up stocks, and misbehaving.
In our first issue of Value Investing Almanack, we asked Neeraj Marathe, an accomplished value investor, this question –
“What’s that one thing that has helped you in most of your successes as an investor? What can other investors do to make that their own success mantra?”
And this what he said –
I think the thing that has helped me the most is avoiding mistakes. The flipside of that is that I have ended up missing a lot of opportunities, but avoiding mistakes has really helped me generate respectable returns over the years.
So am I suggesting that you should avoid making every little mistake? No. That’s not possible and not recommended either.
No matter how much I harp on the pitfalls of making mistakes, there is no doubt about the fact that making mistakes is not only inevitable but essential for investment success.
There is nothing you can do to prevent errors. That’s not what Buffett means by ‘Don’t lose money’.
And that’s exactly what Seth Klarman meant when he wrote this in his book Margin of Safety…
Warren Buffett likes to say that the first rule of investing is ‘Don’t lose money,’ and the second rule is, ‘Never forget the first rule.’
I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of principal.
While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken.
It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.
To be a sensible and intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money. Because by ‘not losing all’ you increase the odds of staying in the game longer.
There is a difference between asking what could go wrong and how bad it would be when it does go wrong.
Thinking about the probability of things going south is not an adequate risk control measure. The real risk averse approach focuses more on the size of the loss and attempts to reduce the impact of that loss rather than taking comfort in the miniscule probability associated with the event of loss.
What matters is not how often you’re right (or wrong) but how large your cumulative errors are.
This is also the central idea that Nassim Taleb discusses in his book The Black Swan. Black swan is an event which is rare, unexpected and has the potential to wipe you out.
In case of black swans, asking what can go wrong can’t help much either. Because by definition, black swan can’t be predicted. So Taleb recommends a framework of non-predictive decision making where you don’t need to know the details of ‘what can go wrong’ but you arrange your affairs in such a manner that you’re never exposed to risks of losing all.
The easiest way to explain is using the example of debt. If you are not leveraged, then the maximum you can lose is 100% of your money. But if you have high debt you can end up in negative which may cripple you so badly that you can’t even start over again. That’s called getting wiped out.
So how do you avoid blow ups in investing?
The critical element of defensive investing is to carry out a thorough research, extensive due diligence, seek high standards and demanding a low price. But the most important one is margin of safety.
Charlie Munger says –
No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.
Using the margin of safety concept, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.
Here’s another way to explain the idea. Let’s say you find a deal where you get to buy a property which you think is worth Rs 100. If you pay Rs 90 you have a good chance of gain, as well as a moderate chance of loss in case your assumption about property’s worth turns out to be too optimistic. But if you buy it for Rs 70 instead of Rs 90, you chance of loss is even lesser. That Rs 20 reduction provides additional room to be wrong and still come out okay.
The beauty here is, like Taleb’s non-predictive decision making, you don’t need to predict the correct worth of the property. By incorporating sufficient margin of safety (by paying low price) you have already covered your downside.
What you are trying to do when making an investment is to find a mispriced bet. Margin of safety is all about finding a “significantly” mispriced bet.
Margin of safety has dual advantage. Paying a lower price is akin to reducing the impact of a mistake, if it turns out to be a mistake. And if your bet turns out to be better than what you expected, then the initial margin of safety magnifies your profits.
That’s how in investing, by avoiding to get strike out, you ensure home runs.
And not just in investing, you have to extend the same attitude in other affairs too. As Prof. Bakshi writes …
…you have to keep on worrying about what can go wrong, where is the risk etc. While doing so, it’s a good idea to keep Robert Rubin’s observation about risk in mind: Condoms aren’t completely safe. My friend was wearing one and he got hit by a bus.
The risk can come from multiple directions and sometimes we are so focused on one area that we completely ignore the other sources of risk.
In his book, Taleb describes an example of a casino which had all the risk control measures at place which included strict gambling policies to reduce losses resulting from cheaters and controlling the bet sizes on each table to avoid taking a hit from an extremely lucky gambler.
Yet, in spite of such sophistication, their risks had nothing to do with what can be anticipated knowing that the business is a casino. For it turned out that the four largest losses incurred or narrowly avoided by the casino fell completely outside their sophisticated models.
First, when their star performer of the main show was killed by a tamed tiger. Second, when a construction worker planted a bomb in casino’s basement. Third, when an employee’s mistake to send a crucial document to tax authorities invited a monstrous fine. And finally there was a threat of casino owner’s daughter getting kidnapped for ransom.
The casino spent hundreds of millions of dollars on gambling theory and high tech surveillance while the bulk of their risks came from outside their models.
Now you can’t really avoid travelling because of risk of losing your life in an air crash. That would be impractical.
What I am suggesting is – while you’re insisting on a very conservative discount rate for your DCF, don’t forget to wear the seat belt while driving.
While you’re double checking the quality of management before committing money to a stock, don’t fall for the temptation to answer your phone or reply a text while you are behind the wheel.
And please remember, this idea is not to increase worry and anxiety in our life. It’s precisely the opposite. You shouldn’t be consumed with the thought of ‘what can go wrong’ all the time else it may affect the quality of your life.
Use it as a tool to find out ways and develop processes to cover your downside.
Focusing on what can go wrong is not just for investing but also a principle for living life prudently.