Breaking News: Investing is Risky
The key question is: how do we define this Risk? And, more importantly, how do we manage it? Before we get into those simple questions, let’s just take a step back and think about what makes investing risky. What makes it risky is simply the massive range of factors (aka underlying events) that affect an investment’s price. And the way the “market” responds to changes in those factors as it affects price is inconsistent, to put it mildly. Ultimately, the problem is that we don't really know about the future path of the value of most investments. As Secretary Rumsfeld put so eloquently during the second Gulf War: there are “known unknowns and unknown unknowns”. The “unknown unknowns” are silent, but violent. He learned the hard way.
So, Why take the Risk?
How else can you beat inflation? This is covered at greater length in “Why Invest?” but I’ll come at it from a different angle here. Compare investing to gambling, which many people do. The range of factors affecting your payoffs at a roulette table is comparatively limited. That’s hard to believe but it’s true. Assuming Danny Ocean and hist Rat Pack aren’t hanging around, the odds of winning at a roulette table are known to us before we spin the ball; about 50% chance of winning red, 1/33 chance of winning the number 23, and so on. In investing, that range of underlying factors and all their permutations is infinite. We just don’t know the odds of winning before we make a bet. We can’t. There are too many factors at play. But strangely enough, that’s a very liberating thought: when investing, we’re not at the mercy of predetermined odds. This is a powerful realization.
Here’s the big difference between Investing and Gambling: In investing – the price we pay or accept for an asset – actually affects our odds of winning. If we overpay, the odds of winning decreases significantly. If we find an opportunity where we can underpay for a good business, “lollapalooza!”,Charlie Munger would shout out.
Now, overpaying or underpaying depends partly on what the market, at any given point in time, deems the price of our asset. That fluctuates. A lot. The way markets react to those innumerable underlying factors that should affect the value of an asset, oscillates between reactions guided by fear, greed, and everything in between. That, in short, is what Wall Street and Academia focus on when they talk about Risk in investing. They take the market’s moods and gyrations as the quantitative fodder for defining Risk. This penchant for precise quantification of Risk using market data has been around for decades. I think that’s the wrong way to look at it, based on my experience and on the experience of the giants of investing – Buffett, Graham, Munger, Soros, Marks et al. Don’t be intimidated by pseudo-scientific mumbo-jumbo masquerading as “Risk Management”. They sound smart; they’re usually not.
Bogus Definitions of Risk
Wall Street and Finance Academics come up with all sorts of fancy jargon to define Risk. The most common definition of Risk is Standard Deviation of returns a.k.a. Volatility. This is an offspring of the “Modern Portfolio Theory” developed by Harry Markowitz. I have serious issues with that theory. And, unsurprisingly, I have serious issues with Volatility as a primary measure of Risk. This is the gist:
- Volatility tries to capture swings in the prices based on the assumption that investment returns are normally distributed (which is not true in the real world). In a non-normal distribution, deviations from the mean (average) are, well, not that standard.
- And most of the time it doesn’t mean much practically speaking. It’s just a number. Maybe, if you’re a day trader, it could have some meaning, because you may want to cash out next week or next month. Your time window for investing makes a big difference in the calculation and relevance of this incomplete measure of Risk. There are awful sounding concepts such as “time-scaling of volatility” to deal with this issue, but they only exacerbate the inadequacy of volatility as the primary measure of risk.
- It’s based on past data – the assumption there being, that past volatility will repeat itself over the long run, so the number means something. Not true.
- It says very little about what really kills you – the real Risk: Permanent Loss of Capital – it’s probability and its magnitude. As Mark Twain rightly observed about life (and maybe about investing) “It ain’t what don’t know that gets you into trouble; it’s what you know that just ain’t so.”
Then there is the ubiquitous Beta. Wall Street loves this. But it has all the same pitfalls as volatility; maybe more. Roughly speaking, Beta could be defined how much a stock swings relative to the market. Again, it’s an offshoot of the flawed but important Modern Portfolio Theory. Pardon my Greek, but in technical terms, Beta is basically a stock’s relative volatility compared to the market’s, multiplied by the correlation between the stock and market. You don’t have to understand all those terms to see that right there we have three layers of potential problems that could amplify the error in each other.
Academics and many portfolio managers love this measure. But I think it’s mildly informative at best, bogus at worst. Charlie Munger thinks so too:
“Beta and Modern Portfolio Theory and the like – none of it makes any sense to me…how can professors spread this? I’ve been waiting for this craziness to end for decades. It’s been dented and it’s still out there.”
In the 1990s academics and quants became more creative. They invented “VaR” which stands for Value-at-Risk. Catchy name, but it suffers from many of the same problems as Volatility. The main improvement in VaR is that it measures “tail risk”, so at least it tries to quantify potential loss of capital. That makes it a bit more intuitive than Standard Deviation. The English translation of VaR goes something like this: “…we can say with 95% confidence that you will not lose more than $X in the next Y days.” Traders love this kind of a deterministic statement. But the longer your time horizon, the more meaningless this type of statement becomes. I think it’s false precision, and generally useless. For starters, what about the other 5%? What could the loss amount to beyond that $X level? That’s the event which might kill your investments. And again, it’s based on past data. In practice, when it really matters, when things blow up, VaR is an unreliable measure.
There are other fancy measures employed by Wall Street and the Investment Management Industry: CVaR, Scenario Analysis, Stress Tests, Expected Shortfall…or (Insert Greek letter of choice here). But the problem with all these measures is simple: garbage in, garbage out. They give us a false sense of comfort. At best, they’re an interesting intellectual exercise. Often, they’re terribly misleading.
“Not everything that counts can be counted; and not everything that can be counted counts” – Albert Einstein (allegedly).
The Buylyst Definition of Risk
Probability of Permanent Loss X Magnitude of Permanent Loss.
One of those without the other isn’t particularly useful. At The Buylyst, I don’t want to quantify this to any degree of false precision. Even if I have some fancy statistical models to give me a number, I won’t depend entirely on it; not to mention the man-hours and computer horsepower I’d need to achieve that level of false precision. Borrowing from another analogy from Buffett, it would be a case of 400-horsepower input for 100-horsepower output. My time is better spent thinking about what the risks could be, logically, rather than obsessing over the minutiae of statistical models. So, here’s how I think of it:
The probability of permanently losing money and the size of the loss are both dependent primarily on two kinds of errors: Analytical Error and Psychological Misjudgment.
Analytical error results in a wrong estimate of value of an asset. This estimate of value is not dependent on market price or by how much it fluctuates. Shouldn’t it be the other way around? Payoff, however, is dependent on market price. But that’s different from intrinsic value, which is dependent on many, many external factors that play a part in the giant ecosystem in which the company operates. Given the scope of the ecosystem, there could be errors in estimating this intrinsic value due to calculation errors. For example, it could be a wrong calculation of cashflow, wrong interest rate on debt, wrong prediction of future capital structure and so on. I’m usually not too worried about math errors; they could happen, but chances are low given that I’ve been doing these for years. The same goes for most “market participants”.
The more potent error lies in subjective judgements like determining whether a company’s profitability is sustainable or whether a whole industry will crash and burn. Sometimes analysts get so caught up in the minutiae of a company’s financial statements that they forget to zoom out and think about the entire ecosystem. Said other way, it’s always a good idea to ask, “Are we playing the right sport?” Every investor, including the great Warren Buffett, has made this error from time to time. Again, too many unknown unknowns.
"…there's another model from microeconomics that I find very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon that I call competitive destruction. You know, you have the finest buggy whip factory, and, all of a sudden, in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you're dead - you're destroyed. It happens again and again and again." - Charlie Munger
Psychological errors come from the fact that we’re all humans. We’re guided by all sorts of emotions – fear, greed, sense of ego, anger, envy etc. Most of us are not as mentally evolved and emotional stable as the Dalai Lama is; we try our best to keep these emotions in check, but they guide our behavior frequently. FOMO – fear of missing out – is a psychological misjudgment which causes a lot of losses in the investment management business. People don’t like lagging behind in a bull market: “everyone’s buying, I should get in on this!” The underlying emotion there is envy. Another common source of error in the investing world is ego. Sometimes we are so married to our investment idea or our estimate of its value that we refuse to pay attention to evidence to the contrary. This is the root of Confirmation Bias. Politicians often suffer from this type of fanaticism.
I try to be aware of my analytical and psychological limitations. That’s the best I can do. It takes a lot of introspection but we all need some guidance from time to time – from friends, advisors and the giants of investing. I highly, highly recommend that you read Charlie Munger’s lecture on “The Psychology of Human Misjudgment”.
How does The Buylyst Manage Risk?
At The Buylyst, I’m aware that these mistakes – analytical and psychological – will happen from time to time. I worry more about psychological misjudgments than about analytical errors. I try to minimize the frequency of psychological misjudgments by constantly questioning my thoughts. I debate with my advisors, ruminate and meditate. I do whatever I can to be mindful of my thoughts and actions. Mindfulness is very important for Intelligent Investing. We must be self-aware and aware of our surroundings before we invest. That involves observing, reading, and thinking about the world at large and, more specifically, our relevant investment ecosystem. Every investment idea should be vetted by what Charlie Munger calls a “latticework of mental models. The Buylyst is my latticework. At the heart of this latticework is a set of unshakable guidelines that I call The Buylyst Dharma, which keeps me in check. At a minimum, its purpose is to make sure that I’m not guided by fear or greed. Those two emotions really magnify both the probability of loss and its magnitude.
Analytical errors are easier to control. Calculations can be checked. But it’s the assumptions behind the calculations that are subject to psychological misjudgments. Analytical errors also come from lack of understanding of the way an industry works or judging demand for a product or if management is honest, and so on. This is why I think it's so important to have a Worldview on an industry or a phenomenon or the ecosystem within which a company operates. These are all subjective judgments that go into answering this question: what is the value of this asset? What is the intrinsic value of an asset? Evaluating this is the first step of sound Risk Management.
Once we have a rough estimate of Intrinsic Value, the main “tool” of Risk Management at The Buylyst is Margin of Safety. This is the foundation of Intelligent Investing. But Margin of Safety is dependent on Intrinsic Value. The point is to buy an asset at a significant discount to its intrinsic value. Think of it as either potential profit, or as a room for error. You buy something that you think is worth much more than its current price and there’s a decent chance that you’ll earn a profit. That’s common sense. But you could be wrong about the value of that asset. And this is the added benefit of Margin of Safety, if you’re a bit of a Debbie Downer like me (thanks to my time spent with Bonds): if you’re buying an asset at, say, a 30% discount to what you think it’s price should be, you’re effectively minimizing your probability and magnitude of losing money. Said another way, how wrong can you be? You could be wrong, if your analysis is wrong or if the market is already too giddy about this asset for no good reason. Obviously, quality of analysis matters. Circle back to Intelligent Investing. The goal is to be approximately right; but if I’m decidedly wrong, I shouldn’t lose much.
“…the function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Benjamin Graham
"The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real." - Howard Marks
At The Buylyst, my primary goal is to not lose money while I harness chances of beating inflation by a big margin. I hate losing money much more than I like yoooge returns. I think of Margin of Safety as the simplest and most effective tool for Risk Management. But a key ingredient of Margin of Safety is Intrinsic Value. I must have a good idea of the intrinsic value of any asset. If I don’t, or I can’t, I should let that opportunity pass, because I'd just be shooting in the dark. I’m simply not going to be seduced by what others are saying or what the market is saying or because everyone else is doing it. If that’s what’s going on, then I don’t know what I’m doing.
“Risk comes from not knowing what you’re doing.” – Warren Buffett
Basket of Eggs
Diversification is interesting, because it’s a popular method of “managing” risk. The idea is simple: don’t put all your eggs in one basket. I agree, but to a limit. Beyond a point, diversification is counterproductive. I say this with an eye towards the traditional sense of portfolio diversification – have a few stocks in a bunch of industries (usually dictated by a benchmark’s definitions and allocations) and you’ll be “well diversified”; or worse, don’t deviate much from a “diversified” benchmark. I think that’s lazy Portfolio Management. What ends up happening is this: the portfolios are too diversified, which means that the level of diversification is way beyond the level that reduces the risk they’re trying to manage. So, they end up with too many bets across too many sectors, which requires them to hire a team of expensive Research Analysts, each of whom could have 30, 40 or even 50 companies to follow. I used to be one of these Research Analysts, and I can tell you that the many analysts end up being spread too thin. Then there’s a real risk of not knowing what you’re doing. So, many money managers trade one type of risk for another. They carry too many baskets of eggs. And then they fumble.
On Stop Loss, The Buylyst doesn’t have binding rules. Generally, the rule of thumb at The Buylyst is that if an asset price falls 20-25% below my entry price, I take a good hard look at the thesis – the assumption being that maybe “the market” is right and I’m wrong. If, upon taking a closer look, my conviction remains unshaken, I’ll hold on to it or maybe even add more. But if I realize that the range of possible outcomes is just too wide, I’ll take my bruises and stop the bleeding. I’ll sell at a loss; hopefully a modest one.
The Boring Risks
I won’t delve too much on Operational Risk, because much of it is really based on common sense. Some of them are:
- think about liquidity – I’d like to be able to buy or sell an asset when I want. This precludes me from investing in very small companies (say, companies with less than $100 million market capitalization).
- think about trading costs – this is a leakage I’d like to minimize. Online brokerages are getting cheaper by the year, which is great. And the fact that I’ll be invested in no more than 20 companies would keep my costs in check.
- think about corporate governance rules in the country of domicile (can I trust the financial statements?) – part of this risk is systemic. There are countries that simply don’t have much a corporate governance culture. But there is also a more micro issue, which is management ethics. This is a big one – management conduct can sink an otherwise great business. But this is often tough to evaluate before the fact. There could be hints in the managements’ treatment of some Accounting line items such as depreciation or pension obligations. But that’s a massive topic that’s outside the scope of this rumination.
Risk Management: The BuyGist Version
I realize I just threw a lot at you. For the sake of brevity and sanity, this is a BuyGist version of the risk management process:
- Determining the intrinsic value of an asset. This deserves a whole slew of articles.
- Buying the asset at a heavy discount. Repeat after me: MARGIN OF SAFETY. MARGIN OF SAFETY. MAR…
- Being aware of as many underlying factors or implicit bets that may change the value of the asset. This involves observing the world, reading, thinking, debating…
- Diversifying across these underlying factors or global phenomena or themes at play today. Don’t obsess over “industry diversification” or “number of holdings” or “industry overweight” or other faulty measures.
- Sitting patiently, with the assumption that I could be wrong despite my in-depth analysis. But since I bought it at a discount, how wrong could I be? I’ve already shrunk the chances of losing money and the size of the loss. Repeat after me: MARGIN OF SAFETY. MARGIN OF SAFETY. MARGIN OF SAFETY. MAR…
- Remembering that we could be wrong but that the market is not always right either. I will use “volatility” to my advantage. If the asset becomes a lot cheaper, I will revisit our thesis and determine whether to stick to my guns or cut my losses. If the thesis remains unchanged, I’d be inclined to buy more. But I need to watch out for Confirmation Bias. And check my ego. Everyday.
- Sell Discipline: Revisit as soon as the price approaches intrinsic value. If the upside from this point on is worse than your rate of inflation, sell. If it’s the same I don’t care if the asset appreciates another 100% after that if I can’t figure out why that would/should happen. No FOMO.
“The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.” – Howard Marks.
That is the visceral realization The Buylyst will always try to summon everyday. There are too many unknown unknowns that are hard to measure; the best hedge against losing money is…MARGIN OF SAFETY.
Be safe. Many Happy Returns.