4
George Soros Doesn’t Take Risks?
“To survive in the financial markets sometimes means beating a hasty retreat.”
—GEORGE SOROS1
“It’s not risky to buy securities at a fraction of what they are worth.”
—WARREN BUFFETT2
“WHAT’S YOUR RISK PROFILE?” After discovering that Master Investors such as Warren Buffett and George Soros avoid risk like the plague, I hope this sounds like a pretty dumb question. Because it is.
But let’s suspend disbelief for a moment to investigate what it means.
The average investment advisor’s recommended portfolio will vary depending on his client’s “appetite for risk.” If the client wants to avoid risk, he will be offered a well-diversified portfolio of “safe” stocks and bonds that (theoretically) won’t lose money—or make much, either.
If a client is willing to take risks, he’ll probably be advised to invest in a portfolio full of so-called growth stocks, all with great promise but no guarantees.
This counsel makes sense to the advisor and the client who both believe it’s impossible to make above-average profits without exposing yourself to the risk of loss … the Fifth Deadly Investment Sin.
When someone asks you, “What is your risk profile?” or “What’s your appetite for risk?” what they’re really asking you is: “How much money are you willing to lose?”
Fancy phraseology like “risk profile” merely disguises the belief that you must be willing to take the chance of losing a bundle of money in order to have the chance of making any.
Yet the practical application of making preservation of capital your first priority (Habit No. 1) is to be risk averse. If, like Buffett and Soros, you can be risk-averse and make far-above-average profits, there must be something severely wrong with the conventional wisdom.
Unsurprisingly, the Master Investor has a very different perspective on risk than the average investment professional. For example, Buffett puts “a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make any sense to me.”2
To the Master Investor, risk is contextual, measurable, and manageable or avoidable.
Risk Is Contextual
Is the construction worker who walks along a plank sixty floors up in an unfinished skyscraper without a safety harness taking a risk? What about the expert skier who zooms down the almost vertical double black diamond slope at sixty miles an hour? Or the experienced rock climber, whose fingers are the only things holding him a hundred feet up a vertical cliff?
You would probably say, “Yes!” But what you really mean is: “Yes—if it was me.”
Risk is related to knowledge, understanding, experience, and competence. Risk is contextual.
While we can’t be certain that the construction worker, the skier, and the rock climber are taking no risks, intuitively we know they are taking less risk than we would, if we did what they did. The difference is unconscious competence.
Unconscious Competence
If you’re an experienced driver, you have the ability to make instantaneous judgments—whether to slow down, speed up, turn right or left—to avoid a potential accident or a pothole in the road.
You can probably recall times when you have hit the brakes or swerved to avoid an accident—yet not been fully aware, consciously, of the nature of the danger until after you’d taken evasive action. The decision was made entirely at the subconscious level.
Such automatic reactions come as the result of years of experience.
Think about it for a moment and you’ll realize that driving a car is quite a complicated activity. Think of all the things you’re monitoring at the same time:
• Is that kid going to run onto the road?
• Is that idiot going to swerve in front of me?
• Is that car behind me too close?
• Will that car stop at the corner? [Has he had his brakes checked recently?]
• Is there enough space between me and the car in front in case he brakes hard—unexpectedly?
… and I’m barely scratching the surface of all the things you’re monitoring as you drive. (Next time you get behind the wheel of a car, take a moment to become aware of all the things you’re doing that you weren’t consciously aware of doing.)
Even an apparently simple thing like changing lanes on the freeway is what’s called a multibody problem in physics. You have to monitor your speed, the speed of the traffic, the speed of the cars behind you and in front of you on the lane you’re in and the lane you want to move into, while maintaining awareness of traffic in the other lanes just in case. And you also have to make a judgment as to whether or not the drivers in the other lane are going to let you in.
And you do all this at the same time, almost instantaneously.
Multibody problems often stump the physicist. That’s even though the physicist has a great advantage over you, the driver: the particles he’s studying don’t have free will. If they’re moving in a certain direction at a certain speed, they don’t suddenly swerve right or left or speed up or slow down. Nor do they drink and drive.
In a state of unconscious competence, you solve the multibody problem automatically—and just change lanes.
While your subconscious mind directs your driving, your conscious mind is free to carry on a conversation, be aware of the sights, or listen to the radio.
But for someone who has never driven before and has no experience or competence, just getting behind the wheel of a car is a high-risk, life-threatening activity. Like you … before you’d learned to drive.
The Four Stages of Learning
The Master Investor acts apparently effortlessly and instantaneously in a way that, to the outsider, seems risky—especially when the Master doesn’t even seem to pause to think.
Warren Buffett can decide to buy a multimillion dollar company in ten minutes or less, doing all the calculations in his head. He doesn’t even need the back of an envelope. What’s more, most of the decisions he’s made so quickly have proven to be the right ones.
That’s only possible for someone who has gone through the four stages of learning:
• Unconscious incompetence: doesn’t know that he doesn’t know.
• Conscious incompetence: knows that he doesn’t know.
• Conscious competence: knows what he knows and knows what he doesn’t know.
• Unconscious competence: knows that he knows.
Unconscious incompetence is the state where you don’t even know that you don’t know: the state of mind so many young drivers are in when they begin to learn to drive. That’s why young drivers have many more accidents than older, more experienced drivers: They fail (or refuse) to recognize their limited knowledge, skill, and experience.
People in this state are highly likely to take risks—expose themselves to danger or loss—for the simple reason they’re totally unaware that that’s what they’re doing.
Investors who subscribe to any or all of the Seven Deadly Investment Sins are in this state. They think they know what they’re doing, and they fail to recognize the reality of their ignorance.
Unconscious incompetence is also the reason why the worst thing that can happen to a novice investor is to make a pile of money on his very first investment. His success leads him to believe that he’s found the secret of trading or investing and that he really knows what he’s doing. So he repeats whatever he did the first time—only, much to his own surprise, to lose money hand over fist.
As futures trader Larry Hite explained to Jack Schwager in his book Market Wizards:
I once worked for a firm where the company president, a very nice guy, hired an option trader who was brilliant, but not very stable. One day the option trader disappeared, leaving the firm stuck with a losing position. The president was not a trader, and he sought my advice.
“Larry, what do you think I should do?”
I told him, “Just get out of the position.”
Instead, he decided to hold on to the trade. The loss got a little worse, but then the market came back, and he liquidated the position at a small profit.
After this incident, I told a friend who worked at the same firm, “Bob, we are going to have to find another job.”
“Why?” he asked.
I answered, “We work for a man who has just found himself in the middle of a mine field, and what he did was close his eyes and walk through it. He now thinks that whenever you are in the middle of a mine field, the proper technique is to close your eyes and go forward.”
Less than one year later … this same man had gone through all of the firm’s capital.3
Being in a state of unconscious incompetence can be highly hazardous to your wealth.
Conscious incompetence is the first step to mastering any subject. It’s the conscious admission to yourself that you really don’t know what to do, and the full acceptance of your own ignorance.
This may result in feelings of despair or futility or hopelessness—which stops some people from investing entirely. But it’s the only way to realize that to master the subject requires a process of intensive learning.
Conscious competence is when you’re beginning to have mastery of a subject, but your actions have yet to become automatic. In this stage of mastery, you have to take every action at the conscious level. While learning to drive, for example, you must be consciously aware about where your hands and feet are, think through each decision about whether to hit the brakes, turn the wheel, change gears … and as you do so, think consciously about how to do it.
The Four Levels of Wisdom
The man who knows and knows he knows is wise. Follow him.
The man who knows and knows not he knows is asleep. Wake him.
The man who knows not and knows he knows not is a student. Teach him.
The man who knows not he knows not is a fool. Shun him.
In this stage, your reactions are far slower than the expert’s.
This doesn’t mean you can’t do it: far from it. You could make the same investment decision as Warren Buffett. But what took Buffett ten minutes to decide might take you ten days … or even ten months: You have to think through every single aspect of the investment and consciously apply the tools of analysis (and acquire most of the knowledge) that Buffett has stored in his subconscious mind.
An amazing number of investors believe they can skip this stage of learning entirely. One way they attempt to do it is by adopting someone else’s unconscious competence: following a guru or a set of procedures developed by a successful investor.
But people who’ve read a book on Gann triangles or Dow Theory, or whatever, and follow the steps outlined, or who adopt someone else’s commodity trading system, sooner or later find that it doesn’t work for them.
There’s no shortcut to unconscious competence.
As your knowledge expands, as your skills develop, as you gain experience by applying them over and over again, they become more and more automated and move from your conscious mind into your subconscious.
You eventually reach the stage of …
Unconscious competence. This is the state of a Master, who just does it—and may not even know how, specifically, he does it.
When he acts from unconscious competence, the Master appears to make decisions effortlessly, and acts in ways that might scare you or me to death.
We interpret the Master’s actions as being full of risk. But what we really mean is that they’d be full of risk to us if we took that same action. For example, as one visitor to Soros’s office recalled thinking—as Soros interrupted the meeting to place orders worth hundreds of millions of dollars—“I would shake in my boots, I wouldn’t sleep. He was playing with such high stakes. You had to have nerves of steel for that.”4
Nerves of steel? Many people have made comments of that kind about Soros. What they mean is: I would have to have nerves of steel to do what Soros is doing.
Soros doesn’t need nerves of steel: The Master knows what he is doing. We don’t—until we learn what the Master has learned.
He knows what he is doing. Similarly, there’s bound to be something you do in your life that, to an outsider, seems full of risk but to you is risk-free. That’s because you have built up experience and achieved unconscious competence in that activity over the years. You know what you’re doing—and you know what not to do.
To someone who doesn’t have your knowledge and experience, what you do will seem full of risk.
It may be a sport—such as skiing, rock climbing, scuba diving, or car racing. It may be those instant, seemingly intuitive judgments you make in your business or profession.
Let me give you a personal example. Since it’s in a field you probably know nothing about, I’ll have to give you a little background first.
When I published World Money Analyst, profits from mailshots—solicitations to gain new subscribers—were a regular source of income for me. There were times when I spent hundreds of thousands of dollars I didn’t have putting a promotion into the mail. Yet I never felt I was taking a risk.
Can You Walk and Talk?
Two examples of unconscious competence that almost every human being on the planet has mastered are walking and talking.
Do you realize that every time you take a step you’re moving dozens of different muscles in your feet and legs? For just one step! You don’t even know what muscles you’re moving. If you tried to take just one step while consciously directing each muscle to contract or relax by the right amount in the right sequence, you’d fall right over.
To walk, you just decide consciously to go there, and your subconscious mind does the rest.
It’s the same with speaking. You have mastery of your native language—and possibly others. Yet you couldn’t explain to me any more than I could explain to you precisely how you store words, find them when you need them, and put them into grammatical (or at least understandable) sentences. Often, when you’re talking, you don’t know what specific word you’ll say next. All you’re aware of consciously is the meaning you want to communicate.
Unconscious competence is the brain’s way of dealing with the limitations of consciousness. We can only hold seven bits of information (plus or minus two) in our conscious minds at the same time. When our subconscious mind takes over, it frees our conscious mind to focus on what’s really important.
Practice makes permanent: Repetition and experience are the tools we use to delegate functions to our subconscious mind.
To send out a mailing, you have to pay for printing, lettershopping (putting everything into the envelopes), renting the mailing lists—and postage. Only the postage has to be paid up front; for everything else you can get thirty to ninety days’ credit.
From records I’d kept of every mailing I’d ever done I knew that by the seventh day of response I would have received about half the total revenue I could expect. Since that was more than the postage, I could start paying the other bills as they came due.
Ah, you might ask, but how do you know that money is going to come in?
The level of response depends on three variables: the headline, the copy (the text of the advertisement), and the mailing list. When you create a new advertisement, you don’t know for sure that it will work. So you test: You mail out 10,000 or 20,000 pieces to the best mailing lists available. Unless the copy is complete drivel, you’re unlikely to lose very much money. (And if you lose the lot, it’s only a couple of thousand dollars, so why worry?)
If the test mailing works (that is, if it’s profitable), you “roll it out” to other mailing lists. Because I was mailing regularly, I knew which mailing lists worked, which didn’t, and which worked sometimes. So I could select which mailing lists to roll out to, based on the profitability of the test. When the test was highly profitable, I could mail half a million pieces or more … if all I had to pay initially was the postage.
Still think I was taking unnecessary risks? I imagine you do. I’m not trying to convince you otherwise. But because I knew what I was doing, to me there was no risk at all.
Think about it for a while and I’m sure you’ll find several similar examples where you feel you are taking little or no risk—but it’s impossible to convince an outsider that there’s no risk involved.
Risk declines with experience: There are many things you do today which you think of as risk-free. But at one time in your life, before you built up the necessary knowledge and experience, they were high-risk activities for you.
When George Soros shorted the pound sterling with $10 billion of leverage (as he did in 1992), was he taking a risk? To us, he was. But we tend to judge the level of risk by our own parameters or to think that risk is somehow absolute. On either of those measures, the risk was huge.
But Soros knew what he was doing. He was confident the level of risk was completely manageable. He’d calculated that the most he could lose was about 4 percent. “So there was really very little risk involved.”5
As Warren Buffett says: “Risk comes from not knowing what you are doing.”6
The highly successful investor simply walks (or more likely runs) away from any investment that is risky to him. But since risk is relative and contextual, the investment that Warren Buffett may shy away from can be the one that George Soros scoops up with both hands. And vice versa.
Risk Is Measurable
Restricting his investments to those where he has unconscious competence is one way the Master Investor can be risk-averse and, at the same time, make above-average profits. But how did he build that unconscious competence in the first place? By discovering that risk is measurable—and by learning what to measure.
The Master Investor thinks in terms of certainty and uncertainty, and his focus is on achieving certainty. He isn’t really measuring risk at all. He is measuring the probability of profits in his continual search for, as Warren Buffett puts it, high-probability events. And he finds them by answering the question:
What Are You Measuring?
I once asked an investor what his aim was. He replied: “To make 10 percent a year.”
“And what’s your measure of whether you’re achieving that?”
He answered: “By whether I made 10 percent or not.”
This investor is rather like an architect who measures the quality of his building by whether or not it stands up when it’s finished. Whatever result you are trying to achieve can only be the measure of whether you have achieved it, not the measure of whether you will.
A good architect knows that his building will stand up while it’s still a blueprint. He knows this by measuring the strength of the materials, the loads they will have to bear, and the quality of the design and construction.
In the same way, the Master Investor knows, before he invests, whether he is likely to make a profit.
Profit (or loss) is a residual: the difference between income and expenditure. As a result, it’s only measurable with the benefit of hindsight.
For example, a business does not make profits by aiming to make profits. It must focus on the activities that are measurable in the present, and later result in profits: in other words, activities that increase sales and income or cut costs. And by only undertaking activities where the managers are confident that income will exceed costs.
Investment Criteria
Master Investors focus their attention not on profits, but on the measures that will inevitably lead to profits: their investment criteria.
Warren Buffett doesn’t buy a stock because he expects it to go up. He’ll be the first to tell you the price could just as easily drop the moment after he’s bought it.
He buys a stock (or the entire company) when it meets his investment criteria, because he knows from experience that he will ultimately be rewarded by either a higher stock price or (when he buys the whole company) rising business profits.
For example, in February 1973 Buffett began buying shares in the Washington Post Co. at $27 a share. As the price fell, Buffett bought more, and by October was the largest outside shareholder. To Buffett, the Washington Post was a $400 million business that was on sale for just $80 million. But that’s not what Wall Street saw—even though most publishing analysts agreed with Buffett on the company’s valuation.
Wall Street saw a collapsing market. The Dow was off 40 percent and the “Nifty Fifty” stocks such as IBM, Polaroid, and Xerox—which only a few years before Wall Street had been happy to buy at 80 times earnings—were off 80 percent or more. The economy was in recession and inflation was rising. That wasn’t supposed to happen: Recession was supposed to send inflation down. To Wall Street, it looked like the “end of the world” might be coming. This was definitely not a time to buy stocks; and with inflation rising you couldn’t even find safety in bonds.
When they looked at the Washington Post Co., investment professionals saw a stock that had fallen from $38 to $20 a share and which, like the market, could only go down. The “risk” of buying was far too high.
The irony is that the Post could have sold its newspaper and magazine businesses to another publisher for around $400 million—but Wall Street wouldn’t buy it for $80 million!
To Buffett, when you can buy a sound, attractive business at an 80 percent discount to its value, there’s no risk at all.
Buffett wasn’t looking at the market—or the economy. He was using his investment criteria to measure the quality of the Post’s business. What he saw was a business that he understood: Due to its effective monopoly in the Washington area it had favorable economics that were sustainable (and because of its “monopoly” could raise prices in line with inflation and, so, was an inflation hedge); it wasn’t capital-intensive; it was well managed—and, of course, it was available at a very attractive price.
While Wall Street was driven by fear of loss, and called it “risk,” Buffett and other investors who knew what to measure were cleaning up. Intriguingly, often when the market is collapsing, investment professionals suddenly discover the importance of preserving capital and adopt a “wait-and-see” attitude—while investors who follow the first rule of investing, “Never lose money,” are doing the exact opposite and jumping in with both feet.
After Buffett had made his investment, the price of the Washington Post Co. kept falling. Indeed, it was two years before the market came back to his original average purchase price of $22.75 per share. But Buffett didn’t care about the share price; his focus was on his investment criteria, on measuring the quality of the business. And that quality—to judge by earnings alone—was improving.
In the investment marketplace, you are what you measure.
Risk Is Manageable
Soros achieves investment certainty in a very different way. Like Buffett, he measures his investments—all successful investors do—but Soros applies very different investment criteria.
The key to Soros’s success is to actively manage risk, one of the four risk-avoidance strategies Master Investors use:
1. Don’t invest.
2. Reduce risk.
3. Actively manage risk.
4. Manage risk actuarially
There’s a fifth risk-avoidance strategy that’s highly recommended by the majority of investment advisors: diversification. But to Master Investors, diversification is for the birds (see chapter 7).
No successful investor restricts himself to just one of these four risk-avoidance strategies. Some—like Soros—use them all.
1. Don’t Invest
This strategy is always an option: Put all your money in Treasury bills—the “risk-free” investment—and forget about it.
Surprising as it may seem, it is practiced by every successful investor: When they can’t find an investment that meets their criteria, they don’t invest at all.
Even this simple rule is violated by far too many professional fund managers. For example, in a bear market they’ll shift their portfolio into “safe” stocks such as utilities, or bonds, on the theory they’ll go down less than the average stock. After all, you can’t appear on Wall Street Week and tell the waiting audience that you just don’t know what to do at the moment.
2. Reduce Risk
This is the core of Warren Buffett’s entire approach to investing.
Buffett, like all Master Investors, invests only in what he understands, where he has conscious and unconscious competence.
But he goes further: His method of avoiding risk is built into his investment criteria. He will only invest when he can buy at a price significantly below his estimate of the business’s value. He calls this his “margin of safety.”
Following this approach, almost all the work is done before an investment is made. (As Buffett puts it: “You make your profit when you buy.”) This process of selection results in what Buffett calls “high-probability events”: Investments that approach (if not exceed) Treasury bills in their certainty of return.
3. Actively Manage Risk
This is primarily a trader’s approach—and a key to Soros’s success.
Managing risk is very different from reducing risk. If you have reduced risk sufficiently, you can go home and go to sleep. Or take a long vacation.
Actively managing risk requires full-focused attention to constantly monitor the market (sometimes minute by minute) and the ability to act instantly with total dispassion when it’s time to change course (when a mistake is recognized or when a current strategy is running its course).
Soros’s ability to handle risk was “imprinted” on him during the Nazi occupation of Budapest, when the daily risk he faced was death.
His father, being a Master Survivor, taught him the three rules of risk which still guide him today:
1. It’s okay to take risks.
2. When taking a risk, never bet the ranch.
3. Always be prepared to beat a hasty retreat.
Beating a Hasty Retreat
In 1987, Soros had positioned the Quantum Fund to profit from his hypothesis that a market crash was coming—in Japan—by shorting stocks in Tokyo and buying S&P futures in New York.
But on Black Monday, October 19, 1987, his scenario came apart at the seams. The Dow dropped a record 22.6 percent, which still stands as the largest one-day fall in history. Meanwhile, in Tokyo the government supported the market. Soros was bleeding at both ends of his strategy.
“He was on leverage and the very existence of the fund was threatened,”7 according to Stanley Druckenmiller, who took over management of the Quantum Fund two years later.
Soros didn’t hesitate. Following his third rule of risk management he got the hell out. But because his positions were so large, his selling drove down the price. He offered his 5,000 S&P futures contracts at 230, and there were no takers. Or at 220, 215, 205, or 200. Eventually he liquidated at between 195 and 210. Ironically, once he was out, the selling pressure was gone, and the market bounced back to close the day at 244.50.8
Soros had lost his entire profit for the year. But that didn’t faze him. He had admitted his mistake; realized he didn’t know what was going on; and, as he always did whether the mistake was minor or, as in this case, threatening to his survival, he went into risk-control mode. The only difference this time was the size of his positions and the illiquidity of the market.
Survive first. Nothing else was important. He didn’t freeze, doubt, stop to analyze, second-guess, or try to figure out whether he should hold on in case things turned around. He just got out.
Soros’s investment method is to form a hypothesis about the market and then “listen” to the market to find out whether his hypothesis is right or wrong. In October 1987, the market was telling him he was wrong, dead wrong. As the market had shattered his hypothesis, he no longer had any reason to maintain his positions. Because he was losing money, his only choice was to beat a hasty retreat.
The crash of 1987 cast a cloud of doom and gloom over Wall Street that lasted for months. “Just about every manager I knew who was caught in that crash became almost comatose afterwards,” said Druckenmiller. “They became nonfunctional, and I mean legendary names in our business.”9
As prominent hedge fund manager Michael Steinhardt candidly admits: “I was so depressed that fall that I did not want to go on. I took the crash personally. The issue of timing haunted me. My prescient forewarnings [recommending caution] earlier in the year made the losses all the more painful. Maybe I was losing my judgment. Maybe I just was not as good as I used to be. My confidence was shaken. I felt alone.”10
Not Soros. He had taken one of the biggest hits of all, but he was unaffected.
He was back in the market two weeks later heavily shorting the dollar. Because he knew how to handle risk, because he followed his rules, he immediately put the crash behind him. It was history. And the Quantum Fund ended up 14.5 percent for the year.
Emotional Disconnect
A mental strategy that sets Master Investors apart is that they can totally disconnect their emotions from the market. Regardless of what happens in the market, they are unaffected emotionally. Of course, they may feel happy or sad, angry or excited—but they have the ability to immediately put that emotion aside and clear their minds.
Being in a state where you are controlled by your emotions makes you vulnerable to risk. The investor who is overcome by his emotions—even if he knows full well, intellectually, what to do when things go wrong—often freezes up; agonizes endlessly over what to do; and ends up selling, usually at a loss, just to relieve the anxiety.
Buffett achieves the necessary emotional distance through his investment method. His focus is on the quality of the business. His only concern is whether his investments continue to meet his criteria. If they do, he’s happy—regardless of how the market might be valuing them. If a stock he owns no longer meets his criteria, he’ll sell it—regardless of how the market prices it.
Warren Buffett simply doesn’t care what the market is doing. No wonder he often says he wouldn’t mind if the stock market closed down for ten years.
“I Am Fallible”
Like Buffett, Soros’s investment method helps distance him emotionally from the market. But his ultimate protection—aside from the self-confidence that he shares with Buffett—is that he “walks around telling whomever has the patience to listen that he is fallible.”11
He bases an investment on a hypothesis he has developed about how and why a particular market will move. The use of the word “hypothesis” in itself signifies a very tentative stance, of someone unlikely to become “married to his position.”
Yet, as his public prediction that the “Crash of ’87” would start in Japan, not the United States, bears witness, there were times when he was certain of what “Mr. Market” would do next. When it didn’t happen that way, he would be taken completely by surprise.
Overriding all the other beliefs Soros has is his conviction that he is fallible—the basis, as we will see, of his investment philosophy. So that when the market proves him wrong, he immediately realizes he’s made a mistake. Unlike too many investors, he doesn’t say “the market is wrong” and hang on to his position. He just gets out.
As a result, he can step back completely from his involvement, so appearing to others to be emotionless, a stoic.
4. Manage Risk Actuarially
The fourth way to manage risk is to act, in effect, like an insurance company.
An insurance company will write a life insurance policy without having any idea when it will have to pay out. It might be tomorrow; it might be a hundred years from now.
It doesn’t matter (to the insurance company).
An insurance company makes no predictions about when you might die, when your neighbor’s house might burn down or be burgled—or about any other specific item it has insured.
The insurance company controls risk by writing a large number of policies so that it can predict, with a high degree of certainty, the average amount of money it will have to pay out each year.
Dealing with averages, not individual events, it will set its premium from the average expectancy of the event. So the premium on your life insurance policy is based on the average life expectancy of a person of your sex and medical condition at the age you were when you took out the policy. The insurance company is making no judgment about your life expectancy.
The person who calculates insurance premiums and risks is called an actuary, which is why I call this method of risk control “managing risk actuarially.”
This approach is based on averages of what’s called “risk expectancy.”
Even though the Master Investor may use the same, commonly accepted terminology, what he’s actually looking at is average profit expectancy.
For example, if you bet a dollar on heads coming up when you flip a coin, you have a 50:50 chance of winning or losing. Your average profit expectancy is 0. If you flipped a coin a thousand times and bet a dollar each time, you’d expect to end up with about the same amount of money you started with (provided, of course, that an unusual series of tails didn’t wipe you out).
Fifty-fifty odds aren’t at all exciting. Especially after you have paid transaction costs.
But if the odds are 55:45 in your favor, it’s a different story. Your total winnings over a series of events will exceed your total losses since your average profit expectancy rises to 0.1—for each dollar you invest you can expect on average to get back $1.10.
Gambling, Investing, and Risk
gamble n. risky undertaking; any matter or thing involving risk
—v.t. risk much in the hope of great gain
—v.i. to stake or risk money on the outcome of something involving chance
Parallels are often drawn between investing and gambling—with good reason: In essence, the actuarial approach means playing the odds.
Another (but bad) reason is that far too many investors approach the markets with a gambling mentality: “in the hope of great gain.” This is even more often the case with people entering the commodity markets for the first time.
To make the analogy clear, consider the difference between a gambler and a professional gambler.
A gambler plays games of chance for money—in the hope of making a great gain. Since he rarely comes out ahead, his primary reward is the excitement of playing the game. Such gamblers keep Las Vegas, Monte Carlo, Macau, and lotteries the world over in business.
The gambler throws himself the mercy of the “gods of chance.” However benign these gods of chance may be, their representatives on earth live by the motto “Never give a sucker an even break.” The result, in Warren Buffett’s words:
Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly small disadvantageous capital transactions.12
A professional gambler, by contrast, understands the odds of the game he’s playing and only makes bets when the odds are in his favor. Unlike the weekend gambler, he doesn’t depend on one roll of the dice. He has calculated the odds of the game so that, over time, his winnings exceed his losses.
He approaches the game with the mentality of an insurance company when it writes a policy. His focus: average profit expectancy.
He has a system that he follows—just like the Master Investor. And part of the system, naturally enough, is to choose the game where it’s statistically possible to win over time.
You can’t eliminate chance from a game of poker, blackjack, or roulette. But you can learn to calculate the odds and decide whether it’s possible to play that game with the average profit expectancy (the odds) in your favor.
If it’s not, you don’t play.
Sucker!
Professional gamblers do more than just calculate probabilities: They look for situations where the odds are bound to be in their favor.
A friend of mine, a member of Alcoholics Anonymous, lived a sixty-minute ferry ride away from town. When he took a late ferry home there were always a bunch of drunks at a table at the back of the ferry, continuing their binge with beers from the bar.
He’d pull up a chair, take a pack of cards from his bag and say, “Anyone feel like a round of poker?”
Professional gamblers never buy lottery tickets.
Professional gamblers don’t actually gamble. They don’t “risk much in the hope of great gain.” They invest little, time after time, with the mathematical certainty that they will achieve a positive return on capital.
Investing isn’t gambling. But professional gamblers act at the poker table in the same way Master Investors act in the investment marketplace: They both understand the mathematics of risk and only put serious money on the table when the odds are in their favor.
Actuarial Investing
When Warren Buffett started investing, his approach was very different from the one he follows today. He adopted the method of his mentor, Benjamin Graham, whose system was actuarially based.
Graham’s aim was to purchase undervalued common stocks of secondary companies “when they can be bought at two-thirds or less of their indicated value.”13
He determined value solely by analyzing publicly available information, his primary source of information being company financial statements.
A company’s book value was his basic measure of intrinsic value. His ideal investment was a company that could be bought at a price significantly below its liquidation or break-up value.
But a stock may be cheap for a good reason. The industry may be in decline, the management may be incompetent, or a competitor may be selling a superior product that’s taking away all the company’s customers—to cite just a few possibilities. You’re unlikely to find this kind of information in a company’s annual report.
By just analyzing the numbers Graham could not know why the stock was cheap. So some of his purchases went bankrupt; some hardly moved from his purchase price; and some recovered to their intrinsic value and beyond. Graham rarely knew in advance which stock would fall into which category.
So how could he make money? He made sure he bought dozens of such stocks, so the profits on the stocks that went up far outweighed the losses on the others.
This is the actuarial approach to risk management. In the same way that an insurance company is willing to write fire insurance for all members of a particular class of risks, so Graham was willing to buy all members of a particular class of stocks.
An insurance company doesn’t know, specifically, whose house is going to burn down, but it can be pretty certain how often it’s going to have to pay for fire damage. In the same way, Graham didn’t know which of his stocks would go up. But he knew that, on average, a predictable percentage of the stocks he bought would go up.
An insurance company can only make money by selling insurance at the right price. Similarly, Graham had to buy at the right price; if he paid too much, he would lose, not make, money.
The actuarial approach certainly lacks the romantic flavor of the stereotypical Master Investor who somehow, magically, only buys stocks that are going to go up. Yet it’s probably used by more successful investors than any other method. For success, it depends on identifying a narrow class of investments that, taken together, have a positive average profit expectancy.
Buffett started out this way, and still follows this approach when he engages in arbitrage transactions. It also contributes to Soros’s success. And it is the basis of most commodity trading systems.
Average profit expectancy is the investor’s equivalent of the insurer’s actuarial tables. Hundreds of successful investment and trading systems are built on the identification of a class of events which, when repeatedly purchased over time, have a positive average expectancy of profit.
Risk Versus Reward
Most investors believe that the more risk you take on, the greater the profit you can expect.
The Master Investor, on the contrary, does not believe that risk and reward are related. By investing only when his expectancy of profit is positive, he assumes little or no risk at all.