In investing, you win more by losing less. Since you always lose money from a higher number but make money on a lower number, avoiding losers and losses is more important than picking winners.
This chapter explains why you should pay at least as much attention, if not more, to risk management (how much you will lose) instead of just thinking about return management (how much you will make).
Repackaging risk, or swapping one kind of risk for another, is not reducing risk. Failure to think about the various types of risks is the bigger challenge, not failure to find.
Avoiding Losers Is More Important Than Picking Winners
Most people believe that if you have the moxie and the mind-set to spot the hot dot or the hot stock, you are on your road to riches. This notion—that successful investing boils down to picking the winners—is so widely accepted and so rarely questioned that it has become the sine qua non of how the “smart” money invests in markets.
It sounds like a great concept—if only it were true!
Let us say you have $100 and make a bad investment in a risky stock that loses you 50 percent. You now have only $50. You need your $50 to double (go up by 100 percent) simply to break even. It is tough to find investments with 100 percent upside, let alone face the added insult that even after you miraculously find such a great investment opportunity, you end up only where you started! On the other hand, let us say you lose only 20 percent on your $100 investment, so your principal declines to $80. Now when you find that 100 percent upside investment opportunity, your $80 becomes $160, giving you 60 percent capital appreciation.
You always lose money from a higher number but gain money from a lower number, which is why incurring heavy losses proves more damaging than missing some gains. Investors are better off researching potential for failure and avoiding losers than chasing success stories and picking the winners. The main reason to invest in equities is to compound capital, and losing money is the albatross. See table 6.1 for gains you must make to cover losses you incur.
Table 6.1
Illustrative performance trajectory of a hypothetical risk-aware active strategy over an arbitrary ten-year period from 2001 to 2010
| Year |
Performance in % |
|
Performance in $ |
| Hypothetical Risk-Aware Active Portfolio (HRAAP) |
Hypothetical Benchmark |
|
Growth of $100 (HRAAP) |
Growth of $100 (Benchmark) |
| 2001 |
−8.9% |
−17.5% |
|
$91 |
$83 |
| 2002 |
−5.2% |
−15.9% |
|
$86 |
$69 |
| 2003 |
33.3% |
38.6% |
|
$115 |
$96 |
| 2004 |
16.7% |
20.2% |
|
$134 |
$116 |
| 2005 |
12.9% |
13.5% |
|
$152 |
$131 |
| 2006 |
32.9% |
26.3% |
|
$202 |
$166 |
| 2007 |
5.7% |
11.2% |
|
$213 |
$184 |
| 2008 |
−23.4% |
−45.8% |
|
$163 |
$100 |
| 2009 |
23.5% |
25.0% |
|
$202 |
$125 |
| 2010 |
7.1% |
18.8% |
|
$216 |
$148 |
| CAGR |
8.01% |
4.01% |
|
|
|
| Annualized outperformance |
4.0% |
|
|
|
Note: The hypothetical performance shown is for illustrative purposes only and is not indicative of any specific return you may receive from a particular investment. Performance does not reflect any deduction of fees or expenses and does not reflect the impact of taxes on an investment.
“You always lose money from a higher number but gain money from a lower number.”
To demonstrate how this plays out over a full market cycle (straddling both bull and bear markets), table 6.1 shows a hypothetical performance history over an arbitrary ten-year market cycle which includes both bull and bear markets, from say 2001 to 2010. I want to underscore, this table should be viewed as an illustrative, arithmetical example of how an actively managed portfolio that pays attention to risk (hereafter referred to as “hypothetical risk-aware active portfolio” or “HRAAP”) ultimately results in higher returns. This harkens back to the point I made in chapter 2, “ ‘And’ Not ‘Or,’” on the paradox of investing where reducing risk is critical to enhancing returns. It is a counterintuitive concept, so it is best to see how this plays out via a case study.
Now, as we shall see later in this chapter, risk comes in many forms and can be described or defined in many ways, but for purposes of this thought experiment, I want you to think of risk as losing money and returns as making money. Also, assume that the performance numbers shown for this hypothetical risk-aware active portfolio are net of all fees and expenses. Furthermore, note that the benchmark’s performance is shown for comparison purposes as one cannot actually invest in it. Last but not least, you should not think of this table as some sort of proof statement that all risk-aware active portfolios will outperform a benchmark (there are no such guaranteed outcomes in the world of investing). It is merely to illustrate the mathematics of losses and gains and showcase the importance of risk management versus return management.
The second and third columns in Table 6.1 show the percentage gain or loss of the hypothetical risk-aware active portfolio and the benchmark, respectively. The fourth and fifth columns capture the moves in absolute dollar terms (often referred to as “growth of $100”). The key is to observe how the relative percentage performance versus absolute dollar performance manifests itself, year by year and then cumulatively.
Notice how in 2001 and 2002, by losing far less than the benchmark, the hypothetical risk-aware active portfolio secured a large lead, only correcting to $86 while the benchmark plunged to $69. Then in 2003, despite underperforming by over 5 percent when markets rallied 39 percent, the HRAAP was worth $115 (column 4), delivering 15 percent capital appreciation while the benchmark was still not breaking even at $96 (column 5). This illustrates how losing less allows you to win more and why you should pay at least equal attention to risk management—if not more.
This is how the paradox plays out and why reducing risk helps to enhance returns, instead of undermining them. You may be familiar with the old adage, a dollar saved is indeed a dollar earned. Furthermore, note that even at the peak of the bull market in 2007, the HRAAP was ahead at $213 versus the benchmark’s $184. This illustrates that attention to risk management does not come at the expense of return management. Most investors pay more attention to returns than risk, while my non-consensus investment approach argues for the opposite: pay more attention to risks than returns. Note how by prioritizing risks (losing less) over returns (making more), the hypothetical risk-aware active portfolio performed double duty by delivering both: lower risks (lower capital losses in bear markets) and higher returns (more capital gains over the full market cycle). This is how the counterintuitive principles underpinning non-consensus investing enable it to deliver the “and” proposition instead of settling for “or,” as described in chapter 2.
Another point to note is that in 2008, when the markets crashed 46 percent, the hypothetical risk-aware active portfolio declined far less that year, and experienced 65 percent cumulative capital appreciation, compounding to $163 while the benchmark just broke even at $100. This is the power of active management: if you deviate a lot from the benchmark, you can also experience returns that are quite different from it. Of course, different performance cuts both ways—underperformance or outperformance. A sound investment process can help to improve the odds of the latter versus the former.
Frequency Versus Severity
Another interesting thing to call out in the performance table above is that even though the hypothetical risk-aware active portfolio outperformed in only four out of the ten years (frequency), three out of those four years were mega bear markets (severity). The significant point is this: Losing less during those big market corrections enabled the HRAAP to grow from a higher base in the next upcycle and develop a large lead over the benchmark, in both relative and absolute terms. Cumulatively, the annualized 4 percent outperformance over ten years means a million-dollar invested in the HRAAP would have appreciated to $2.16 million, compared to $1.48 million if invested passively in an index fund that mirrors the benchmark.
This is why I recommend adopting an unconventional approach of considering the risks of an investment idea first and returns thereafter: it saves you both money and effort. Here is how. Avoiding or abating the risk of large losses upfront means you save your hard-earned money and you do not need to hit a lot of home runs. Because the losses are small, you can easily offset them by hitting good singles. Not only is that easier, it also keeps you out of trouble: you don’t have to take unnecessary risks.
Indeed, the deeper the hole gunslingers dig themselves into, the more desperately they need to chase large moneymaking ideas, which often means taking on more risk, trapping them in a vicious cycle.1 As we all know, large moneymaking ideas are hard to come by. By not needing large upside to begin with, you have improved the odds of finding such winners. Ergo, weeding out risk upfront saves you both money and effort.
From 2012 through 2014, by not owning risky or richly valued oil stocks, I avoided the blowups that crippled that sector in 2014–2016, when oil prices crashed. So, despite not owning high-flying social media and internet-related stocks, my performance did not suffer. This is because my portfolios did not need hefty returns from the winners (social media and internet-related stocks) to offset large losses as I had avoided the big losers (risky oil stocks) in the first place.
Out of Sight, Out of Mind: Exposure Versus Experience
Ironically, despite its importance, few investors proactively pay attention to risk management. Those who do often only pay lip service. Worst of all, there are many who consciously take on more risk instead of reducing it. Why is this? Why do so many work against their best interest?
They do so because risk is invisible and intangible—a silent killer, rather like high blood pressure. We all know that high blood pressure works in stealth mode inside the body with few visible external signs. But left unattended, it eventually reveals itself in spectacular form as a massive heart attack or stroke. The terrible twist is that such a tragedy can usually be avoided, as there are ample ways to manage the disease with medications and lifestyle changes. Likewise, while investment risk is not always visible, we can proactively identify and manage it to avoid its worst effects.
Sticking with the analogy, we know that not only can high blood pressure be genetically inherited, it can also be self-inflicted via poor lifestyle choices. In the same way, not only is risk inherent in business and investing, it can also be self-inflicted by poor financial and strategic choices. The positive aspect to both chronic conditions is that we can overcome them with a sound regimen.
It is tempting to think that you can assess risk with a simple checklist. Unfortunately, it’s not that easy. For one thing, risk comes in many forms: financial-leverage risk, corporate-governance risk, currency-devaluation risk, regulatory risks, low-barriers-to-entry risk, and on and on. For another, risk is often hidden from plain sight or comes in a disguise, not revealing its true character or intensity until it is too late.
But where to look? It’s obviously easier to look for risks that have materialized in the past, so you can benefit from experience. For example, think about investing in bank stocks during a recession. That might involve estimating loan-underwriting risk, but you would have ample statistical data on default rates to help you handicap future expected losses. You would be benefiting from underwriting experiences of the past. However, there is another, more sinister type of risk you should be on the lookout for, and it can be vastly different from risk experience. I’m talking about risk exposure.
Exposure is a risk that has not yet materialized, which makes it all the easier to overlook. However, this is exactly the kind of risk that can come back to haunt you with devastating consequences. The common insight applies here: absence of evidence is not evidence of absence. Just because you do not see the evidence of risk, does not mean it does not exist. If you did not wear your seat belt and did not have an accident for five years in a row, it does not mean that you were not taking a risk with your life. You exposed yourself to the risk of a severe or fatal injury all along; you just didn’t experience the consequences of it.
Bear Markets Reveal the Power and Payoff of Risk Management; Bull Markets Do the Opposite
In bull markets, where the focus is on returns, there is a greater tendency to become complacent about risk. This is dangerous. At precisely the time when investors should be paying more attention to risk, they pay less.
It is unfortunately fairly typical for gunslinging money managers who outperform to earn glowing accolades in the media, more business from their clients, and larger bonuses from their employers, while risk-conscious managers who underperform are criticized or canned. Faced with such skewed incentives, it should not surprise anybody that few money managers pay attention to risk. This feeds a self-fulfilling cycle of ignoring risks which multiply unabated and finally blow up in our faces (as we all confronted in 2008). Only then does the payoff appear for the risk-conscious manager, who suffers the pain of underperformance in the present while the benefits of risk management arise in the future.
Risk Measurement ≠ Risk Management
Although it is crucial to measure risk, do not focus unduly on the numbers at the expense of the narrative. No amount of quantitative measurement will give you a full picture of risk management; you must judge facts and data in context. Indeed, many risks cannot be measured mechanistically or statistically. Remember, risk is an exposure, not only an experience. You cannot really measure what you have not experienced.
In fact, many managers who claim to measure risk by running risk optimizers and risk reports are taking false comfort because they are relying on current or historical data. Risk management is forward, not backward, looking. In a sense, you need to apply both science and art to understand risk experience and exposure. You will fall short if you rely solely on formulas, checklists, or risk reports. Worst of all, running such reports will engender a false sense of security, deluding you into thinking you are proactively managing risk when in fact you are just as likely to get blindsided by risk as someone who does not run such reports.
“You cannot really measure what you have not experienced.”
In my view, this is exactly what happened in the years leading up to the financial crisis of 2008. It is not that regulators, central bankers, management teams, rating agencies, and money managers were not looking at risk reports on the banking sector. The problem is that they were looking at misleading metrics such as value at risk, or VAR.2 The formula for calculating VAR relies on measuring volatility experienced, which was of little help in 2008 because the securities were often new and had limited trading history (data). Therefore, to understand risk exposure, investors needed to use judgment, not statistics. If they had, they would have realized that the facts, taken out of context, were misleading. They would have seen that during a persistent bull market with an upward trending bias, volatility was likely to be understated, and thus would give a skewed sense of risk exposure.
Before all this, in 2006–2007, instead of relying just on VAR, I researched a whole range of risk factors and exposures in the banking sector and foresaw the high-risk exposures such as asset/liability mismatch risk, maturity-mismatch risk, wholesale-funding risk, counterparty-risk, and so on, that had eluded many. You do not need to understand the definition or details of these risks to appreciate the point that risk is not one-dimensional and cannot be properly identified unless analyzed from all vantage points. I supplemented these quantitative analytics with qualitative assessments. For instance, I examined corporate-governance incentives of CEOs and found that their compensation packages often incentivized them to expand their banks and maximize short-term returns rather than walk away from risky assets. Thanks to such a holistic assessment of risk, I proactively reduced my exposure to bank stocks and was able to better protect my clients during the financial crisis of 2008.
But even though what I did was right, it was not easy. My proactive risk management helped me to outperform in 2008, but it had caused me to underperform in 2007. I had been put on watch lists in 2007, which is institutional code for “If you don’t fix this soon, you will be fired.” The irony is that although I was looking out for my clients (by paying attention to risk), they thought I wasn’t (because they were looking at my returns). My word of advice to all those who may find themselves in this unfair predicament: Think of professional money management as good parenting. Your kids will undoubtedly resent you when you deny them their mac and cheese in favor of veggies, even though you are acting in their best interest. Like a good parent, keep fighting the good fight. The resentment eventually turns into gratitude and the critique into compliments.
Measuring the Wrong Thing Is the Biggest Risk You Can Take
Many people in the investment world rely on statistics to measure returns and risks, but they don’t always measure the right things. One statistic that is often used—frankly misused—is beta, which is defined as the ratio of a stock’s or portfolio’s volatility to the volatility of the market as a whole.
It works this way: A beta of, say, 0.8 or 1.2 means that if past relationships hold, the price of a security is likely to move up or down in that proportion to the market benchmark. A beta below 1 suggests it will move with less amplitude, and vice versa. But risk is not a proportionate or relative move; it is an absolute and permanent impairment of capital. Just because something has a smaller or larger amplitude does not make it risky per se.
This is a case of confusing volatility with risk. As we saw in chapter 3, they are not the same thing. Think of stock-price volatility as the minor heart-rate fluctuations that we routinely experience when we move from resting to walking to running. They are not significant, and you can usually ignore them. On the other hand, chronically high blood pressure, for which you may see no obvious outward signs of fluctuation, is a huge risk. You would find it absurd if your doctor measured your heart rate all day long and completely ignored measuring your blood pressure. But this is exactly the absurdity we indulge in when we focus on beta or volatility instead of risk. Unfortunately, because we cannot easily measure or visualize risk before it happens, while measures such as historical beta, volatility, or tracking error are precise and tangible, people fall into the trap of measuring something that does not matter because they can, not because they should. Measuring risk is right but not easy; measuring beta and volatility is easy but not right.
Another measure of risk used by investors is tracking error, a number that expresses how closely a portfolio follows the index to which it is benchmarked. I view it as a misleading metric because it ignores a critical point: why is that manager tracking far from the benchmark? If it is to avoid permanent impairment of capital (which is the definition of risk), then a high tracking error is a good thing (because it reduces risk). Too often, though, the marketplace views a high number as increasing risk. Adding the insinuating word “error” is the culprit. Just as not all cholesterol is bad for you, not all deviations from the benchmark are bad.
Swapping Risk Instead of Reducing It
As if ignoring or mistaking risk were not bad enough, another trap that even some well-informed investors fall into is to swap risk instead of reducing it. It is among the most dangerous forms of risk-taking because you do not even know that you are exposed to it.
I recall researching Aggreko, a global company headquartered in the UK that rents portable power-generation equipment to countries and companies experiencing power outages or shortages. I was quizzing a member of the management team on their risk-management strategy, especially in emerging markets such as Latin America, where the risk of currency devaluation is high. He explained that they had proactively addressed this risk by structuring all their Latin American contracts and payments in U.S. dollars, so it was the customer, not Aggreko, that assumed the currency-devaluation risk. To any “check the box” type of investor, this response would have been satisfactory. But I have learned from experience to assess the larger context, and my contrarian conclusion was that the company remained exposed to a lot of risk, except it was not currency risk but counterparty risk instead. (Counterparty risk is the risk to each party of a contract that the other side will not live up to its contractual obligations.) Here is why.
When a currency devalues, unless the customers have dollar revenues to pay off dollar-denominated liabilities, they will end up defaulting on that obligation. While Aggreko was being truthful about its arrangement, it was nonetheless a misleading and myopic form of risk management because all they had done was swap risk, not reduce it. Sure enough, several years later in 2012, Aggreko stock took a big hit when many Latin American customers defaulted on their payments and the company had to write off a large chunk of their accounts receivables as bad debts.
A well-meaning but equally damaging form of swapping risk comes from the recent obsession with owning stability at any cost and avoiding volatility at any cost. Of late, this has manifested itself in stocks of consumer staples becoming quite expensive because, in their rush to avoid earnings volatility, investors were willing to pay more for stocks that felt stable. They swapped earnings-volatility risk for stock-valuation risk. Risk is risk, no matter what label it wears. The goal of risk management is not to swap one form of risk for another, but to reduce or get rid of it, or at least get paid for it and not pay for it.
Doubling Up on Risk Instead of Reducing It
Once upon a time, activists (people who attempt to use their rights as shareholders of a publicly traded corporation to bring about change within or for the corporation) focused on highly mismanaged or undermanaged companies. Of late, however, it is astounding to see the list of companies that have attracted activist attention: companies like Apple, Nestle, and Fanuc, a veritable who’s who of their respective countries. What is more worrisome is that instead of focusing on fundamental improvements in corporate strategy or execution, many activists now overwhelmingly focus on what they call “maximizing capital structure.” It’s nothing but a euphemism for leveraging up the balance sheet to fund share buybacks.
Rampant short-termism and the rising threat of shareholder activism have put many CEOs and boards on notice. They feel compelled to engage in short-term quick fixes even at the expense of the long-term health of the company. It has bizarrely become both a badge of honor and a form of blackmail for boards to bless share buybacks at any cost, under the pretext that if they do not do so proactively, an activist investor will force them to do so anyway, often by removing them from their coveted seats.
Expensive share buybacks funded with “cheap” debt are nothing but a form of doubling down on risk. Not only are you taking valuation risk on your overvalued shares, you are adding financial-leverage risk onto your balance sheet. Many investors encourage companies to buy back their shares in bull markets only to cut those programs in bear markets, when they should be doing the opposite. Buybacks serve the interests of short-term traders by temporarily boosting the share price but hurt the long-term investors who are left holding the bag when the business cycle turns for the worse. Sadly, this is what played out at GE in 2018. The once iconic blue chip went into a free fall after squandering precious capital in buying back shares in prior years when it should have used that capital to strengthen its balance sheet, reduce its underfunded pensions, and invest in its business. Long-term stock-price performance arises from value creation in the underlying business, not from tinkering with the capital structure via financial engineering.
To add insult to injury, the companies and money managers who have the guts and grit to stay out of this fray find themselves in the unfortunate predicament of having to apologize for their conservative risk management. Cash has become a four-letter word, while debt is not. It has become fashionable to ridicule companies holding cash (which is nothing but a form of risk management), while taking on debt is encouraged.
I view a net-cash balance sheet as a sign of strength, not weakness. In an uncertain world, cash is king. It enables companies to take advantage of opportunities or combat threats. Of course, we should not take any precept or principle to an extreme. I am not for management teams hoarding excessive cash, and obviously deciding what level is excessive is a judgment call. But I would rather the board and long-term shareholders make that decision than short-term traders or fly-by-night activists.
I find an acute form of double-barreled foolishness in the private equity markets (meaning investments in equities that are not listed on a stock exchange and are unavailable to the public at large). Many private equity investors are turbocharging their risk (although they flatteringly refer to it as enhancing their returns) by loading up on leverage to boost returns. A little leverage for a short period of time can be useful, but a lot of leverage is dangerous and can wipe you out.
When a private equity fund’s portfolio holding loads up on debt, recognize it for the risk that it is: it could unravel during less sanguine times and negate any returns you hoped to make. In 2007, a consortium led by Kohlberg Kravis Roberts & Co., Texas Pacific Group, and Goldman Sachs acquired the largest electricity utility in Texas, then known as TXU, for $48 billion. Then they loaded it with about $40 billion of debt. A short seven years later, in its new incarnation as Energy Future Holdings, the company filed for Chapter 11 bankruptcy—one of the ten biggest nonfinancial bankruptcies in history! While the private equity managers managed to earn more than $560 million in fees from the transaction, many investors lost billions of dollars on the deal. This goes to show how excessive debt can wreak havoc even in a presumably stable, low-risk business such as a utility and trip up even the savviest investors.
Private equity funds going on a debt binge in their portfolio holdings is a contemporary twist on an old trick played by conglomerates on unsuspecting investors in the 1980s and 1990s. Back then, conglomerates loaded up their subsidiaries with debt while the holding company’s balance sheet appeared pristine because debt was not consolidated upstream. Many family-owned conglomerates in Asia engaged in this accounting maneuver in the 1990s and ended up defaulting on or restructuring their debt. This hurt their creditors and investors as well as the financial system at large, culminating in the Asian crisis of 1998. Think of a private equity fund as a conglomerate that owns multiple businesses. The fund may not appear to be leveraged, but the underlying holdings are, exposing you to more risk than you realize. The Financial Times shed light on this practice in an article titled “Private Equity’s Love Affair with Leverage” (October 25, 2009). The article referenced a study conducted by Boston Consulting Group which concluded that, after fees and adjustments for risk, private equity funds do not outperform public equity markets. This is a doubly dismal outcome: private equity is an illiquid asset class and needs to compensate for that illiquidity with higher returns.
Debt and bear markets are a disastrous combination, as many consumers found out when house prices crashed in 2008. Everyone who had taken, given, or invested in mortgage debt had assumed the house was worth X, then found themselves in trouble when it suddenly became worth far less. But the debt owed stayed the same as before, causing many homeowners to face foreclosure.
Despite clear evidence of the risks arising from excessive leverage, we still hear the argument that debt is inexpensive and surely taking advantage of cheap money is smart. But no matter how cheap it appears to be from the standpoint of interest cost, debt comes with a deadline. It must be repaid in full someday, and that day may come sooner than you plan for.
This is what some adventurous traders and foolhardy companies found out when the Swiss National Bank (SNB) stunned markets on Thursday, January 15, 2015, by scrapping its three-year-old peg of 1.20 Swiss francs per euro. In a chaotic few minutes after the central bank’s announcement, the Swiss franc soared by around 30 percent in value against the euro.
As the currency continued to oscillate wildly, many traders were suddenly faced with margin calls (requirement to repay debt immediately by selling the collateral backing it). As the collateral value of their underlying assets plunged but the margin debt stayed fixed, these traders watched their net worth get wiped out. They went bankrupt within hours. Not only did those traders lose all their money, but several of the foreign exchange trading platforms that had hosted them were also wiped out, which in turn caused their counterparties to book losses as they suffered collateral damage. It was like watching dominoes fall in rapid succession, except it was happening to real people and institutions.
The world’s third largest retail foreign exchange broker, FXCM, had to get a $300 million bailout after taking huge losses. Its shares plunged more than 70 percent in after-hours trading on Friday, January 16, 2015. Still, FXCM fared better than its competitor Alpari, a UK-based foreign exchange broker, which entered insolvency.
It took mere hours to annihilate what had taken years to build. The traders and foreign-exchange-trading platform companies learned a costly lesson: Debt is a double-edged sword; it can amp up your returns in the good times but wipe you out during the tough times. Such binary outcomes make a highly indebted company very speculative. My advice: avoid it.
A similar doubling-up on risk plays out in the corporate world, where management teams often justify expensive acquisitions on strategic grounds of speed to market or amplifying the growth rate. Studies repeatedly show that most acquisitions do not create value, yet that has not prevented companies from arguing they will be the exception that defies the rule. During the heyday of emerging markets between 2001 and 2011, many companies and investors alike chased the heady growth rates of emerging markets and justified egregious acquisitions as the new “must have” beachhead asset. Even the conservative German company Beiersdorf (the maker of Nivea-branded skin-care products) fell for this “growth at any price” trap and paid close to half a billion dollars for an expensive Chinese hair-care acquisition, only to write it off a few years later.
Acquisition risk is a special form of denial in which inferior risk management is indulged in the name of superior return management. Invariably, management teams and investors justify their expensive forays with arguments of faster growth and immediate profit accretion. The downside emerges much later, when accounting regulations force them to confess to their mistakes by impairing the value of the asset. Once again, focusing on short-term gain and ignoring long-term pain proves to be a losing investment strategy in the fullness of time. Overpaying for an asset in the name of strategy is simply obfuscating the valuation risk.
Another form of doubling up on risks comes when a company with operating leverage takes on financial leverage. That is a deadly cocktail in times of adversity. Many financially leveraged energy companies went bankrupt when oil prices crashed unexpectedly in 2014 because their bonds and shares plunged simultaneously as investors priced in both bond default and equity-dilution risk. At exactly the time that the company needed to raise money to get through the downturn, both equity and debt markets closed their doors because of this layering of risk upon risk.
Risk is absolute, not just relative. A lot of small risks with low probabilities can add up to a gigantic fat-tail risk. Layering risk upon risk ensures multiple ways to lose, instead of multiple ways to win. Doubling up on risk means that a humdrum downturn can explode into a full-blown crisis. Do not put yourself in such a vulnerable position in the first place.
Risk Management Is About Assessing Risk, Not Avoiding It
Risk is omnipresent. There is no denying it or avoiding it. Your only choice is to find it and deal with it. Equity investors need to be especially vigilant about risks because they are the risk-bearers of first resort. Risk management is not an attempt to eliminate all risks (that is impossible) but to distinguish between those risks that are minor—in which case the equity is worth buying at a good price—or major, meaning you should steer clear at any price.
If the risks in the business are outsize, unquantifiable, or of a binary/speculative nature, stay away. Do not own the stock at any time or any price. This is an absolute standard, not mitigated by a low or falling price. Warren Buffett put it best in his 1996 annual letter to shareholders: “If you wouldn’t own the business for ten years, don’t even think of owning it for ten minutes.”
If, on the other hand, the risk is small and manageable, that’s the time to adopt an engagement policy and assume the risk when you are paid for it, in the form of an attractively discounted price. Markets are often efficient or ebullient and may not pay you to take the risks. But I have found that if one waits patiently for something, somewhere in the world, to go wrong, it usually does. In the real world, even high-quality, low-risk businesses can face air pockets in earnings, missteps in execution, or any number of externalities that might cause temporary weakness. If that makes their stocks experience a swoon, you should scoop them up as investment bargains.
In other words, when markets pay you to assume the risks of a high-quality business, you should bear them. When markets do not pay you, you can sit back and wait for a setback in the business or pullback in the share price. Let the opportunity come to you, and only engage when the risk/reward balance becomes attractive. Thus, risk management is not only about risk reduction but also about return enhancement. You can take advantage of risk to generate returns if a stock is mispriced.
Obviously, if the litmus test of whether to own or avoid a business is its innate quality, you need to know how to evaluate that. That is the topic of the next chapter. Here I want to focus on how to identify and manage risk. This brings us one more important risk we must consider: the risk of making a mistake.
Despite all our training, good intent, and best efforts, we are human beings and not immune from mistakes. Investment mistakes are inevitable, but you can still have solid returns. The way to do that is by insisting on a margin of safety.
Margin of Safety = Heads I Win, Tails I Do Not Lose
Investors can reduce the risk of large losses by insisting on a large value spread between the price of a stock and its intrinsic value. That difference is your margin of safety. If you buy an asset at a steep discount to its underlying value, the odds of a permanent loss of capital are low, protecting you from risk. The greater the discount, the larger the margin of safety, and thus the better the risk-reward of the investment opportunity.
Let us say you have estimated the intrinsic worth of a company as $100 per share, but it is trading at $80. This means that the stock is at a $20 discount to its intrinsic worth. If that $80 stock then falls to $50, an exceptional investment opportunity appears. If your assessment of the business as being intrinsically worth $100 does not change, the fluctuation in the share price is giving you an amazing opportunity.
It is important to recognize what has happened to both the upside potential and the downside risk. Risk is reduced because the share price has gone well below the intrinsic value. At $80 converging to $100, you will generate a 25 percent profit on the investment. At $50, you will make 100 percent. That’s the magic of the discount: as the price falls well below intrinsic value, the downside is limited and the upside has increased.
That said, securing a margin of safety is not an absolute fail-safe. It improves the odds of a good payoff but does not make you impervious to a loss. No matter how well you research an investment proposition, you will get some wrong. Investing is not about making no mistakes; it is about keeping the costs of the mistakes low enough that you can recover from them and not ruin all the excellent work done on other investment decisions. Differently put, having a margin of safety reduces the scope for a mistake to turn into a mishap.
A margin of safety is also about making sure markets pay you for the unexpected to happen, rather than just focusing on what you must pay for the expected. Benjamin Graham, the father of value investing, explained that the function of the margin of safety is to render unnecessary an accurate estimate of the future. This means that with a margin of safety, even if the future does not pan out as you forecasted, your losses are low. With a margin of safety, your nest egg suffers less, and often it is only your ego that gets bruised.
Proactive risk management demands that you consider what can go wrong and quantify the downside scenarios instead of banking on the upside potential and what can go right. By buying stocks when bad news is priced in but good news is not, you create an additional margin of safety. The stock may not go up, but it doesn’t go down much either: heads you win, tails you don’t lose. Thus, risk proves to be an opportunity cost, not an actual cost. It is underperformance compared to expectation (annoying but not critical), not permanent impairment of capital (damaging to your financial well-being).
Error of Omission: You Snooze, You Lose
Part of astute risk management is to not be afraid, because excessive fear can cause you to miss out on opportunities. I call this risk an error of omission, and I too have fallen into this trap.
I made this mistake a decade ago, when I passed up on owning Interactive Brokers, a leading low-cost platform to trade equities, especially international ones. It is the largest electronic stock brokerage firm in the United States, by number of daily average revenue trades, and the leading foreign-exchange broker (firms that facilitate trade in foreign currencies). It is also very well capitalized; its equity capital exceeds $6 billion. Management and employees own more than 84 percent of the company, so they have ample skin in the game and are as exposed to the downside as they are to the upside. This ensures that they will run their business conservatively and explains why they hold no material positions in exotic, high-risk securities such as CDOs (collateralized debt obligations), MBSs (mortgage-backed securities), or CDSs (credit default swaps), or unlisted securities or derivatives. The gross amount of their portfolio of debt securities, with the exception of U.S. government debt securities, is less than 10 percent of their equity capital. Rated “the low cost online broker” for eighteen years in a row by Barron’s, they offer low-cost access to invest in stocks, options, futures, foreign exchange, and fixed income on more than 120 global exchanges in the world. Their low-cost position is derived from their homegrown proprietary online trading technology, built over the past forty years, which enables them to provide competitive pricing, high speed, diversity of global products, and advanced trading tools. Their low-cost position is also a function of their assiduous focus on simplicity and frugality. In my opinion, they are the Costco of the brokerage world—high quality and unbeatable prices.
While I recognized the quality of the franchise, I was worried about the low free float of 16 percent and limited trading liquidity in the stock. This was flawed thinking on my part. As a long-term patient investor, I could afford to take the risk of lack of liquidity. In addition, I could have managed the risk by limiting my position size. This error of omission proved costly; the stock quintupled, from around $15 in 2008–2009 to $80 by mid-2018.
Conclusion: Seek and Ye Shall Find (and Get Paid)
In life, we don’t give up striving for success because some struggles or sacrifices come with it. We figure out how to manage and overcome them, so they do not overwhelm us. Similarly, in investing, you must not give up the pursuit of any return just because it comes with some risk. Instead, you learn to identify risk, manage it proactively and prudently, and insist on getting paid for it.
That said, I know it is not easy. In the real world, businesses and stocks do not come with black-and-white risk labels attached to them; they come in many shades of gray. It takes a great deal of due diligence and acumen to figure out the risk and reward of an investment opportunity and decide whether you should engage or walk away. In markets, such truth may reveal itself in years and decades, not days or weeks. During that time, a great deal of risk may exist without your realizing it.
When the risks of an investment are not obvious, but the returns are, this does not mean risks are nonexistent. They are just not in plain view or have not materialized yet. I refer to this out-of-sight-out-of-mind risk as a blind spot. Risk management requires a contrarian bent of mind. It means that you must proactively seek out bad news and figure out what can go wrong, and you must do it before the horse leaves the barn. Nonetheless, many investors behave like daredevils, hoping for the best instead of preparing for the worst, as if some magical risk alert will go off a minute before midnight so they can wait to deal with it then. Think of risk management as an insurance policy: you need to buy it before the accident or catastrophe occurs, not after.
Risk is a virus that can mutate unpredictably, not a bacterial cell that multiplies predictably. Your doctor would not confuse a bacterial infection with a viral one, and neither should you. Like a potentially deadly virus that keeps morphing, risk requires you to be constantly vigilant and stay a step ahead. This requires judgment, foresight, and multidimensional approaches, not reliance on rote checklists or static metrics. Managing risk is an ongoing process, not a one-and-done task.
While identifying and managing risk may appear daunting at first, it is not that hard to find if you know what you are looking for and how to look for it. But if you do not look, you will not find, even if it is staring right back at you. In fact, failure to think about the diverse types of risks is the bigger challenge, not failure to find.
Remember: Being risk aware does not mean you should be risk averse. You must strike the right balance between worrying about losing money (my definition of risk) and worrying about missed opportunity (to make money). One way to clarify this is to remember that risk and uncertainty are not the same thing. In his 1921 book, Risk, Uncertainty, and Profit, Frank Knight, an economist, formalized a distinction between the two. He understood that an ever-changing world brings new opportunities for businesses to make profits, but also means we have imperfect knowledge of future events. Risk, according to Knight, applies to situations in which we do not know the outcome but can accurately measure the odds. Uncertainty, on the other hand, applies to situations in which we cannot know all the necessary information to set accurate odds in the first place.
“Being risk aware does not mean you should be risk averse.”
Fundamental research is about figuring out what you know and do not know or cannot know, to separate risk from uncertainty. This chapter has given you cues and clues to sharpen your antennae on risk. However, if you do not know how to tune into risk, or do not want to, that’s fine. Outsource it. You do this in many aspects of your life, by finding the best doctor to avoid the risk of dying from some disease or the best lawyer to avoid the risk of losing a lawsuit. Apply the same logic in investing. Find the money managers or financial advisers who know how to manage the risks of your investment portfolio, not just its returns. As Peter Bernstein, the guru on risk management, rightly noted: “Risk is a choice, not a fate.”
1. You always lose money downward from a bigger number and gain money upward from a lower number. This explains why avoiding losers is more important than picking winners.
2. Risk experience can be vastly different from risk exposure. The former may understate the latter, resulting in more risk than you bargained for.
3. Swapping risk is not reducing risk. Risk comes in many disguises. By unduly focusing on one form of risk that is top of mind, you may be ignoring another form of risk that has not yet reared its ugly head.
4. Investors often benefit from risk management in the future, but they always experience the costs in the present. Rewarding risk takers at the expense of risk managers incentivizes wrong behaviors: trying to win the battle instead of the war.
5. Risk is omnipresent. Instead of trying to avoid it or ignore it, manage it, and insist on getting paid for it. Always strive for a margin of safety in investments; it ensures a mistake does not turn into a mishap.
6. Being risk aware does not mean you should be risk averse. You must strike the right balance between worrying about losing money (risk) and worrying about missing the opportunity to make money (returns). When you are paid to take risks, you should take them.
7. Do not mistake risk measurement as risk management.
8. Risk is a choice, not a fate.