Wit, Wisdom, Warren (Issue #11): Risk

“Risk means more things can happen than will happen.” ~ Elroy Dimson.

Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.”

Read any literature from any legendary investor, and “avoiding permanent loss” or “avoiding risk” emerges as the primary factor that has helped him or her become successful, and legendary.

Howard Marks writes in The Most Important Thing…

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential— I think the essential — element in investing.

It’s not hard to find investments that might go up. If you can find enough of these, you’ll have moved in the right direction. But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk.

The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.

Now, while Buffett’s rule of “never lose money” does not mean that you should never incur the risk of any loss at all, it means that over several years, your investment portfolio should not be exposed to appreciable loss of principal.

Where does RISK come from?
Warren Buffett answered this in one defining statement…

Risk comes from not knowing what you’re doing.

As an investor, if you don’t know what you don’t know (like whether you are an investor or a speculator) or you do something you don’t know (like investing outside your circle of competence), that’s where risk comes from.

A case I remember from my own investment experience is that of investing in Hotel Leela in 2006.

I was in Bangalore sometime early that year, and visited Leela Palace to meet a friend who was attending a conference there. I was in awe of the property – it was grand, and amazingly beautiful.

On enquiring, I got to know that the hotel was one of the most expensive locations in India and was still completely booked for the next few months. The story was same everywhere – most of Leela’s properties were booked for months, despite their premium pricing.

“What an amazing business!” I told myself. “Just imagine the kind of profits these guys must be making. I must have this stock in my portfolio!”

The next day, without trying to know more about the economics of the hotel industry and Leela’s business and financial performance, I bought the stock, expecting it to be a story that was waiting to be unveiled.

Well, it was indeed a story waiting to be unveiled…and for me!

When I glanced through the company’s annual report after buying its stock, I saw a business that had been high on debt and low on returns in the past – indicating a management that had been reckless in capital allocation and was willing to put its company on high risk to grow its business.

Anyways, by the time I accepted the fact that I had made a huge mistake of speculating on the stock without knowing that I did not know about its business, the stock was already down around 45% from my purchase price.

With a heavy heart, I sold it off, and thankfully so…as the stock is down around 60% since then!

There were a few other instances when I ventured into unknown territories (things outside my circle of competence) during the 2005-08 bull-run, though I was lucky to be saved by a rising market that lifted all ducklings, even the ugly ones.

I now realize how big a risk I had taken with my savings then, which could have caused me permanent loss of my hard-earned savings.

In Charlie Munger’s words, I have been on several journeys to places that could have killed me, only to return before reaching the dead end.

Know What You Don’t Know
If I can share just one lesson from my limited and average experience as an investor, it’s that you must try to be smart enough to know what you don’t know.

Here is what Buffett wrote in his 1996 letter…

Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses.

Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

A key idea that comes out of the above words from Buffett is that, if you seriously wish to reduce the number of times you expose yourself to the risk of going wrong, you just need a handful of investment ideas in your lifetime.

Buffett wrote this in 1992…

An investor needs to do very few things right as long as he or she avoids big mistakes.

Over the last two years, I have heard from lot of tribesmen how mentally burdened they are by the sheer thought of picking up the right stocks from the thousands of stocks listed out there.

My answer always has been to cite Buffett’s “twenty punches” approach.

He is supposed to have said…

I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime.

And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.

The problem with most of us investors is that, too often, we scatter money around while saying to ourselves, “Okay, let me throw a little money in this stock and little in that stock and then see what happens. At least, one of the stocks will work!”

Now, that’s a sure shot road to a hell lot of risk – first you don’t know where you are scattering your money, and then you think you are investing while the reality is that you are speculating in the hope of hitting the “right” stock.

Buffett wrote this in his 1993 letter to shareholders…

Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire’s capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically.

Therefore, we adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we’ll now settle for one good idea a year. (Charlie says it’s my turn.)

Other Sources of Risk
As an investor, not knowing what you are doing is the biggest source of risk. But it’s not the only source. Some other ways you add tremendous risk to your investments are…

• Focusing on the outcome (return) and not the process (to earn such a return while minimizing losses)
• Borrowing money to invest or speculate in stocks (you cannot handle the worst of situations with debt on your head)
• Thinking and acting like others

Why Assessing Risk is So Important
Risk, as you know now, is…not knowing what you are doing.

The question is – why is assessing risk (of permanent capital loss) such an important step in your investment process?

In The Most Important Thing, Howard Marks outlines three reasons risk assessment is so important…

First, risk is a bad thing, and most level-headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk-averse, meaning they’d rather take less risk than more. Thus, for starters, an investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.

Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.

Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones? In fixed income securities or stocks? In large, established companies or smaller, shakier ones? In liquid stocks and bonds or illiquid private placements? With help from leverage or without it? In a concentrated portfolio or a diversified one?

Risk Comes in Many Forms
Buffett said this in his 1997 shareholder meet…

We think first in terms of business risk. The key to Graham’s approach to investing is not thinking of stocks as stocks or part of the stock market. Stocks are part of a business.

People in this room own a piece of a business. If the business does well, they’re going to do all right as long as long as they don’t pay way too much to join in to that business. So we’re thinking about business risk.

Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there’s a hiccup in the business, then the lenders foreclose.

It can come about by their nature – there are just certain businesses that are very risky. Back when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial airplane as a sort of bet-your-company risk because you would shell out hundreds and hundreds of millions of dollars before you really had customers, and then if you had a problem with the plane, the company could go.

There are certain businesses that inherently, because of long lead time, because of heavy capital investment, basically have a lot of risk.

Commodity businesses have a lot of risk unless you’re a low-cost producer, because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. We had fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren’t the low-cost producers so it was a risky business. The guy who could sell it cheaper than we could made it risky for us.

We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise.

The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation.

Then the risk becomes the risk of you yourself – whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market. The stock market is there to serve you and not to instruct you. That’s a key to owning a good business and getting rid of the risk that would otherwise exist in the market.

Stock Price Volatility Is NOT Risk
Buffett said this in his 1997 shareholder meet…

You mention volatility – it doesn’t make any difference to us whether the volatility of the stock market is a half a percentage of a point a day, or a quarter percent a day, or five percent a day. In fact, we’d probably make a lot more money if volatility was higher because it would create more mistakes in the market. Volatility is a huge plus to the real investor.

Ben Graham used the example of Mr. Market. Ben said that just imagine that when you bought a stock you in effect bought into a business where you have this obliging partner who comes around every day and offers you a price at which he’ll either buy or sell and that price is identical. No one ever gets that in a private business, where daily you get a buy-sell offer by a party. But you get that in the stock market, and that’s a huge advantage. And it’s a bigger advantage if this partner of yours is a heavy-drinking manic depressive.

The crazier he is, the more money you’re going to make. So, as an investor, you love volatility. Not if you’re on margin, but if you’re an investor you’re not on margin, and if you’re an investor you love to get these wild swings because it means more things are going to get mispriced.

Here’s what Buffett’s partner Charlie Munger has to say on this topic of volatility as risk…

It came to be that corporate finance departments at universities developed the notion of risk-adjusted returns. My best advice to all of you would be to totally ignore this development.

Risk had a very good colloquial meaning, meaning a substantial chance that something could go horribly wrong, and the finance professors sort of got volatility mixed up with a bunch of foolish mathematics and to me it’s less rational than what we do. And I don’t think we’re going to change.

Finance departments believe that volatility equals risk. They want to measure risk, and they don’t know how to do it, basically. So they said volatility measures risk.

I’ve often used the example of the Washington Post’s stock. When I first bought it in 1973 it had gone down almost 50%, from a valuation of the whole company of close to $170 million down to $80 million. Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for $80 million than if you bought it for $170 million.

That’s something I’ve thought about ever since they told me that 25 years ago and I still haven’t figured it out.

In his 1994 shareholder meeting, Buffet made a very important point. He said that one key aspect to risk is how long you expect to hold an investment.

So, stocks in sound businesses like Asian Paints, Hawkins, or Cummins India – even if bought at a reasonable price – might be very risky if bought for a day trade or to hold for only a week. But, over a 5 or 10 year period these would probably have negligible risk.

Don’t Fly Too Close to the Sun
Here is something Buffett wrote in his 2000 letter…

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.

Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice.

But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Understanding that risks exist, recognizing those risks, and then controlling them are the most important steps you will take in your investment lifetime.

As Howard Marks writes…

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.

Finally, here is what Seth Klarman writes in Margin of Safety…

While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken.

It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

Mind your behaviour, dear investor. YOU are, after all, the biggest RISK to your investments!

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