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Risk comes from not knowing what you are doing
Warren Buffett
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 is probably advised to invest in so-called growth stocks which all have great promise but no guarantees.
This idea 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.
But this is not the case.
A great investor understands that risk is contextual, measurable and manageable or even avoidable.
What is risky for me might not be risky for you
Is the experienced rock climber, whose fingers are the only things holding him a hundred feet up a vertical cliff taking a risk?
Or is the expert skier who zooms down the almost vertical double black diamond slope at sixty miles an hour taking a risk?
You would probably answer “Yes!” But what you actually mean is “Yes, if it was me doing it”.
Risk is related to knowledge, understanding, experience and competence. Risk is contextual.
While we can’t be sure that the rock climber or the skier are taking no risk we intuitively understand that they are taking less risk than we would in the same situation.
Even when we observe something that feels very high risk we can assume that for somebody else it might not be risky at all.
To even better understand the concept, think about driving a car. Chances are that you are an experienced driver and you have the ability to make instant judgments while driving - You can even listen to the radio and switch lanes at the same time.
When you first started driving it was not as easy as it is now. When switching a lane you actually have to consider several things:
Is my speed OK compared to the speed of the other cars to switch lanes?
What’s the speed of the cars in front and behind me?
Will the drivers in the other lane let me in?
…and so on.
The more you practice driving the better you get at it - to the point that you will be able to do it unconsciously leaving your conscious mind to be able to listen to the radio.
The more you practice something the better you get at it - until at one point it becomes a habit where you do what you do unconsciously.
This is the case with the death defying rock climber and the skier but it is also the case with professional investors.
There is a story of George Soros interrupting a meeting to place orders worth hundreds of millions of dollars. A person who was attending the meeting told later:
“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”
For this person it looked like George Soros was taking a huge risk but in fact he didn’t. In order to be able to make fast decisions concerning hundreds of millions of dollars like this we would have to know what Soros knows and it would not look like such a huge risk any more. We would simply have to learn to drive the “trading car” as well as George Soros is doing it.
Remember:
Risk declines with experience
How can we embrace risk as a winning investment habit?
Restrict your investments to the areas of life where you can make competent decisions. If you don’t know anything about computer chip makers don’t invest in them even if a stock has an attractive price. If you know about construction find a company that does just that. It will be so much easier for you to understand what they are doing.
Warren Buffett:
It’s not risky to buy securities at a fraction of what they are worth.
Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether who was a former vice-chairman and head of bond trading at Salomon Brothers.
Long-Term Capital Management had developed complex mathematical models to take advantage of arbitrage opportunities on the bond market. Because of the enormous profit they made on the first years they had more money to invest than they knew how to invest. In other words they had too much money to use with their successful model. Because of the pressure to keep making the amount of money they did in the first years they took very risky positions outside their know-how and burned badly.
Victor Niederhoffer is a well known fund manager and a professor of finance in University of Berkley (1967-1972). After having an average annual return of 35% Victor Niederhoffer had made so much money that he gave most of it back to the investors but he took the 130 million dollars and invested it in Thai bank stocks after they had fallen heavily because of the Asian financial crisis. On October 27, 1997, losses resulting from this investment, combined with a 554 point (7.2%) single day decline in the Dow Jones Industrial Average (the second largest point decline to date in index history) forced Niederhoffer Investments to close its doors.
That’s what happens to companies who don’t make preservation of capital their primary aim - they lose their money.
Seems that a lot of people agree that professional investors are better in investing than you and me or the so called amateur investors.
While this might often be the case there is literally tons of information out there about exactly the opposite being true. If you would like to know how an ordinary person can beat the professionals in their own game I would recommend to start from reading the classic One Up On Wall Street by Peter Lynch.
But that’s not what this post was supposed to be about.
While there is no doubt that an amateur can beat a professional there is also no doubt that there are people (usually professionals) who have an amazing track record. Peter Lynch and Warren Buffett are the first to come in mind. These are the people who have shown year after year that they can beat the market. For example Warren Buffet’s portfolio has grown an average of more than 20% per year.
With a rate like that it takes a little less than 4 years to double your money. The average return of the markets is widely believed to be about 12% . With a return of 12% you would double your money in a little less than 7 years.
The key point to agree upon here is
There are people who constantly outperform the markets.
The Average Joe
Let me ask you this. Have you ever lost money in the markets? Chances are that when you have done at least a few investments in your life you have lost money.
Now let me ask you another thing – Have you ever made back what you lost – in the markets?
I bet that the answer is NO. It is no for the majority of people.
For the average investor, investing is a sideline. When he takes a loss, he usually subsidizes his portfolio from his salary, pension fund, or other assets. If the average Joe has 1000 dollars less than his goal he will simply put a little more money aside each month to get back to the desired level.
The Master Investor
For the Master Investor investing is not a sideline – it is his life. So when you take a hit and lose a portion of your portfolio – you can’t subsidize it from your salary (because you only get paid when you make money). The only way to get the money back is to make it back in the markets.
Consider this - if you lose 50% of your investment capital and you manage to achieve the average 12 percent a year return – it will take you a little less than 7 years to get back to where you were before the loss.
With Buffett’s average return of 24.4 percent it would take 3 years and 2 months and for George Soros with an average yearly return of 28.3% it would take 2 years and 9 months.
What a waste of time!
Isn’t it simpler to just avoid the loss in the first place?
So there you have it:
The biggest difference in the thinking patterns of highly successful investors and the not so successful ones is that for professional investors losing is not an option. If you lose then it will take a lot of time to get the lost money back. So you only invest when you are absolutely certain that you won’t lose it.
If you can’t subsidize your losses then your thinking shifts from “Make profit” to “Keep what you have and after that if possible make a profit”
So here you go – Only invest when you are certain that YOU WILL NOT LOSE YOUR MONEY.
Excellent investors always take responsibility for their results.
When a good investor takes a loss he doesn’t say „The market was against me” or „My stock broker gave me bad advice”.
After a mistake an excellent investor always admits „I made a mistake”.
A winning investor accepts the result without recrimination and always analyses what they did or didn’t do so that they won’t repeat the mistake.
A true investor acknowledges that the best lessons are always the ones that you get from your own mistakes.
By taking responsibility for your actions – both profits and losses - a good investor stays in command of himself.
It’s exactly like the expert surfer dude hitting the waves. He doesn’t believe that he controls the waves but because of his experience he knows when to ride a wave and when to avoid it. He is in control of his own actions. If he falls – it’s his fault.
Below is a short video about the things that make us successful in life. The presenter is Richard St. John who made his observations based on over 500 interviews with successful people.
Here is a short review about the video.
Here are the 8 common things that help us be successful.
1. Passion
Do it for love not for the money. The money will always follow when you truly enjoy what you are doing.
2. Work
It’s all hard work. Nothing comes easily. But remember to have fun.
3. Good
Put yourself into something and get damn good at it.
Practice makes perfect.
4. Focus
It all has to do with focusing yourself on one thing
5. Push
Push yourself. Physically, mentally. You have to push, push, push and push
6. Serve
Serve others something of value - that’s how people really get rich.
7. Ideas
Have ideas and make them come true.
Listen, Observe, Be Curious, Ask Questions, Solve Problems, Make Connections - Ideas will follow.
8. Persist
Persistence is the number one reason that successful people are successful.
Once upon a time there was an entrepreneur who understood how important it is to educate himself in order to stay competitive.
He set himself a goal that he will take 10% of what he makes and spend it on seminars and educating himself.
After 10 years the guy was struggling – thanks to all these seminars he had made so much money that in order to keep spending 10% of what he made on educating himself he was attending seminars 3 months a year.
This is actually a true story that I read some years ago but I can’t remember who this guy was. If you know then let me know!
When we lose money, we count the dollars we actually lost. Not Warren Buffet. His loss is what those dollars could have been. For him losing money is a gross violation of his underlying aim, which is to “watch money grow”.
Preservation of capital is an investment rule propounded by many but practiced by few.
When asking investors how it would feel to make preservation of capital, most report a sense of paralysis or a feeling that you can’t do anything because you might lose your money.
Here is a graph how most investors think about investing and risks. The conventional thinking goes like this – in order to make a 1000 dollars I need to risk to lose the 1000 dollars I already have.
Here is another graph showing the thinking behind the best investors of the world.
There are a couple of reason why the graph for the best investors in the world looks a lot better to anyone even remotely acquainted with the principles of risk versus potential profit. The second graph illustrates a proportionally smaller amount of risk with better profit.
Here is why the second graph is the right way to think about risk and reward.
1)While investing money the most you can lose is all of it but the most you can win is unlimited. If you bought the stock of Microsoft in the early 80’s you would have made more than 100 times the money you put in on your investment.
2)The second reason for this graph to look like it does is even more important. Because of the compound interest every dollar that you make on your investmet further increases the amount that you are going to make. For instance if you manage to buy a stock with a dividend yield of 10% then after the first year your 100 dollars would be 110, after the second year 121, after the third year 133,1 and so on. As you can see the first year you made 10 dollars, the second year 11 dollars and on the third year 12 dollars and 10 cents. When you have a stock that keeps rising 10% a year that doesn’t pay any dividends it is essentially the same thing – the first year your stock price will rise 10 dollars, the second year 11 dollars and the third year 12 dollars and 10 cents.
The investors that consider the second graph to tell the truth are more often focused on the investment process. They don’t view each investment to be a discrete, individual event because they know that even if you only invest for a relatively short term and make 10 per cent on your investment – it will give you 10% more to invest the next time.
Thanks to the compound interest you will potentially make more money with every passing year. Thus the longer your investment period the lower is the risk to lose all your money compared to what you can make.
Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1
Warren Buffet
„Survive first and make money afterward.”
George Soros
„If you don’t bet, you can’t win. If you lose all your chips, you can’t bet”
Larry Hite
What’s the difference between a Winning Investor and a Loosing Investor?
The winning investor – Believes that his first priority is always the preservation of capital, which is the most important cornerstone of his investment strategy.
The loosing investor – Has only one investment aim – „to make a lot of money”. As a result he often fails to keep the money he already has.
Did you know that if you have a stock that drops 20% then you would need it to grow 25% in order to get back to the same price level before the price drop. (Example: If you start with 100 dollars and lose 20% you will end up with 80 dollars. In order to go from 80$ to 100$ you need a gain of 25%).
If you lose 50% of 100 dollars you will end up with 50 dollars. But in order to get from that 50 dollars back to 100$ you need to double the 50 bucks. This means you need a growth of 100% .
It might not seem like a big deal – 50 dollars to lose is nothing catastrophic. But consider the same on a larger scale.
Let’s say that you have a pension fund that holds 1 million dollars. Because of problems in the subprime market your fund loses half of its value – now you only have 500 000 dollars left. What do you think how much time would it take to get back to the initial 1 million?
Well no one can tell for sure but the only thing that is known for sure is that it will take a lot more effort (and time) to get the money back.
Here is a chart that on the left give you the initial loss in % and on the right it shows how much you need to make afterwards in order to get the initial sum back.
% of loss of initial investment
% that your investment must grow to get even
1%
1,02%
5%
5,3%
10%
11,1%
15%
17,8%
20%
25%
25%
33,4%
30%
42,9%
40%
66,7%
50%
100%
75%
300%
80%
400%
90%
900%
95%
1900%
99%
9900%
This is exactly why Preservation of capital is ALWAYS the number 1 priority of any half decent investor. If you have a loss of 1 per cent you need a growth of more than 1 per cent to get the money back. The more you lose the bigger the gap between what you lost and how much you need to make to get it back will grow.
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