Saturday, July 16, 2011

The Most Important Things to successful investing via the Howard Marks' Way (Part 1)

*The principles behind this note are drawn from Howard Marks thinking. What I learnt and think deeply from all of Mark's principles is his thoughts on risk. I've to be honest that I've not paid as much attention or thought of risk so much as to generating return.

"What has been will be again, what has been done will be done again; there is nothing new under the sun." (Ecclesiastes 1:9-14 NIV)

I came across the following portfolio:

On the outlook, it looks like a decent performance over the last decade. But in investing, luck can be mistaken as skill. A lucky idiot can be mistaken as a successful investor. So could the above portfolio be skill or luck? Was the return achieved with the correct risk control in mind? Whatever it is, I hope to design my portfolio for a safer, more consistent return that can last for a full investing career, rather than to chase for return that is incommensurate with risk which can come back to bite you on a dime.

Beating the market can be far from synonymous with superior investing. So the question lies in exactly what is successful investing and how to construct a risk-adjusted portfolio that can perform consistently over a full investing career.

Successful investing is to beat the market and to beat the market, you've to be above average, i.e., in the top half of the crowd. Anyone can be average just by investing in an index fund. How can you achieve superior return? Either you need good luck or superior insight. But counting on luck doesn't enhance your chance of success. So you'd better concentrate on insight.

To be above average, you have to find an edge where the crowd don't have. You must think of something they haven't thought of, or have thought of but is restricted to act on, see things they miss or bring insights they don't possess. In short, you have to act and behave differently – i.e., be a contrarian. However, being a contrarian doesn't guarantee success. The key is you have to be more right than others.

To achieve a consistent above-average result, you need superior insight, intuition, a sense of value and awareness of psychology. All consistent successful investors have something in common – second-level thinking. First level thinkers say, “The economic outlook sucks because of lower-than-expected growth and higher-than expected inflation” Second-level thinkers say, “The outlook stinks but everyone else is selling in a panic; let's buy!”

Superior performance comes only from correct non-consensus forecasts, but non-consensus forecasts are hard to make, hard to make correctly and hard to act on. But doing so correctly will lead to superior investment results but that's not easy. And investing is not supposed to be easy. In short, second-level thinkers must be different from and better than first-level thinkers.

An accurate estimate of intrinsic value (IV) is the indispensable starting point for reliable successful investing. Without it, any hope for consistent success as an investor is just that: HOPE.

Investing can be divided into two basic schools: 1) those based on analysis of the company's attributes, known as “fundamentals,” and 2) those based on the study of the price behavior of the securities themselves, known as “technicals.” In short, an investor is faced with two choices: first, gauge the security's underlying intrinsic value, or, second, make an investing decision purely on expectations regarding future price movements.

Technical or momentum investing might allow you to participate in a bull market that continues upward, but there're a lot of drawbacks. For one, if something cannot go on forever, it will stop. Trees don't grow to the sky. Neither does much things go to zero. What happens to momentum investors then? Without a strong core, they'd likely yield to emotions which will cause them to sell when they should be buying, or buy when they they should be selling. They capitulate to emotions than to facts, causing them pain both emotionally and in the pocketbook.

Another main flaw of momentum investing is the investor considers themselves successful if they bought a stock at $10 and sold at $11, bought it back the next week at $20 and sold at $21, and then bought it another week later at $39 and sold at $40. If you can't see the flaw in this where the trader made $3 in a stock that appreciated by $30, you're like the guy in the casino where after a few rounds, and if have not figured out who the patsy is, it's the guy.

Now on fundamental investing, there're two approaches: 1) value investing and 2) growth investing. In value investing, the goal is to quantify the company's current value and buy its securities when they can do so cheaply with a margin of safety – i.e, value investors buy when the current price is low relative to the current value. Growth investing is to identify companies with bright futures. By definition, that means there's less emphasis on the company's current value and attributes, and more on its potential – i.e, growth investors buy securities when they believe the value will grow fast enough in the future to produce substantial return. So, the choice isn't really between value or growth, but rather between value today or value tomorrow.

All investing involves coming to a conjecture about the future, be it growth or value. For value investing practitioners, it's easy to say value investing allows them to avoid conjecture about the future and that growth investing consists only of conjecture about the future, but that's not exactly right. After all, establishing the current value of a business requires an opinion regarding its future. Even a net-net investment can be doomed if the company's assets are wasted unwisely on expensive acquisitions or money-losing operations. So, it is better to regard growth investing as having a conviction about the future, whereas value investing emphasizes current-day attributes but cannot escape dealing with the future.

There's no question that's it's harder to see the future than the present. Thus, the batting average for growth investors are lower, but the payoff for doing it well is higher, naturally.

The difference in upside potential between growth and value is growth is more dramatic while value is more consistent. So value is the better approach in my opinion. Consistency trumps drama.

How do you produce a successful investing result consistently? Remember, it starts with an accurate estimate of intrinsic value. Without an accurate estimate, you'll be as likely to overpay as to underpay. If you overpay, what can you count on to bail you out? Either, it takes a surprising improvement in value, or a strong market, or an even less discriminating buyer (what we used to call a “greater fool”) to bail you out. An accurate intrinsic value will not only result in success but also serves as a protection from investing risk.

In investing, we wish the stock will tick up the moment we buy them and thus proving ourselves right immediately. But a stock falling the next day or month, or even a year thus, does not prove we are wrong. In investing, being correct about a security isn't synonymous with being proved correct right away. It's hard to consistently do the right thing as an investor. But it's even harder or impossible to consistently do the right thing at the right time. The most we value investors can improve our chances for success is to be right about an asset's value and buy it when it's available for less. Thus, a firmly held view on value can help you to cope with this disconnect (where buying today doesn't mean you're going to start making money tomorrow).

As an example, you found something that is worth $100 and have a chance to buy it for $60. Chances to buy well below actual or intrinsic value don't come along everyday and you should welcome it. So you buy it and feel you've gotten a great deal. But seldom the security price will move up on the next tick the moment you buy it. Chances are you'll often find that you've bought in the midst of a decline that continues. Pretty soon you'll be looking at paper losses. But one of the greatest investing adages reminds us, “Being too far ahead of your time is indistinguishable from being wrong.” So now that the security that is worth $100 is selling for $40 instead of $60, what do you do? In normal course of life, people want less of something when price goes up and more of something when price goes down. It makes perfect sense. But not in the world of investing. In investing, many people tend to fall further in love with the thing they've bought as its price rises because they feel validated, and they hate it when price falls, and then they begin to doubt their decision to buy. This psychology effect makes it very difficult to hold or even to buy more at lower prices, especially if the decline proves to be extensive. (Think about March 2009, securities were all at multi-years low, how many of us really bite when we should have?)

Now, if you like it at $60, you should like it even more at $40, and much more so at $30 and $20. But it's not that easy psychologically. We, humans, will wonder, “Maybe it isn't me who's right. Maybe it's the market.” The danger is maximized when they start to think, “It's down so much. I'd better get out before it goes to zero.” That's the kind of thinking that makes bottoms and causes people to capitulate and sell there.

The thing that can prevent you from capitulating at the wrong time is to have a strongly held sense of value and an accurate estimate of intrinsic value. Without which, investors who have no knowledge or concern for profits, dividends, sense of value, understanding of the business prospect and attributes, simply cannot be counted on to have the resolve to do the right thing at the right time. With most of everyone around them buying and making money, they cannot know when a stock is too high and therefore resist joining in. And with a market in free fall, they also cannot possibly have the confidence and knowledge needed to hold or buy at severely depressed price. So to be consistently successful in investing, you need an accurate opinion on valuation. Not only accurate, but also strongly held because a loosely held opinion will be of limited help when you need it the most. However, you must be aware that an inaccurate opinion on valuation, strongly held, is far worse. This shows how hard it is to get it all right. Investment is not supposed to be easy, especially superior investing. In a declining market, you need to have an accurate non-consensus estimation on value, and hold that view strongly enough to be able to hang on and buy even as the declining prices suggest you are wrong, and of course, you've to be correct on your estimation of value. Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis worked out. There's no deal better than buying from someone who has to sell regardless of price during a crash. To cater for errors, you need a margin of safety. You either have to be more conservative with valuation or buy a security at a larger discount to the intrinsic value.

Charlie Munger is known to advocate: “It's better to buy a great business at a fair price than to buy a fair business at a great price.” But the caveat is the price paid. Investment success doesn't comes from buying good things – Facebook is a good thing but is the price good? – but from buying things well. So price is the starting point in achieving investing success. History has demonstrated time and again that no asset is so good that it cannot become a bad investment if bought at too high a price. And there're few assets so bad that they cannot be a good investment if bought cheaply enough. In other words, there's no such thing as a good or bad investment regardless of price. An investment that is well bought is half sold. All is needed is to figure out the value, price to pay and the of course, the opportunity to act. If the opportunity is not there, there is no point to chase for one. Opportunity in market comes about naturally and not because you want it, it is not created out of an individual's needs or doing. So to chase for an “opportunity” which isn't there just for the sake of getting what you want is close to suicidal in investing success.

In the day-to-day pricing of a security, there're two considerations: First, the value of the security and second, the price-to-value relationship of the security. The key to ascertaining value (or the earnings) is skilled financial analysis – this is the easier part. While the key to understanding price-to-value relationship or the outlook for it lies largely in insight into other investors' state of mind or psychology. When people are fearful, they assign a low price-to-value to the security, and vice versa if they are intoxicated. Investor psychology is like a pendulum that can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals. The more people likes an investment now, the higher the value of the current price-to-value relationship, and vice versa. Future price-to-value relationship movements (increase or decrease in P/E) will thus be determined by whether the security will come to be liked by more people or less people in the future. If you boil it down, investing is like a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already baked into the price, and no or few new buyers are left likely to emerge (i.e, all the greater fools have been used up).

It is surely hard to know exactly when the market will peak (bubble does not announces its arrival or ring the bell before it departs) but it is not difficult to know where we stand in the market pendulum. In a typical bubble, buyers do not worry about whether a stock is priced too high because they are sure someone else would be willing to pay them more for it. “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time or become even more overpriced. Those who have initially resisted buying may eventually question their wisdom, then capitulate and buy when they see seemingly easy massive profits everyone else is enjoying. Unfortunately, the greater fool theory works only until it doesn't. Eventually, valuation comes into play, and those who are holding the bag will pay the price. Market will self correct itself without anyone knowing the exact timing.

The problem in bubbles is that a security that is attractive will morph into “attractive at any price.” How often have we heard people saying,”I know it's not cheap but I think it'll keep going up because of excess liquidity and many people are willing to pay more at any price.” How I wish I could sell my car or house to you at any price! Buying or holding on that basis is simply playing with chance and blinkmanship, but that's what makes bubbles. During a bubble, investors become complacent and disregard any notion of value and fairness of price, and are infatuated with market momentum on the upswing, and greed takes over (ok, maybe not totally greed but envy because most investors are alpha types who cannot stand missing out what others are seemingly enjoying and look like a loser). Thus, just when an investor needs prudence the most, they forsake it and chase for return by bearing above-market-risk-adjusted return.

As we have seen, an investment approach that is based strongly on solid value is the most dependable. In contrast, to count on others to give you a profit or bail you out regardless of value (to rely on an ever-expanding bubble) is probably the least.

Just like there're many ways to skin a cat, there're also a few possible routes to investment profit:
  1. Benefiting from a rise in the asset's underlying intrinsic value. But the caveat is that increases in value are hard to estimate accurately. Further, the potential for increase is usually factored into the asset's price. So unless your view is superior and different from the consensus, it's likely you're already paying for the potential improvement – i.e. hard to get any alpha return.
  2. Use leverage. The problem here is that using leverage doesn't make a security a better investment or increase the probability of gains. What it does is just magnifies whatever gains or losses that may materialize. Moreover, it introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are at its worst. Over the years, leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes.
  3. To sell for more than your asset's worth. Everyone hopes to sell his assets to a buyer who is willing to overpay. But certainly, to hope for a less discriminating buyer cannot be counted on. Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.
  4. Buying something for less than its value. This is the most dependable way to make money consistently in my opinion. Buying at a discount from intrinsic value and having the asset's price move to its fair value doesn't require luck; it just needs market participants to wake up to reality.
Of all the possible routes, buying cheap is the most reliable. But even buying cheap isn't sure to work. You can be wrong on the intrinsic value. Or events can come along that reduce the business value. Or deterioration in markets can make something sell even further below its value. Trying to buying cheap isn't foolproof but it's the best chance to investing success.

Successful investing requires us to buy below value and to have an opinion on value. Thus, to have an opinion, we are dealing with the future. And because it involves the future which none of us can know for certain, risk is inevitable. Dealing with risk is the essential element in investing.

There're three steps to risk. The first step consists of understanding risk. The second step is to recognize it when it's high. The final step which is the most critical is controlling it. We know that the riskier the asset, the higher the return but riskier investments absolutely cannot be counted on reliably to deliver higher return. Why not? Because if riskier investment can reliably produced higher returns, they wouldn't be riskier.

What is risk? First, risk is covert. Risk can only be seen on hindsight, that is, after the fact if events happen in a certain way. But it doesn't mean that if things don't turn up in a certain way, risk is not there. Almost remember, risk is stealth. The risk of an investment cannot be measured in retrospect any more than it can be measured beforehand. Let's say you makes an investment that works out as expected, does that mean it wasn't risky? Maybe you bought something for $100 and sold it a year later at $300. Was it risky? Who knows? Maybe it exposed you to great potential uncertainties that did not materialize. Thus, its real riskiness may have been very high though events did not turn out to be that way. Or say the same investment produced a loss instead, does it mean it was risky? If you think about it, the answer is simple: The fact that something – in this case, a loss happened does not mean it was bound to happen, and the fact that something did not happen mean it was not likely to happen. Nassim Taleb, in his book, Fooled by Randomness, talks about the “alternative histories” that could have unfolded but didn't. Even after the investment is sold out, it's impossible to tell how much risk it entailed. The fact that an investment makes money does not mean it was not risky, and vice versa. Did the investor do a good job assessing the risk entailed? It's hard to answer. Something that is probable does not mean it will happen and something that is improbable does not mean it will not happen. History has proven time and time again that probable things fail to happen and improbable things happen all the time. That's something you need to take into account about investment risk.

How do investors measure risk? First, it is nothing but a matter of opinion. Second, the standard for quantifying risk is nonexistent. Some people will think the risk high and others low. Some will state risk as the probability of not making money, and others as the probability of losing a fraction of their money. If you herd all the investors involved in a room and show their cards, they'd never agree on a single number or method representing an investment's riskiness. Third, risk is deceptive, covert and stealthy. When you boil it all down, risk is subjective, hidden and unquantifiable. For simplicity, we shall define risk as the probability of loss which hopefully, we can agree on.

So where does that leaves us? We certainly cannot ignore risk. If risk of loss cannot be measured or even observed, how can it be dealt with? Skillful investors can get a sense of risk present in a given situation. They make judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value. Other things will enter into their thoughts, but most will be subsumed under these two.

Risk of loss does not necessarily come from weak fundamentals. A fundamentally weak asset – a cigar-butt company's stock, a speculative-grade bond, or a building located in the wrong part of a town – can make for a very successful investment if bought at a low-enough price. There's no asset that is so good that will become a successful investment regardless of price, neither, are there many assets that are so bad that cannot produce a successful investment if bought at a low-enough price.

Risk is ubiquitous regardless of economic conditions. It is present even without weakness in the macro-environment. Risk is most dangerous when we let our guard down, when we become too arrogant, or fail to understand and allow for risk. And then a small adverse development in the environment can be enough to wreak havoc.

Mostly, risk comes from investors' psychology that's too positive and thus drives up prices. They expect high returns from things that have been doing well lately, and thus, buy more. The investments may deliver on people's expectations for a while, but they certainly entail a higher risk. In theory, high return is associated with high risk because the former exists to compensate for the latter. Thus, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher return. The market has to set things up to look like that'll be the case, if it did not, no one would make risky investments. But it can't always work that way because if it does, it wouldn't be risky at all. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they're worth. In the same way, overpaying means both low prospective return and high risk.

Bargain securities are by nature dull, ignored, beaten-down, and possibly tarnished but are often the ones value investors favor for high returns. Their returns during bull markets are rarely at the top, but their performance is generally excellent on average, more consistent than that of “hot” stocks and characterized by low variability, low fundamental risk and smaller losses when market do badly. Much of the time, the greatest risk in these unloved bargains is in the possibility of underperforming in heated bull markets. That's something the risk-conscious value investor is willing to live with. During a bull market, it is more than enough to keep even with it or perform slightly below it. But in a bear market or crash, the risk-conscious investor will beat the market, often by a large margin. That's when on average the risk-conscious investor will outperform the market over a full investing career.

In the world of investing, one can live for years on a great coup or a long running bull market. But does that proved one's success? During a booming market, the best results often go to those who take the most risk. Were they really so smart and have the insight to anticipate good times, or just aggressive individuals who were bailed out by the positive events? Simply put, how often in our business are people right for the wrong reasons? These are the people Nassim Taleb refers as “lucky idiots,” and until the tide goes out, it's definitely hard to tell them from skilled investors.

Here's the key to understanding risk: it's subject largely to a matter of opinion. It's also hard to measure even after the fact. Many future scenarios are possible but only one future scenario will occur. The future that happens may either be beneficial or harmful to your portfolio, and may be attributable to your foresight, prudence or luck. The performance of your portfolio under the one scenario that unfolds says nothing about how it will perform under the many other “alternative scenarios (or histories)” that were possible. Consider the various scenarios below:
  1. Portfolio A is set up to withstand 99% of all scenarios but succumb because it's the remaining 1% that materializes. Based on the outcome, it may appear to have been risky, whereas the investor might have been quite cautious.
  2. Portfolio B may be constructed so that it'll do very well in half the scenarios and very poorly in the remaining half. If the favorable scenario materializes and the portfolio propers, onlookers may conclude it was a low-risk portfolio.
  3. Portfolio C is structured entirely to be contingent on one single oddball scenario, but if the scenario occurs, wild aggression can be mistaken for foresight and even conservatism.
The above scenarios alone show return alone – and especially return over short periods of time – say very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly, it cannot be gauged on the basis of what “everybody” says at a moment in time. However, risk can be judged by sophisticated, experienced second-level thinkers.

Great investing requires both generating returns and controlling risks. And recognizing risk is the prerequisite for controlling it. Dealing with risk starts with recognizing it. Recognizing risk inevitably starts with understanding when investors are paying too little attention to it, being too optimistic and paying too much for a given asset as a result. Value investors think that high risk will lead to low prospective return, both stemming primarily from high prices. Thus, an essential component of dealing successfully with risk is the awareness of the relationship between price and value – whether for a single security or the entire market.

In the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk. Investors should not plan on getting added return without bearing incremental risk unless they can generate “alpha.” For added return, they should demand risk premiums. But at some point in the swing of the pendulum, investors forget that truth and embrace risk taking to excess. The fact is, risk tolerance is detrimental to successful investor. When people are not afraid of risk, they'll accept risk without being compensated for doing so.

A prime element in risk creation is the belief that risk is low, or even nonexistent. That belief drives up prices and leads to the embrace of risky actions despite the prospect of returns is low. Investors bid up assets, essentially, accelerating into present appreciation that would otherwise have occurred in the future, and thus lowering prospective returns. The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum's swing, the belief that risk is low and the investment in question is sure to produce profits intoxicates the herd and causes its believers to forget caution, prudence, worry and fear of loss, and instead obsess about the risk of loss opportunity.

In every bubble that ever existed, its believers inevitably thinks “this time is different,” and worst still, think they can exit in time before the door closes and will not be the last one holding the bag. Unfortunately, under every bubble lies a pin, and during the bubble party, there's no clock that tells the time is ending for the party. Bubble participants have demonstrated that what will be will be again, and what will be done will be done again. There's nothing new under the sun.

Worry and its relatives, distrust, skepticism, questionings, fear, and risk aversion, are essential elements in a safe financial and investing system. Lack of these will lead to a lack of discipline and succumb to imprudence for the sake of chasing return without proper consideration. Adequate risk premiums will only come when investors are sufficiently risk-averse.

The market is not a static arena. It is responsive and dynamic, shaped by investor's own behavior. The herd is wrong about risk as often it is about return. Investment risk resides most where it is least perceived. When everyone believes something is risky, their unwillingness to buy often reduces its price to the point where it is not risky at all. Over-pessimism can make a security the least risky thing since all optimism has been driven out of its price – all bad news has been baked in and often overly so. Conversely, when everyone believes something is of low or no risk, it is usually bid up to the point where it's enormously risky. No one fear for risk and demand for risk premium, and thus, no reward for risk bearing. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something is risky. But high quality assets can be risky and low quality assets can be safe. It's just a matter of the price paid for them.

At the core, it's the investor job to intelligently bear risk for profit. Doing it well is what separates the best from the rest. Outstanding investors are distinguished at least as much for their ability to control risk as they are for generating return.

A great job on risk control is unobservable and thus lowly recognized in the mainstream media and public. High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That's why it's them who get their pictures in the news. Because it's difficult to gauge risk and risk-adjusted performance (even after the fact), and the importance of managing risk is widely under-appreciated, investors rarely gain credit and recognition for having done a great job in this respect. But, great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk.

Risk is covert, invisible, and unobservable. What is observable is loss, and loss generally happens only when risk collides with negative events. Homes in California may or may not have construction flaws that would have collapsed during earthquakes. We do not know until an earthquake occur. The fact that the environment was not negative does not mean it could not have been. Thus, the fact that the environment was not negative does not mean risk control is undesirable. The important thing here is that risk may have been present even though losses did not occur. So, the absence of loss does not necessary mean the portfolio was constructed safely. Risk control can be present in good times, but it is unobservable because it's not tested. You do not buy an insurance only after the fact. Risk control is like buying a house insurance: It's invisible in good times but still essential, since good times can so easily turn into bad times.

How do you enjoy the full gain (or just a little below it) in a up-market while simultaneously being positioned to achieve superior performance in down markets? You need to capture the up-market gain while bearing below-market risk and that is not an easy task. But an inefficient market can allow a skilled investor to achieve the same return as the benchmark while taking less risk, and this is a great accomplishment even though you did not beat the market. It is important that you recognize that not all the time it is worth to chase the market and beat it, especially in heady times. In heady times, it's a great achievement if you can even keep up with it by bearing below-market risk.

Because there're more good years than bad years in the market, and because it takes bad years to show the value of risk control in smaller-than-market losses, the cost of risk control – in the form of foregone returns – can seem excessive. Risk-conscious investors are like the prudent homeowners who carry insurance and feel good about having protection in place even when there's no fire. While risk control is inevitable, it is neither wise or unwise per se. It can be done well or poorly, and at the right time or the wrong time. Think about how most investors become more prudent and risk averse in a crash when they should have more risk tolerance and vice versa in an up-market.

Extreme volatility and loss occur infrequently. And as time passes without that happening, it appears more and more it will not happen, and that risk assumptions were too conservative - just like a frog that is boiled slowly to death. Thus, it lures investors away from their prudence, relax their rules and increase leverage. And all too often, this is done just before risk finally rear its head. Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver which has hundreds, if not thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of bullet, under a numbing sense of security. Second, unlike a well-defined game of Russian roulette, where the risk are visible to anyone capable of multiplying or dividing by six, one does not observe the chamber of reality. One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative “low-risk” game.

Can we avoid risk altogether? No. So how conservative should we be? If you think about the high-risk game which the financial institutions played from 2004 to 2007, it is easy to say they should have made more conservative assumptions now that it is after the fact. If we say they should be more conservative, then by how much? You cannot run a business on the basis of worse-case scenario. And “worst-case scenario” is a misnomer: there's no such thing, short of a total loss. If every portfolio was to run such that it is able to withstand the scale of decline that we witnessed in 2008, it's possible no leverage would ever be used. What do you do about that? There's no easy answer. However, risk control is the best route to risk avoidance. On the other hand, risk avoidance is likely to lead to return avoidance as well. We shouldn't run from risk. We should welcome it but only at the right time, in the right instances, and most importantly, at the right price. It's by bearing risk when we're well paid to do so – and especially by taking risk toward which others are most averse to – that we can add value either to your clients or your personal portfolio.

The road to long-term investment success lies in risk control more than through aggressiveness. Aggression at the wrong time can make you look like a hero for as long the good time lasts and generally is associated more with rashness than intelligence. Skillful risk control is the hallmark of the superior investor. 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. This last statement alone gives an important insight: Investing, like tennis, can be a loser's game. In tennis, there's the game played by professionals who win by going for aces and volleys. Then there's the other game played by amateurs: let your opponent commits all the mistakes by going for volleys and aces, while you keep your stroke just enough to go over the net – that is, commit less mistakes than your opponents.

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