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The investor has two possible outcomes: he managed to achieve investment goals or failed. let’s talk how to increase your chances of success by using a little trick called the right to be wrong.
The right to make a mistake is underestimated and misunderstood. This is usually seen as a conservative hedge for those who don’t want to take too much risk. And as we know: less risk – less potential return. But when used correctly, the opposite happens. The room for error allows you to stay here long enough that the odds of benefiting from an unlikely outcome are in your favor.
Morgan Housel (private investor, writer)
I don’t know what will happen in the future. I don’t know how the market will behave in a year, two, three. But leaving myself room for error, I think (but this is not certain) that everything will be fine with me and my portfolio.
My approach to investing can be summed up in three principles:
- I don’t aim for my portfolio returns to outperform 80% of investors. I do not need to be among the outstanding investors.
- But at the same time, I do not want to lag behind these 80% of all investors in terms of profitability. I don’t have to be a bad or terrible investor.
- As long as I am in the middle, my long-term investment strategy will be considered good.
Which of these items is the most important? I think the second one. In investing (and in life, too), prioritize avoiding dire situations.
Have you heard of Charlie Munger, vice president of Warren Buffett’s Berkshire Hathaway? Grandpa Charlie was born in 1924 (determine how old he is now). He even took part in World War II.
In the 40s, Charlie worked (or served) as a meteorologist for the US Air Force. He produced weather reports for airmen and pilots during World War II.
Munger didn’t know how best to approach his work, so he turned to inversion. In mathematics inversion can be used to turn a math problem inside out. The solution to the problem inside out can then be “returned” to find a solution to the original problem.
Instead of thinking “How can I become the best meteorologist?“, Munger flipped the question to “How can I be a terrible meteorologist?”.
Answer: you need to create dangerous scenarios for the lives of pilots.
How to do it?
At the time, the two most common life-threatening risks were:
- Cold weather forms ice on the wings, adding extra weight and degrading the aircraft’s aerodynamics.
- Strong wind pushes planes so far away from the military base that they run out of fuel before they can return.
Then Munger turned the answer inside out and got: Avoid these risks at all costs. The use of error space allowed Charlie Munger to become, if not excellent, then definitely a good meteorologist.
I was reminded of an old Soviet joke:
The forecaster was asked about the weather for tomorrow.
He replied: “There is a 40% chance it will rain.”
Counter-proposal: “Maybe you should say that tomorrow with a probability of 60% it will not rain. Then the accuracy of your forecast will increase by 1.5 times!”
Invest like a manager
I am impressed by the approaches of the American investor and manager Howard Marks (not to be confused with Karl Marx, and even more so with the full namesake of “the famous hashish and marijuana dealer”, as Wikipedia says).
Howard Marks focuses on risk management and says that investors should develop an investment strategy according to their personal situation and ask themselves, whether they are more worried about the risk of losing money or the risk of missing out on an opportunity.
Marks thinks it’s hard to get an investment edge through research, because a lot of smart people are already doing it.
Howard Marks hopes to make an average return during a bull market while minimizing losses during a bear market because he believes that losses do more harm than any gain investors get from profits.
When the market rises by 30%, Marx feels good even when his portfolio has grown by only 20%. But when the market falls by 30%, Marx’s capital reduces by only 10%.
This strategy (including) allowed the Howard Marks fund to be more successful than other investors. According to Wikipedia, Marks-led funds generate long-term returns minus fees of 19% per year.
Simple math tells us the following:
- after a loss of 10%, it is required to receive 11% profit in order to return the capital to its original value.
- but the loss of 70% of the capital requires 233% wagering.
Howard Marks’ strategy avoids situations where almost the only option to restore capital after serious drawdowns is a miracle!
The stock market paradox or how an investor loses money from scratch
Incidentally, one of the reasons why most investment funds underperform the market is due to the margin for error. Many professional money managers, whose mission should be to deliver good long-term results for their clients, focus on risk reduction rather than profit maximization.
Have you thought about the question:
Why do you need bonds in a portfolio?
Shares on average bring 5-6% real yield (above inflation), bonds – 1-2%. Why then buy these bonds for the long term at all? The math is not in favor of debt securities. The conclusion is logical and obvious – the addition of bonds will reduce the portfolio return and … worsen the investor’s results.
Is it really? Let’s flip the script:How can an investor get a terrible result over a long time horizon?
Imagine that your investment goal is to accumulate capital for a decent retirement. What can prevent you from reaching your goal by the given time?
- Don’t invest money at all.
- Invest in very conservative instruments with a minimum return (at the rate of inflation).
- Expose your capital to excessive risks. When there is a 50%-60%-70-80% drop, many of you (us) will just go crazy with such a loss of money, pee in your pants from fear and try to sell everything as quickly as possible and save what is left. And forever abandon “these profitable investments of yours.”
Now let’s flip this answer back to what we need.
To ensure, if not excellent, but good long-term results, the investor needs:
- Take reasonable risks in order to receive a more acceptable reward (the so-called risk premium).
- Avoid high risk. Painful results of investing (even if short-lived) can forever kill your desire to invest and derail your financial plan (goodbye to a decent pension and life at sea).
Tests, portfolios and possible fiasco
When drawing up an investment portfolio, testing is carried out, the purpose of which is to determine the so-called investor’s risk tolerance. In simple words, what portfolio drawdown can you safely withstand. Based on this, the ratio of assets in the portfolio is calculated.
From my own experience I will say that testing has nothing to do with reality. You can, in theory, have a high risk tolerance and say that you can safely survive a 50% portfolio decline. Yes even -60-70% you are not afraid. But when the fall actually occurs, some places on the body begin to contract strongly (press-press).
Imagine that you have been saving and investing for many years. We have accumulated some capital. And suddenly, in a short time, half of the capital evaporated. And every next day the amount on your brokerage account becomes less and less.
Panic, fear, anxiety. What to do? Can pick up before it’s too late, what’s left on the account?
I’ve often had these thoughts during market crashes (even though I kind of have a high risk tolerance). It wasn’t easy. But I held on. Although a couple of times was on the verge. I wanted to quit everything and go into some bonds or deposits where I would not lose money and sleep peacefully. But I persevered. And someone is not. Although, when passing the test, they believed that they had a high tolerance for risk and were able to calmly survive almost 99% of the drawdown of the portfolio.
Investors and Pavlov’s dogs
We all know about Pavlov’s dogs. During the experiments, the scientist developed a conditioned reflex in dogs: after the ringing of a bell, the dogs were given food. Over time, just hearing the familiar ringing, the dogs began to salivate (the anticipation of food).
But few people know about another story (rather sad).
In 1924 St. Petersburg was flooded. Many of Pavlov’s dogs became trapped in their cages as the water rose around them. Needless to say, the dogs have experienced a lot of stress.. They forgot everything they were taught, they forgot that the ringing of a bell means “meal time”. What kind of salivation? They even stopped eating for a while.
Something similar happens to people in critical situations. Severe stress rewires our brains. For some people, large capital losses (even if only for a short period of time!) can be extremely stressful. And subsequent reactions “I will never invest again!” often harmful to us.
Returning to the question: “Why would anyone else include bonds in their portfolio? Why would someone deliberately reduce their return on equity, ignoring the obvious mathematical result (stocks outperform bonds in the long run)?”
Because on your way to maximum profit, you may find yourself a drowning dog locked in a cage. Or a pilot who is far from the base, with frozen ice on the wings of the plane and an empty fuel tank.
These scenarios can break the investor and (or) his capital. It’s best to avoid them and use the error space to your advantage.