I can’t put any top spin on the ball. My backhand usually lands outside the lines. It’s safe to say I’m no tennis pro. But that doesn’t stop me from trying.
I thoroughly enjoyed the last few times I played tennis. My favourite part of the match is when a rally gets going. The back and forth, feeling the rhythm of each forehand is what makes the game so enjoyable. But these magically rallies between amateurs happens only once or twice each set.
If you also occasional play tennis player, I’m going to go out a limb and bet we both have the same strategy to win. Get the ball over the net and hope your opponent makes an error.
If we instead try to hit winning backhands down the line, you or I would be sure to lose. And that’s because such shots workout maybe one-tenth of the time. Therefore the best strategy is to keep the ball in play and hope your opponent can’t do the same.
The tennis pro has the complete opposite strategy. Instead of playing it safe, they want to try and hit as many winners as possible. It’s not enough to just keep the ball in play and rely on the other guy making an unforced error.
Both strategies are kind of obvious. The amateur’s best strategy to win is to avoid risk (just hitting the ball back in play) because of their lack of experience and pros best strategy to win is to take risk (hit winners) because of their experience.
But the same principle does not apply to investing.
Managing risk is the most important thing
“Investing is very difficult because it’s counter intuitive. And it, kind of, turns back on itself all the time.”
This is what billionaire investor, Howard Marks told Google employees while giving a speech about his book ‘The Most Important Thing’.
I’m sure if you asked any investment great, they would say the same – it’s not easy.
But that does stop us from trying. While some like to dig down into businesses analysing one by one, others like to use screens and models to make things easier.
But what is the most important thing when investing? What one factor that trumps the rest?
Developing a screen or model can only take you so far. Invariably you will find investments duds that the screen has picked up. The hard thing about investing is that it’s so unpredictable. There’s no formula or model which reliably guarantees returns. Even buying undervalued businesses doesn’t guarantee success.
That’s why Howard Marks sought teach readers how to think about investing in his book. He urges investors to think about investing similar to how an amateur thinks about winning a tennis match. While the investor shouldn’t avoid risk, they should focus on hitting the ball over the then than trying to hit winners.
No matter how experienced you are, it’s incredibly hard to take on mountains of risk and reliably produce returns. It’s why billionaire investors don’t amassed their fortunes with few large risky bets.
Instead, investors like Buffett and Marks manage their risk religiously. In Buffett’s case he gravitates towards businesses that have done more or less the same thing for years. He likes consistency and looks for great companies resistant to change.
Even if you’re a deep value investor, you’ll spend most of your time thinking about minimising your risk. It’s why they look for a large margin of safety between liquid asset values and market price.
(what to learn more about deep value investing, click here.)
OK, we get it, risk is important. But why is risk and how should you manage it?
The last thing you want
Many people think of risk as volatility. Yet it is volatility that investors pray for. It is volatility that allows us to buy at levels below and sell far above intrinsic value. Even if an investment purchase trends down, its gives the savvy investor an opportunity to buy at a further depressed price.
So if risk is not volatility, what is it? Risk is the chance of permanent capital loss. It is the uncertainty of something happen.
When investing the idea isn’t to eliminate risk, but rather manage it. That means you invest in highly likely outcomes and risk being proven wrong. But I feel I’ve made a simple concept more complicated than it actually is.
All you really need to do is follow Buffett’s two rules.
Rule 1#. Don’t lose money.
Rule 2#. Don’t forget Rule 1#.