Introduction
As many investors can attest, risk does not even enter the mind during times of exuberance. If people took risk into their decision making, bubbles wouldn’t exist. Risk should always be top of mind during investing because not understanding it is how you lose money. Nobody goes into investing to lose money, so spending some time on risk is muy importante.
The thing about risk is that it's not a new discovery. Humans have taken risks since the beginning of our existence. The quantification of risk is a newer concept.
To combat risk, we all have tools in our arsenal. In the context of investing, proper analysis and a margin of safety are a start. Without utilising these tools, you'll be the one swimming naked when the tide goes out!
Risk-Taking Is Inherently Human
Gambling is a good way of looking at risk. Merriam-Webster defines risk as "the practice of risking money or other stakes in a game or bet." The word risk or its permutations is present in all definitions. The reason gambling is a good way of looking at risk, is because it's been around a lot longer than woke bro who lost all his money using 100x leverage to go long on Bitcoin.
Picture this: it's 3500 BC. You finished a long day of work of hunting and gathering or wrestling a fish. Now it's time to kick back and get up to some debauchery with friends. You pull out a bag of Astragali (knucklebones of a quadruped) and get some friends to gather around.
This 4-sided "die" was marked with values of 1, 3, 4, and 6. You'd roll them and whoever had the highest score, or rolled a 7, or whatever rule set they used back then, won. There are paintings of this being played in Egyptian tombs.
I bet you participants at this time weren't thinking about the odds of winning and losing. They were trying to have a little fun and bank a few extra pieces of copper.
The point of this is to say that gambling and risk-taking have been around for thousands of years. If we remove gambling from the equation and look at hunting, we are still looking at risk. When you had to spear an animal, there was also a chance that the animal would kill you in the process. So hunting carried large amounts of risk, but it had to be done because there wasn't a Circle K around the corner.
The reason this matters is that we tend to take risks without quantifying them. We may make a decision with our money and never imagine all the possible outcomes that could happen. This leads to the definition of risk that I like from Peter Bernstein: risk is when more things can happen than will happen.
Let's use a quick example. We invest in a stock of a company in an emerging market about which we know very little. The reason we do this is that the stock has been going up and we don't want to miss the boat. Lurking around our decision-making choices are many possible outcomes.
One possible outcome is that we 5x our money in the next year. This is the outcome our mind fixates on, as this is the outcome we want. What we fail to think about are the 100 different outcomes that are more probable than the one that we are envisioning. If we take a bet where 1 out of 101 possibilities makes us a winner, are we investing or gambling? I would say the latter.
The greatest advantage from gambling comes from not playing at all.“ - Girolamo Cardano, 16th Century Degenerate Gambler. Who was also brilliant.
Enter Risk Management
The concept of Risk Management has only been around for a couple of hundred years. A rich French guy asked a scientist and a lawyer to solve this problem for him. You play a gambling game where the winner has to win 6 rounds but had to cut it short. If one participant wins 3 rounds vs. 2 rounds for the other, how would you split the winnings?
Blaise Pascal and Pierre de Fermat broke the problem down and came up with a framework to answer this problem and others like it.They looked at all the possible outcomes of the game, then derived a system for calculating the odds of specific events. Risk management was born.
Most people have never heard of Pascal and Fermat. And even if they have, there's a high likelihood they have no idea about their system of calculating odds. If more people understood this system, there would be fewer bubbles out there. But since it's been 4 centuries since their system was released, it's unlikely we'll ever learn how to manage risk properly.
Since the time of Pascal and Fermat, risk management principles have flourished into complex mathematical models. These aren't necessary to make quality investment decisions. You should be able to simply do back-of-the-envelope math or do calculations in your head that account for risk.
Utilising Risk Management In Investing
If you're still reading, it means you would love to learn more about how to use risk management in your investing. I'm all about usable information, so let's break down a real-life scenario. I won't use the exact same system that Pascal and Fermat developed, because there are easier ways now. Let's go over a few of them.
1. Understand in detail, what it is you are investing in.
2. When you are forecasting your: revenues, earnings, and free cash flow use a: bear, base, and bull case.
3. Use a margin of safety for your companies.
Let's cover each in a little bit more detail. If you don't understand what you are buying, you will be acting blindly. Would you ever drive with a blindfold on? Then why invest in something where the likely outcome is capital destruction?
When you are researching a company, you should take stock of the "Risk" section in their 10K. The company will tell you what risks are around that could impair the company. Read these, and do some research on which points are more likely to happen and which would have the largest effect. These sections are often overly wordy and detailed. And there are probably only a few main risks you need to focus on anyway.
It is important that you understand what the risks are, and what could happen if they in fact come true. If you deem the probability of a wealth-destroying event to be probable, you know that this is an investment that you want to avoid. If you find an investment where there are no events that could destroy or even inhibit the company from growing, then you know you can safely go ahead and invest.
Another method you can use to help you identify the risks is to invert and create your own short report. People who short a company, think the probability of a value-destructing event happening is more likely than an event being value-creating. If you can find out why people are short your company and they are completely wrong then you increase your conviction and can make the bet.
The next method, of using bear, base, and bull cases can help you as well.Use the table below to see an example.The point is, that if you forecast earnings for a company over a 5-year period, you can forecast different rates. Let's say your base case is that earnings grow by 17% over the next 5 years. With this info, you know the bear case will be less than 17% and the bull case will be greater than 17%.
Let's say $XYZ is earning $1 today. With our base case, in 5 years they would then be earning $2.19. We look at their worst earnings growth period and see they have had 1 period of 14% growth. We decide to use that for our bear case. For the bull case, we see the current year has accelerated earnings to 20%. We plug these growth rates in. The bear case gives us $1.93, the bull case gives us $2.49.
Now we have to apply an earnings multiple. Low growth companies generally have lower multiples compared to higher growth companies. So we decide to give a 25x multiple on the bear case and a 35x multiple on the bull case. We use a 30x multiple on the base case.
Now that we have this information, we can combine it all into one number. Add up the product of probabilities and values of each outcome and you get your final answer.
The simplest way is to apply a 33% chance to each. The equation would look like this: (.33*$48.14)+(.33*$65.77)+(.33*$87.09) = $66.33. If you think the bear/base/bull case is less or more likely, then you can adjust the risk by increasing or decreasing the “.33.” But remember they all have to add up to 1 (or .99 in the example above).
Use A Margin Of Safety
Although this is something everyone should be doing, I'm not sure how many people actually do use a margin of safety. Let's hear what the king of MOS himself, Seth Klarman, says on the matter.
"Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of margin of safety that best distinguishes value investors from all others, who are not as concerned about loss. - Seth Klarman
The way I apply this to my investing is when I come up with my base case. I just take 50% off the price after discounting it at my rate of return (15%). So using the base case above, we have a terminal value of $65.77. I discount that back by 15%, and we get a present value of $32.89.
This tells me if all my assumptions are correct, if I buy below $32.89, then I should make 15% returns over the next 5 years. But if we are using a margin of safety, I'll take a 50% haircut to account for all the things that could go wrong. This means the price I'm looking for will be $16.44. You can use whatever percent you want for your Margin of Safety, but the more you use, the less risk you are taking.
If you analyse many companies, you will notice during bullish times, the prices of most companies will deem them ineligible to buy if using this MOS. This is because investors are either using:
Unrealistic growth rates
Too high terminal multiples
Zero margin of safety.
When you run into markets evaluating companies like this, you run into market crashes. If you follow the above criteria, then if one of these things goes sideways, you will lose a lot of money. If you have unrealistic growth rates, you run the risk of earnings downgrades, and the market will dump your company. If you have a too high terminal value (which ends up being incorrect), then your rate of return will decrease significantly. If you have no margin of safety, then all your assumptions about your company have to be perfect.
As the Oracle of Omaha would say: “It is better to be approximately right than precisely wrong.”
Conclusion
Key takeaways:
Risk-taking has been around for many thousands of years. It’s a part of us.
Don’t let risky decisions impair your goals of generating wealth.
If you aren’t investing, we don’t need to use any mathematical risk models in our day-to-day life. But if you decide to invest, you should be taking risk into account for all investments. This is NOT optional.
Your three main tools for combating risk in investing are in-depth understanding of what you own; using bear/base/bull cases for determining investment decisions; and using a margin of safety.
I think the first and third tools are the most important. Never neglect them.
So unless flushing your hard-earned money down the toilet is your idea of a good time, then you should reserve some mental energy to thinking about risk. It’s all around us at all times. It’s just hidden most of the time. Force yourself to reveal risk and you will make money by avoiding risky decisions and profiting when the markets risk appetite shifts towards prudence!
Love your articles and keep practicing your Spanish ;)
Great article. “It is better to be approximately right than precisely wrong.” 👌🏼👌🏼👌🏼