Let’s face it-there is risk in everything you do. From driving a car to eating at a restaurant, from walking down a flight of stairs to shaking someone’s hand, you are risking your life every second of every day. Why? Hey, you can’t control everything and you have to take some chances in life.
What are we to do? Go agoraphobic and confine ourselves to our homes? Not quite-the building could collapse, germs could creep under the door. Where is all this going? Right here: The more risk you take in life, the more likely you are to die. Maybe not the first time…but definitely the last. The same is true in investing.
Engaging In Battle
When you invest-be it in stocks, bonds, real estate, or any other investment-your money is engaged in war. Investing is a zero-sum game. Like betting on a coin flip, investing is a match where somebody’s gains are always offset by somebody else’s losses. Wealth isn’t created or destroyed-it changes hands.
When you try to trade in stocks for short-term profits, you are battling against the largest, greatest gamblers in the world. You are betting that you know more, can react quicker, and have a better stomach than the hedge funds, mutual funds, pensions, and professional traders that make their living off of regular peoples’ losses.
“You Can’t Win, Rock”
When you trade stocks, you are gambling. Nothing more, nothing less. The problem is that you do not have the information, time, or money your opponents have. More times than not, you are fighting a battle you can’t win.
Think about it-why do you think these hedge fund managers make such big money? Why do they have massive returns and take home multi-million dollar salaries? Surely you do not believe it is because they routinely lose money to people like us!
The Vegas Casino
When you gamble in stocks, you do not have the edge-they do. Sure, you can put your money on the table and hope to break them. That is the Vegas gambler’s dream. But you know what? Las Vegas was built, and continues to expand, because of one simple fact: The house always has an edge.
From time to time, you’ll hear a story of someone breaking the bank-taking a casino for a few hundred thousand. Why is that? Was the gambler more informed? Did the gambler have an edge? No-the gambler got lucky.
Don’t Take Chances
So, what are we to do? Stay away from stocks altogether? Give our money to some mutual fund manager? Nope. You simply run into another risk-the risk of not achieving your goals because your investments didn’t grow. Remember: You don’t get to have a comfortable retirement because you saved and invested. You get to have a comfortable retirement if you saved and invested…if your investments performed well.
The better option is to not take chances in the first place. Rather than gambling in stocks and trying to beat the professionals on a daily basis, why not sit back patiently and wait for a great opportunity? Wait until you get lucky-that perfect moment when the gamblers screw up and allow you to buy a wonderful business at an attractive price.
Weigh The Risks
In the 1980s, Warren Buffett put more than 20% of his company’s assets into Coca-Cola. Was it a big risk? Hardly. Pretty much everyone in the U.S. was drinking Coke, or a Coca-Cola product, and the company was gaining sales around the world. It had almost no competition.
What was the bigger risk: Coca-Cola, the world’s foremost soft drink provider, going out of business or Buffett trying to make a better return by trading in stocks? Where was there more value: Coca-Cola or a random land development deal? Who got lucky: The gamblers who oversold Coca-Cola, pushing its price below its value so Buffett could buy it, or Buffett, who bought a large stake in a wonderful business that generated tons of cash.
Use Common Sense
Investing isn’t all that difficult-especially if you use some common sense. Don’t gamble in stocks. Find an amazing business. Figure out the value of the business and wait until it is selling at a discount to its value. The more confidence you have in your company, the more of your money you should put into it.
Don’t put all of your eggs in one basket. Instead, look for five or six baskets-baskets as beautiful as Coca-Cola in the 1980s. Spread your eggs around a little, but don’t overdo it. Otherwise, don’t be surprised when you consistently lose battles you shouldn’t be fighting in the first place.
Filed under: Miscellaneous
To me the most important two topics of this piece are don’t take chances and weigh risks.
In my mind there three goals in investing: safety of principal (you work hard and sacrifice to save why throw it away), preserve the purchasing power of your savings (offset inflation), and grow you savings to improve you standard of living (both now by saving less and later by having more). The first two are much more important then the last one. The last one is the hardest thing to do and is a job that requires real skills. Those skills don’t come cheap.
If we think about the first two goals then the primacy of don’t take chances and weigh risks become apparent. By my way of thinking the first two goals also drive us to take a slightly different approach to investing. That is to evaluate our downside risk first. After all, the goal should be to maximize upside risk vs. downside risk to a position. There are two levers in that comparison. Limited downside risks leaves lots of opportunity for good things to happen. If I can’t determine the downside, how well am I going to determine the upside? If you’ve ever read anything Seth Klarman has produced or said then you would know that this is his view as well. Buffett and Marty Whitman as well.
I think one of the interesting aspects of the current market is that we have been able to see who really understands the importance of evaluating the downside. Bill Miller of Legg Mason comes to mind as somebody who got caught evaluating the downside risk incorrectly. My sense is that they mis-read the risks to the balance sheets. Without a good balance sheet value to work from the going concern business value and growth potential are much more complicated to value.
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I would like to take issue with the statement that trading is a zero sum game. It’s actually in minus sum game. Your position and the guy on the other side of the trade make it zero sum. What is minus sum is those people in the middle (brokers, taxes) who are picking your pockets along the way. This goes for real estate as well as stocks. Lawyers, tax collectors and banks.
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