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The Science of Hitting
The Science of Hitting
Articles (622) 

Living With Uncertainty

Some thoughts on navigating market cycles

March 23, 2020 | About:

In 2004, Wall Street Journal reporter Jason Zweig sat down for an interview with Peter L. Bernstein, the author of investment classics like “Against the Gods: The Remarkable Story of Risk” and “Capital Ideas: The Improbable Origins of Modern Wall Street.” Zweig described Bernstein as an “economist, historian, investment thinker and one of the wisest and most philosophical people on Wall Street.”

During that interview, Zweig asked Bernstein how investors can prepare themselves for shocking developments in markets so they would remain calm and not overreact during periods of short-term dislocation. Bernstein said the following (bold added for emphasis):

Understanding that we do not know the future is such a simple statement, but it’s so important. Investors do better where risk management is a conscious part of the process. Maximizing return is a strategy that makes sense only in very specific circumstances. In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches. You should try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.

The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions. Once you’ve been right for long enough, you don’t even consider reducing your winning positions. They feel so good, you can’t even face that. As incredible as it sounds, that makes you comfortable with not being diversified. So, in many ways, it’s better not to be so right. That’s what diversification is for. It’s an explicit recognition of ignorance.

And I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place. I want to make sure I’m exposed to it…

Can you manage yourself in a bubble, and can you manage yourself on the other side? It’s very easy to say yes when you haven’t been there. But it’s very hot in that oven. And can you save your ego, as well as your wealth? I think I might have just said something important. Your wealth is like your children - the primary link between your present and the future. You should try to think about it in the same way…”

In another section, Zweig asked Bernstein about the most important lessons that he wanted to get through to readers in “Against the Gods.” This was part of his answer:

“Pascal’s Wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.”

From where we sit today, these lessons may seem too late. But I honestly think there’s a lot of value in hearing and thinking about this while we're in the eye of the storm as well. The message may resonate more today than it did a few weeks ago when all was rosy.

Here are a few of the key takeaways for me.

First, the world is always uncertain. Warren Buffett (Trades, Portfolio) said it best in the 2010 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholder letter:

“Commentators today often talk of 'great uncertainty.' But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.”

To me, that suggests you should always prepare for the unexpected. It shouldn't dominate your thinking, but it should be a consideration. As an example, the S&P 500 has fallen by roughly 35% over the past month. It was the fastest 30%+ decline ever. And while this type of rapid decline has certainly been rare historically, we've learned a good lesson: you better not position yourself such that you cannot withstand the one in a hundred year storm - because eventually, it will happen.

That’s why I’ve never been drawn to a strategy like selling puts. You make a little bit of money if the stock goes up and can end up owning a stock you like at a "fair" price if it goes down. But the problem is that there’s no guarantee that a falling stock will stay anywhere near your strike price. In addition, if you’re broadly engaged in this strategy, you’re susceptible to a nasty surprise at exactly the wrong time (when the world goes to hell in a handbasket, correlations move to one). For those reasons, I’ve always viewed this as akin to picking up nickles in front of a steamroller. Maybe some of the folks who have employed this strategy in recent years will end up viewing it the same way.

Second, survival is key. Currently, we’re in an environment where any company that has questionable forward prospects (even for just a quarter or two) and a weak balance sheet has seen their share price get smashed. It’s easy to forget about times like these at the top, when the economy is booming and lending standards are lax. An environment like this is a good reminder that any company that is dependent on the kindness of strangers can quickly find itself in a precarious position when the tide goes out. For that reason, companies should always be sure they are in a position to withstand short-term choppiness (obviously this has a limit, and I can understand owning some companies in your portfolio – if appropriately sized – that are riskier in this regard).

Finally, to use Bernstein’s words, consequences are more important than probabilities ("the consequences of decisions and choices should dominate the probabilities of outcomes"). Again, I think Buffett put it best, this time from his 2008 shareholder letter: “I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Buffett has decided that he is not willing to chase a few extra points of return if it means increasing Berkshire’s chance of ruin. (As a shareholder, that's a trade-off I accept as well - and one that I'm grateful for in difficult periods.) As with many of these “rules,” it comes down to a choice – what are the opportunities and risks associated with the decisions you’re making? And if you think you’ve found easy excess returns with little to no risk, you’re probably wrong.

In a nutshell, it’s about maintaining a level head and never letting yourself get overextended. Doing so won’t protect you from short-term pain when markets move against you – but it will protect you from financial ruin and put you in a position to act rationally when other's are doing the opposite. As a long-term investor, that’s all you can reasonably ask for.

Disclosure: Long Berkshire Hathaway.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

sadanandvs
Sadanandvs - 1 day ago    Report SPAM

Its insane to risk what you have for sometning you don't need .. Warren Buffet

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