Last week, I wrote about two elements that Seth Klarman (Trades, Portfolio) considers to be essential for any good value investor: the idea of bottom-up investing (ie basing your thesis on analysis of individual companies rather than trying to predict the direction of the economy) and the idea of absolute vs relative performance (i.e. investors should not benchmark themselves to indices or other investors).
Today, we will take a look another tenet of Klarman's investing philosophy: risk management.
Klarman strongly believes that all good investing should be strongly focused on reducing drawdowns as much as possible. As Warren Buffett (Trades, Portfolio) once said, “Rule number one is never lose money. Rule number two is to never forget rule number one.”
What is risk?
According to Klarman, a common misconception held by investors is that risk and return are always correlated. That is, investments that offer low returns must be low-risk, and investments that come with high risk must hold within them the potential for high returns. Similarly, they often believe that more volatility (the degree to which the price of an asset fluctuates) must be synonymous with risk.
In reality, this is not true. Just because an investment is high-risk does not mean that it has the potential to secure the investor a good return; in fact, an overpriced stock is often both risky and carries with it a lower yield.
Unlike return, risk cannot be described by a single number. Here is what Klarman had to say about the nature of risk in his book "Margin of Safety:"
“Intuitively we understand that risk varies from investment to investment: a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about their risks the way food packages provide nutritional data. Rather, risk is a perception in each investor’s mind that results from analysis of the probability and amount of potential loss from an investment...If a bond defaults or a stock plunges in price, they are called risky. But if the bond matures on schedule, and the stock rallies strongly, can we say they weren’t risky when the investment was made? Not at all.”
Klarman takes a humble approach to risk management. He acknowledges that it is impossible to know all the potential risks of a given investment. Value investors can protect themselves by adequately diversifying, hedging when it is possible to do so and maintaining a proper margin of safety. You can’t always be right, but you can make the odds work in your favour.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Has the Unicorn Bubble Burst?
- Seth Klarman: Absolute vs. Relative Performance
- Warren Buffett: Banks Are Healthy Right Now
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