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Stepan Lavrouk
Stepan Lavrouk
Articles (514) 

Seth Klarman: How to Balance Risk and Reward

Investors can reduce risk by having clearly-defined time horizons

June 04, 2020

Investors face constant pressure to balance the two opposing forces of risk and reward. On one hand, there is the ever-present need to curtail risk and keep an eye on the downside. It is important to resist the urge to keep up with markets which might not be trading rationally. On the other, if you are too conservative, you will lose out on good opportunities when they are presented to you. Holding cash during periods of market exuberance is all well and good, but you also need to be able to pull the trigger when the time comes.

In his 2018 letter to investors of his Baupost Group, value investor Seth Klarman (Trades, Portfolio) explained how to balance risk and reward effectively.

Focus on investments with defined catalysts

Although his approach to investing can undoubtedly be characterised as risk-averse, Klarman also strongly believes that investors who emphasize risk avoidance too strongly will miss out on opportunities, and that it is possible to get out of practice if one remains on the sidelines for too long. He also believes that it can be beneficial to focus on value opportunities with clearly defined catalysts on the horizon - events that can lead to a rapid re-evaluation of the asset by the market:

“Catalytic events shift the outcome of investments from a reliance on future market multiples and macroeconomic developments (which are not at all under your control) to a dependence on your assessment of the outcomes, probabilities, and implications of announced or anticipated corporate events, including mergers and acquisitions, bond maturities, debt restructurings, bankruptcies, major corporate asset sales, spinoffs, and tender offers...A portfolio of near infinite duration (such as an all equity portfolio without catalysts) can trade just about anywhere. With such exposures, if stock prices plummet, the odds go up that an investor will feel pressure to do the wrong thing and sell into market weakness. A limited duration portfolio, both because of the hopefully truncated downside in a bad market as well as the beneficial cash inflows (buying power) that catalysts usually generate, is hugely advantageous in navigating through turmoil.”

Klarman believes that focusing on these "catalytic" investments reduces the risk of broad market decline, which investors have no control over. This is no trivial consideration. Many an intelligent and well-argued investment thesis has been undone by a surprise recession or an exogenous event that affects all businesses, regardless of quality or underlying value.

This certainly does not mean that you shouldn’t think in the long - far from it. If anything, Klarman’s Baupost Group is known for being long-term oriented and happy to wait for opportunities to arise. You shouldn’t shrink your investment time horizon, but you should be very aware of its duration for each given asset. Doing so will give you a better feel and understanding for when to sell. A catalyst either releases value or it doesn’t, and in either case you will know after a certain point whether or not the investment has worked out.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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