"Right at the core, the mainstream has it backwards. Warren Buffett (Trades, Portfolio) often quips that the first rule of investing is not to lose money, and the second rule is not to forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance." -- Seth Klarman (Trades, Portfolio)
Seth Klarman (Trades, Portfolio) is considered to be one of the best value investors alive today. Despite his acclaim, however, Klarman rarely gives interviews, so insight into his investment style is limited.
The above quote is taken from a speech he gave at the MIT Sloan Investment Management Club on Oct. 20, 20007. The whole speech gives a really fascinating insight into his way of thinking and approach to value.
As the above suggests, Klarman's whole strategy is based around the idea of not losing money. He is doing whatever it takes to minimize the risk of permanent capital impairment and is not targeting returns. He believes it is this focus on the downside that has allowed him to outperform over the years.
"For 25 years, my firm has strived not to lose money -- successfully for 24 of those 25 years-- and, by invest and cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio-- and with risk comes losses. Some investors target specific returns. A pension fund, for example, my target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal-- which foremost is a non-starter-- or invest in something riskier than they would like."
He goes on to say this focus on limiting losses is a key trait of the best investors:
"The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk."
The problem is, most investors following a strategy just don't know what to do in a volatile market. The strategy may suddenly stop working, leaving unprepared investors swimming naked as the tide goes out.
"Many investors lack a strategy that equips them to deal with a rise in volatility and declining markets. Momentum investors become lost when the momentum wanes. Growth investors -- who pay a premium for the fastest growing companies -- do not know what to do when the expected growth fails to materialize. Highly leveraged investors... are forced to sell...
By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy. "
The best way to protect yourself from unpredictability, according to Klarman, is:
"Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying business, is one strategy that provides a roadmap to successfully navigate not only through good times but also the turmoil. Buying at a discount creates a margin of safety for the investor -- room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies."
Unfortunately, most investors just can't follow value because it requires unique traits:
"Following a value approach won't be easy for everyone, especially in today's media dominated, short-term orientated markets, in that it requires deep reservoirs of patience and discipline. Yet it is the only truly risk-averse strategy in a world where nearly all of us are, or should be, risk averse"
According to Klarman, it really is that easy. To be a successful investor, you have to do everything you can to limit losses. If you are buying stocks cheaply as well, then the returns should follow with no additional effort on your part.
