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Rupert Hargreaves
Rupert Hargreaves
Articles (1191)  | Author's Website |

Seth Klarman: 'Over Time the Returns Will Come'

Some advice on risk from one of the world's best value investors

May 14, 2019 | About:

Yesterday, I wrote an article on Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) and why it is essential to view Warren Buffett (Trades, Portfolio)'s conglomerate not as a growth stock, but as a vehicle designed to protect your capital over the long term. As part of the article, I included one of my favorite quotes from value investor Seth Klarman (Trades, Portfolio) on the topic of risk.

In Klarman's view, avoiding risk at all costs is the most essential job every investor has. He believes that if an investor consistently follows a rigorous and disciplined approach, focusing on minimizing risk above all else, over the long-term the returns will come.

Following yesterday's article, here are some of Klarman's most informative quotes on the topic of risk avoidance. The quotes below have been taken from his now out-of-print book, "Margin of Safety." To start with, here is the quote I highlighted yesterday:

"Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating that you want to earn, say, 15% a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come."

There are really only two things investors can control: costs and the price at which they buy and sell investments. Between the point of buying and selling, investment prices are at the mercy of the market, which makes it almost impossible to target an annual return, particularly for individual equity investors who do not have the resources and financial firepower available to the world's largest hedge funds.

Targeting a return could force you to take more risk by chasing opportunities you do not understand in the hopes of making a better return. Some of the time, taking the extra risk might pay off, but it will only be a matter of time before you suffer a setback that could take years to recover from. Working as hard as possible to eliminate risk entirely is the only way to make sure you do not fall into this trap.

That being said, choosing to avoid loss is not a complete strategy in itself, as Klarman also explained in "Margin of Safety:"

"Choosing to avoid loss is not a complete strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in US Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality."

Even though Klarman believes risk avoidance should be the base of every investment strategy, it is not a complete strategy in itself, and investors need to be aware of the speed at which the investment world can change, and why it is important to remain nimble, continually keeping an eye open for new investment opportunities and being open to cutting losses when the situation changes.

What's more, some risks are more acceptable than others. For example, U.S. Treasury bills are generally considered to be one of the most risk-free (in terms of capital loss) assets, but they are exposed to inflation risk and return risk. Over the long term, these risks can be just as damaging to your wealth as capital losses.

However, as Klarman also explained, any potential risk taking should be judged against this risk-free rate:

"Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk."

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here: 

Ben Graham's Advice on Growth Stocks 

Warren Buffett: Book Value Does Not Intrigue Us 

Berkshire Hathaway: It's All About Downside Protection 

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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