David Einhorn: How to Manage Investment Risk

Hedge fund manager David Einhorn (Trades, Portfolio) made a name for himself shorting bubbles during both the dot-com era and in the run-up to the 2008 financial crisis, when his bet against Lehman won big. Although 2018 was a singularly poor year for Einhorn’s Greenlight Capital, 2019 has been much more positive, with the fund up 17% this year.

In particular, his short of Tesla (TSLA, Financial) has finally begun to play out in his favor. In a talk with students at the Oxford Union in 2017, Einhorn explained how his risk management strategy deviates from the controversial "value-at-risk" method used by many large financial institutions in the run-up to the crisis, and how he avoids debt as a point of principle.

Avoid leverage

The big challenge for investors is dealing with unknown unknowns -- risks that are uncertain in character and magnitude, but that definitely exist. One principle that Einhorn adheres to in order to do this is the avoidance of financial leverage:

“We manage risk by the level of investment that we make. We’re not levered. We don’t borrow more money to make even more investments. That’s one way that you avoid risk, or control your risk. If you don’t ever have to repay anybody, you’re not subject to lending terms and conditions.”

Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)'s Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have both said that using securities is a sure-fire way to go broke, so Einhorn’s rule is pretty in-line with standard value investing practice.

The limitations of value-at-risk

“People say, ‘There’s a stock trading at $10 with $1 of downside and $10 of upside,’ and I say, ‘No, it has $10 of downside,’ because you can lose your whole investment in any stock when you make it ... What was most exposed during the financial crisis was the flaw in the mathematical modelling of tail risk -- so-called ‘value at risk,’ which is a method used by all of the large banks and institutions. What value at risk does is it says: 'If the risk is something that is going to happen beyond a certain level of frequency, you don’t have to put any capital aside. So we’re going to put capital aside to cover 95% of all possible outcomes, but we’re not going to do it for really, really remote things beyond whatever the tail is.'”

Value at risk is a controversial risk management method because it assumes that the probability and magnitude of "Black Swan" events can be accurately estimated and accounted for. In addition to this, Einhorn’s point is that reliance on this method created a moral hazard that incentivized the banks to take on infinite risk against these tail events:

“I think that’s what one of the big problems was. People thought, 'If I don’t have to put any capital against it, I can put on a bet against it an infinite number of times.' So it’s like if you are on the house’s side of roulette, and you’re offering 35-1 odds on a 38-1 opportunity and you have a rule that says, ‘I only have to put out capital against a 1-in-25 event. How much capital do I have to set aside if someone is going to bet the number 13 against me?’ And the answer is zero."

As we know now, the risk of blowup was actually much higher than the risk managers imagined. For this reason, Einhorn always looks at the worst-case scenario for his investments.

Disclosure: The author owns no stocks mentioned.

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