Research is the best way to reduce risk in an investment. Meanwhile, understanding the probabilities of success is the best way to swing the odds in your favor.
In many respects, investing is just a giant game of chance. If you spend hundreds of hours analyzing a business and its prospects, there is no guarantee that you will be rewarded for your hard work.
This is particularly true with young, growth businesses. Most early-stage businesses fail in their first few years of life, so no matter how much work you have put into understanding the company, its growth potential and the market, there's always going to be at least a 50% chance you will be left empty handed.
Some of the time, companies run into problems through no fault of their own. An economic recession, rising or falling interest rates, government policy or volatile commodity prices can all inflict immense pain on businesses, and they may not be able to recover.
The point I'm trying to make is that no matter how much time and effort you put into understanding a business, there is no guarantee of success.
This is why it is essential to consider all of the possible outcomes and probabilities of each scenario playing out.
Calculating the probabilities
If we want to be successful investors, we need to do everything we can to swing the odds of success in our favor, which means reducing exposure to companies with exposure to multiple factors outside of their control. This means avoiding businesses with high levels of leverage, which are beholden to their creditors, and sticking with companies that have a proven record of value creation.
Warren Buffett (Trades, Portfolio) has a preference for companies that either dominate a market or have a strong brand. This, in my view, is all part of his efforts to tilt the odds in his favor. A company that dominates a market or has a strong brand is less likely to see volatile sales and is less likely to struggle to grow sales. Therefore, the chances of the business succeeding over the long term are greatly increased.
In comparison, Seth Klarman (Trades, Portfolio) likes to buy investments that have an upcoming catalyst. This catalyst removes some uncertainty and guarantees a payoff within a set period of time. By targeting investments with a guaranteed payoff, he is swinging the odds in his favor and does not have to spend time considering all the different potential outcomes.
Mohnish Pabrai (Trades, Portfolio) does consider all the potential outcomes of an investment. This is something he has written about many times before. He only targets companies where the chances of a permanent impairment are nearly zero, however, and he wants to buy at a valuation that almost guarantees a positive return.
Limited risk of loss
One of the things I have noticed writing about successful investors over the years is that they all target investment opportunities with a limited level of uncertainty. Some really successful investors have targeted only investments with a guaranteed payoff, and these investors have become fantastically rich as a result (Carl Icahn (Trades, Portfolio) and the private equity giants are a great example).
Good investors tend to shy away from uncertainty and unpredictability. After all, there is so much uncertainty out there in the market, it does not make sense to enter an opportunity where there is even more uncertainty.
Research does help reduce uncertainty to a certain extent, but there will always be uncontrollable factors investors have to contend with. The best strategy to cope with these factors is to try to surpass them altogether. Investing is hard enough, and we should make sure we are doing as much as possible to swing the odds of success in our favor.
Disclosure: The author owns no share mentioned.
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