Before he became an investor and started Pabrai Funds, Mohnish Pabrai (Trades, Portfolio) was an entrepreneur. He founded two businesses -- the first made him a multi-millionaire, and the second was a failure. These experiences continue to inform his investment approach to this day, and he believes that all investors could benefit by taking a leaf out of the entrepreneurial playbook. On April 12, 2010, he gave an interview at the Forbes Intelligent Investing event where he explained his thinking on the subject.
Low risk, high uncertainty
The main investment insight that Pabrai gleaned from his time as a businessman concerned risk management. He opined that successful entrepreneurs do well because they know how to limit their downside:
“There is a misnomer (regarding entrepreneurs). People think that entrepreneurs take risk, and they get rewarded because they take risk. In reality, entrepreneurs do everything they can to minimise risk. They are not interested in taking risk. They want free lunches. If you study entrepreneurs what you’ll find is that they have repeatedly made bets which are low-risk bets, with high-return possibilities. So they are not going ‘high risk, high return’, they are going ‘low risk, high return.'
"Even with Bill Gates (Trades, Portfolio), for example, the total amount of capital that ever went into Microsoft was less than $50,000, between the time it started and today. So Microsoft you cannot say was a high-risk venture, because there was low capital deployed, but it had high uncertainty. Bill Gates (Trades, Portfolio) could have gone bankrupt, or he could have ended up the wealthiest person on the Forbes 400 … So entrepreneurs are great at dealing with uncertainty, and also very good at minimising risk.”
This concept crops up in almost every financial field, from entrepreneurship to trading. It is very similar, for instance, to Nicholas Nassim Taleb’s "barbell strategy" -- the idea that an investor or trader should pursue a bifurcated approach: hold the majority of their net worth in an extremely conservative portfolio, and expose the other part of their net worth to opportunities with very high uncertainty. This differs from standard portfolio management theory, which advises investors to aim for an intermediate level of risk in order to secure middling returns.
What both Pabrai and Taleb referred to is the idea of a free lunch. Taleb also calls it a free option (in both the general and financial sense). You should aim to get something that has the potential to be a big winner, while also limiting the total amount of money that you can lose by doing so. For instance, incorporating a limited-liability company that addresses an unserved need in the market. Or targeting cheap value stocks that have good potential upside, but low downside (due to their depressed price).
Conversely, "high risk, high reward" strategies should be avoided. There is no fundamental reason the price of a highly speculative asset like bitcoin shouldn’t go to $0 (or $1,000,000). It is based purely on what other people are willing to pay for the asset. In this case, you are assuming both high risk and high uncertainty. Best to minimize the former and become comfortable with the latter.
Disclosure: The author owns no stocks mentioned.
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