How many times have we seen - in complete disbelief - something that's seemingly promising go under? How many times have we seen a seemingly smart person pull off something so catastrophically stupid that they never fully recover again? How many times have we seen a good project, led by good people, fail? How many times have we seen a good idea fizzle out? And how many times, have you looked at the reason these case studies went under and thought ‘how was this not obvious to anyone? We have a tendency to dismiss some of these cases as bad ideas to begin with - ideas that were always doomed to fail. But that’s just hindsight bias at work. Most of them are pretty revolutionary. For some, the main reason they failed was because they didn’t manage the risks well. Something occurred, that they hadn’t fully factored in. And that was the beginning of the downfall. Most times, another entity just fills the space, but with better risk management than the previous one.
Good Ideas
Charlie Munger recently said that good ideas tend to get us into more trouble than our bad ideas. I think it’s because good ideas tend to get us excited and motivated. They give a sense of what’s possible, what can be done. We over-index all the things that could go right. The lifestyle we’d live. the prestige we’d have. The issue is that because of this, we tend to under index all the things that could go wrong. And when they do, we’re completely unprepared to deal with the situation. From what I’ve observed, people tend to oscillate between two distinct ends of a spectrum - over enthusiasm (hype) and under enthusiasm (FUD). When things are going well, we assume they’ll always go well. It hasn’t been any other way so far. And when things are bad, we assume the same thing. That’s the whole basis of Bull and Bear markets. And its in these situations that we fail to prepare adequately.
Risk vs. reward
Just as the excerpt says, its a whole lot better to not be stupid than it is to be smart. A lot of smart people have ended up in bad situations trying to be the smartest person in the room. What I advocate for is the opposite. Ensure that in whatever you do, you are not stupid about it. That’s a low bar to have, but you’d be surprised how many people are below it. Reward is a function of risk. They mostly balance each other out. Most situations where the rewards are exponential are also situations where the risk of losing it all are high. Cases such as Long-Term Capital Management are classic example of having smart people in the room, but few people actually thinking consciously about risk. Warren says that every time you see a smart man going broke, there’s leverage (debt) involved. I’ve recently been digesting the FTX collapse, and with every detail that comes out, I’m left wondering how it all could go unnoticed. How no one in the organization could identify the gaping holes, and raise an alarm. Whatever trades the Alameda was doing, they had very little risk management procedures in place. Whatever the relationship was between Alameda and FTX, there was very little protection placed on the company’s and customer’s funds.
Diversify
As for me, my risk management strategies have evolved over the past year drastically. In the first three months of starting out on this journey, I was highly concentrated on tech stocks. What that meant is that whenever the market went up by a point, my portfolio went up by two. A good thing. But whenever the market went down by a point, I went down by two. If you know anything about psychology, you’ll know that losing a dollar is a lot more painful than winning a dollar. Just look at how emotional people get over some ten shillings with conductors. In order to reduce that volatility, I started diversifying into other industries - industries that would be considered boring. These included mining companies (we’ll always need building materials and fuel), healthcare companies (feeling unwell is part of the human condition), food manufacturers (food, duh!) among others. These have provided a level of stability to my portfolio that allows me to worry a little less whenever we have these big swings in the market, a little being the key words here.
Buy the Basket
Another thing I’ve done is to increase the percentage of my portfolio that’s in index funds. Index funds have the big advantage of averaging out the performance of the market, so that you don’t have large swings in the value of your portfolio. They also allow you to have exposure to a large number of companies and industries at once, diversifying your portfolio in one fell swoop. This relieves you of the trouble of doing that yourself - you won’t have to buy and keep track of 30 stocks. Add on top of that the fact that its is extremely - and I mean extremely - rare for active investors to beat the indexes over a period of time. The percentage you settle on is your choice, but active investing needs a lot of attention. If you can’t put in a few hours of research into every position you enter, or simply don’t have the expertise to do this, then you’d be better off having a higher - if not 100% - of your portfolio in index funds. While I do a bunch of research into companies before pulling the trigger, I still keep approximately >40% of my portfolio in index funds.
Cash is King
And most importantly, I keep some cash locked away. We’re headed into a pretty bad recessionary period - if we’re not already in one. For us later millennials, this is the first recession we’re experiencing, and it won’t be the last. People are losing jobs, while others are getting salary cuts. Businesses are cutting spending, as is the government. This is going to slow down the economy for a year or two. The period of overindulgence caused by Covid is ending. We’re entering a period where we’ll have to hunker down and basically survive as we wait it out. And one of the best things to have during such a period is a cash war chest that’ll allow you to weather the storm. This is a period where, unless you work for the government, you should be saving as much as you can. You should make yourself as irreplaceable as you can be in your place of work, but there’s no guarantee they’ll keep you. There’s no guarantee the business will be around in a year’s time. So stock up. Wars aren’t won in the battlefield. The more you can manage your risks, the more of those risks you can take.