Perfection is a dumb goal. Not because it would not be worth having, but rather because to achieve it, you would need to avoid doing anything that might fail. In financial matters, particularly investment, there is more risk in not doing things than there is in doing them.
As I said the other day, the wealthy person rule is lose small, win big.
There is a recent story in Forbes that points out that over the past 20 years Carl Icahn, net worth $21 billion, has invested in 94 positions. Of those, 39 lost some or all of the money invested. Right about 58% of the time. Average rate of return, net of losses, 31% annually.
Small affordable losses are required to have large wins. All billionaires know it too.
“It’s not whether you’re right or wrong, but how much money you make when you’re right and how much money you lose when you’re wrong.” – George Soros
Wealthy people begin with the idea that there is a big win possible and very soon after that follow it with an assessment of the downside. If the downside is affordable then the upside becomes something to think about.
Suppose you can find deals where the investment is $10,000 and when you are right you get back $100,000 and when you are wrong you lose the entire $10,000. You have $100,000 in your hand, and make ten investments today. Three years from now eight have lost all of your money and the other two hit. You will have $200,000. Double your money in three years is an attractive rate of return.
Now that you see the way, it is easy.
Not so much.
You will need to find deals that can become worth ten times the investment in three years. Without leverage. If you use leverage as the tool, then the downside becomes potentially much larger. The key to the arrangement is protecting the downside, not maximizing the upside. That can come later. In our example above, right once in ten tries is good enough to avoid loss.
Nicholas Nassim Taleb, The Black Swan author, used derivatives of one kind or another to develop substantial wealth. The idea was sooner or later some previously unseen result will occur and when it does the percentage return will be huge. The problem he and his staff had is that the distribution of returns was quite difficult to deal with psychologically. If you lose small on six of every seven deals, win small on 90% of the rest and win huge once in a while, it is very difficult to stay sane. For most of us that is the problem. Dealing with losses is trying and we are not easily able to do so.
There is another approach that gets to the same place. Super-investor, value buyers like Buffett, Munger, Karman and others, are risk averse too, but do not develop value by fixing the business. That is a different skill. They have fewer positions than an Icahn and lose less often. They are patient first, analytical second and capable of making objective decisions. They take lower returns and hold for longer.
Icahn’s average hold is 2.3 years. Buffet’s could be forever because he does not sell until someone offers him quite a lot more than he thinks it is worth.
Both styles control their downside. It is only the upside management that is different.
Both styles start every investigation with this thought.
“That looks like a good deal, how much can I lose?”
Fear keeps us alive sometimes but it gets in the way too. Do not stop there. Most of us intuitively avoid losses and in so doing avoid wins too.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
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