Playing defence

Early in the quarter, we were faced with a dilemma.

At a micro level, the portfolio largely consisted of securities selling for less than our opinion of their intrinsic value.

At a macro level, we observed manic investor behaviour, a world that’s still suffering from a pandemic enforced lockdown, a stock market which was very expensive, and an uncertain inflation and interest rate outlook.

We felt that any one of these risks could easily result in a period of lower asset prices and so we were sleeping a little uneasy. Our conclusion was that greater cash level was more respectful of the risks, and, would give us greater options should asset prices fall.

We raised the cash via a combination of:

1. Selling stocks which had reached our valuation

2. Receiving new capital from investors

3. Selling stocks that were likely to come under selling pressure should there be a market correction

Playing a loser’s game

While our objective is to earn the best returns possible, our priority for any single investment decision is somewhat counterintuitive. Instead of simply chasing returns, our main objective is to avoid losing money.

In his 1995 essay, Charles Ellis referred to investing as a loser’s game. He suggested it was like amateur tennis where instead of trying to hit big winners, you’re best off playing it safe and letting your opponent make inevitable mistakes.

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Investing is a unique game, intuition suggests that you should seek out the investments with the largest potential gains if you want to earn the biggest returns. But this is a false dichotomy as it ignores two key elements.

1. Extraordinarily high returns are usually coupled with a low probability of occurrence. This means that when you make a high risk/high reward investment, you are more likely to lose big than to win big.

2. Capital losses are difficult to make up. All else being equal, a 100% loss requires a 200% gain to break even. People chasing big returns often quit early because of how difficult it is to recover from a big loss.

So, if there’s logic in this defensive approach to investing, why doesn’t everyone do it?

Humans (generally) have:

• A habit of extrapolating recent success: This means that a recent win is likely to encourage additional risk-taking, which will eventually lead to the investor coming unstuck. Investors who have lucked out with a big return usually don’t save their winnings, but instead double down on the next one and bring themselves one investment closer to catastrophe.

• An aversion to loss which is amplified by recent experiences: This means that after suffering a large loss, they’re likely to become more conservative and often retire from the game completely. It’s hard to achieve long-term success after retiring hurt early.

• Overconfidence in their own abilities: Our egos encourage us to believe we are more educated than we really are. There’s no free lunch in investing. Overconfidence can cause investors to ignore the risks and render the all-important margin of safety unnecessary.

A conservative approach to investing makes sense to most people, but the promise of winning big lures them in too much. Casinos thrive for exactly this reason. However, investing (unlike gambling) allows us to manipulate the odds in our favour. That’s what playing the loser’s game is all about.

The promise of returns means nothing to us if there’s a more than fair chance that we could be left with nothing. It makes no sense mathematically to speculate, and we are very aware of the psychological tendencies handicapping that approach.

While I love the thrill of getting a big serve in, I’m playing for the championship (not the point). I’m confident that it is our consistent execution of high percentage (low risk) shots which will get us there.

Principles

These principles have been both learned and taught.

I was lucky enough to lose money early on in my investing life which provided a unique lesson in the perils of speculation.

I am also in a unique position where I get to witness a variety of investment approaches in action over long periods. I have some perspective of what works and what doesn’t OR what works very well in some periods might result in collapse.

Seth Godin preaches his preference for the ‘long cut’ over the ‘short cut’. Our conservative approach is unlikely to be the best in any single short period, but that isn’t our objective. We are more than comfortable delaying gratification if it means we are increasing the probability of long-term success.

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Acknowledgements: Charles Ellis, Seth Godin.