south african investing - Lunar Capital

Risk

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1” Warren Buffett

What does Buffett mean when he says that the first rule of investing is never to lose money, and the second rule is to never forget the first rule? Has Buffett never lost money?

To answer the second question first: over his investing career and his portfolio as a total, Buffett has not lost money. In fact as we all know, he has had spectacular gains. However, there have been periods when he has lost money and he has also invested in some companies that had to be sold at a loss.

So, to get back to the first question: what does Buffett mean when he says don’t lose money? What he means is that one should not approach investing in a frivolous way. Investing is not like gambling, it requires a systematic approach, careful analysis and an expectation that one’s analysis could be wrong or that unforeseen risks may be lurking in the future. One of his investing guidelines is to try and identify a margin of safety in any investment that he makes. The margin of safety is one way of trying to manage the risk in any investment.

Investing and risk management are two sides of the same coin – they go together.

Risk is not binary

Many investors think about risk in a binary manner, i.e. either something will happen or it won’t. For example, you will buy a listed company because you think that the share price will rise. But, after you do your analysis and you assess that the price that the share is trading at offers good value, a number of scenarios can play out:

The share goes up exactly as you analysed. However, this is not how it pans out most times;
The share could go up more than what you thought. This is a positive risk and is sometime termed as an upside risk;
The share could go up by less than what you thought;
The share could stay more or less the same;
The share could go down;
Etc.

Any number of factors could cause any of the above scenarios:

Unanticipated risks could have materialised;
Other investors either correctly or incorrectly may have an opposite view to you and this impacts the share price;
Your analysis may have been flawed;
Regulatory changes;
Etc.

So, when one thinks about risk in a binary way, this is really very flawed way of thinking. Risk is in fact a range of probabilities that different outcomes may occur. Your analysis suggests the most likely (i.e. highest probability) outcome, which may or may not occur. Even lower probability outcomes may occur. And, these may occur for rational or irrational reasons.

One of the key tenets then of risk management is to assess how different scenarios may or may not play out over time in your portfolio. Rather than betting that an event will occur, assess the different scenarios and position your portfolio in a way that reflects the different probable outcomes. A good example would be in the South African context: assume that you are thinking that the Rand will weaken against major currencies over a 2-3 year period by 20% to 25%. In this case, if you were 100% sure that this will occur, then arguably you should have all your investments in Rand hedge shares.

Now let’s play out the above position, assuming everything else stays the same:

If the Rand does weaken then arguably you should get the benefit in your portfolio of whatever the Rand has declined by. In fact, you wish that the Rand can weaken a lot, so that you can get the benefit (in Rands) in your portfolio. In this case, you are a hero! Crazily, poor risk management resulted in a good outcome!
Let’s take the opposite scenario: the rand actually strengthens. In this case your portfolio loses by the value of the rand strengthening. The more the Rand strengthens, the more you lose in your portfolio. In this case, you are an idiot! You have broken Rule No. 1.

Remember, that even a small probability of an event happening could occur.

Arguably then, if you thought that the Rand was going to weaken, but if your conviction was not 100%, say 70% chance of weakening and 30% chance of strengthening, then perhaps you should have some (approximately 30%) of your portfolio in shares that would benefit if the Rand strengthened.

In this case, you would be neither hero nor idiot; maybe a little better off if the Rand weakened, and a little less well off if the Rand strengthened relative to the market. But, arguably you would have better managed your risk, i.e. following Buffett’s rules of investing.

Risk is not volatility

Many investment professionals make the mistake of defining risk as volatility. Volatility is rapid and unpredictable change. Volatility may be due to several factors: lack of liquidity in a share, derivative traders hedging positions, many or large uninformed investors in the market, sentiment, etc.

True, if a company’s business is prone to many unpredictable factors, then it is a risky company to be invested in. But, if you have the ability to predict the performance of a company with relative accuracy, but its shares trade in a volatile manner, then this can in fact give you a great advantage. You can buy at much lower prices than the underlying value of the business.

Many great investors talk about buying when there is blood on the streets. Risk analysts and volatility indicators will in fact say that the market is very volatile and thus very risky. But for the greats like Buffett and Templeton, these volatile times are likely to be great times to be investing. They provide an opportunity to pick up good businesses or assets at great prices (when price is below intrinsic value).

Risk is not volatility, it is in fact paying more for an asset than it is worth. Even great businesses can be over-priced, leading to poor investments if they are bought at over-priced levels.

If you are geared either through loans or derivatives (both not recommended), and you are required to make interest or margin calls, then in this case volatility is a risk for your portfolio.

Sentiment and Risk Appetite

There’s another factor that should be considered and that is your ability to stomach volatility. If you constantly watch the stock prices and are jittery to sell when share prices come down, then in fact YOU may well be the risk in your portfolio, i.e. you panic and sell at the wrong time.

You are required to be quite rational and not driven by sentiment when making investment decisions. Most people in fact are not geared this way. They are affected by sentiment, selling when everyone else is also selling thus forcing prices down, or buying after large returns have already been made.

If you are prone to sentiment in your investment decisions, then you should rather let a professional invest your money for you, whether it is through low cost index trackers or through actively managed funds or a combination of those.

Do your homework

Risk management is thus as much about understanding the potential hazards and unknowns in an investment, as it is about understanding the businesses that you are invested in. It is also about understanding yourself and how you may behave under volatile market conditions.

It is thus important that you do as much homework as possible and develop a risk management strategy that suits your risk appetite.

Similarly, invest only in businesses that you understand and that you have a high conviction in.

If you do not have the time and/or inclination to do proper analysis, then select an investment strategy, possibly with the assistance of a qualified financial advisor and rather let professionals manage your investments.

First prize is always that you are able to manage your own investments.

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Buffett’s rules of investing therefore is that you should aim to protect your capital or permanent losses as a fundamental rule. Only swing to the fences when you are certain that you will be able to do so, otherwise balance your portfolio accordingly. This could mean sitting on a bit more cash until the better opportunities come along.

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Ring the Bell

Please let me know when market guru of the Johannesburg and/or the Nasdaq Stock Exchange rings the bell to tell us that we are at the top of the market cycle. Similarly, let me know when our market guru declares that we have reached the bottom of the next bear cycle.

You know that I am been facetious about the market guru. Nobody rings the bell or for that matter can reliably predict the top or the bottom of a bull (rising market) or bear (falling market) cycle. There are far too many factors that influence the markets. Behavioural economics also teaches us that investors can display huge doses of irrationality – pushing stock prices higher in an already overheated market or pushing them lower in an already under-priced market.

So, anyone that can claim to predict the top or bottom of a market is simply lying. But, we as investors can also get caught in this same lie. Amongst us, we often hear someone saying that they are waiting for a crash in the market, so that they can then enter the market, only to watch the market go higher.

What alternatives do we have if we cannot predict when to enter or exit the market?

When we’re around a braai and I inevitably get the question is it the right time to invest or do I think that the market is in for a crash or something along those lines, then my response is generally what most non-professional investors don’t want to hear:

It is very difficult to predict the markets, especially in the short-term. An over-valued market can remain over-valued or even get more over-valued in the short-term. However, at some point in the future, it will correct itself. But when and how this correction will take place is very difficult to predict;
Similarly, an under-valued market can remain so for a long-time and even get more undervalued. Again, it will correct itself but how and when this will take place is difficult to predict;
Another response, maybe yes, the markets are over-valued in general, but we may be of the view that there are opportunities in certain sectors or shares;
Lastly, our responses may not be what is generally perceived, i.e. the general sentiment may be down but we may be seeing opportunities or vice versa.

Generally, most people don’t like to hear these less definitive answers. They want a high degree of certainty: it’s a great time to buy or the market is due for a correction soon and then it will be a great time to buy. To try and help things along, I suggest to non-professional investors that they develop an investment strategy and stick with it.

Given the uncertainties, risks, knowledge, skills as well as the opportunity to build wealth over the long-term; the non-professional investor could consider two very simple strategies for investing in the equities (stock) markets:

Invest by Debit Order

In this strategy, you take it as granted that it is very difficult to predict the top or the bottom of the market; so you invest a fixed amount every month. Ideally, it is automatically debited from your bank account, so you don’t have the administrative hassle every month and you don’t get cold feet. The advantage of this approach is that as the market rises, the funds that you have already invested benefit from the rising market. However, when the market declines, then you get the benefit of getting more units for the money that you now put in, i.e. you get more units for each rand that you invest. This method is called rand-cost averaging.

Your biggest advantage is that you are not trying to time the market, which you know is a futile exercise. By investing over the long-term, you have a much better chance of building real wealth over this period as you stay the course.

By not investing a lump sum at a point in time, you take away the timing risk, i.e. that soon after you have invested there is a crash in the market and you lose a big percentage of that lump sum early on, which impacts your lifetime returns, i.e. it takes you longer to achieve your target.

Another huge advantage is that you take the emotions out of investing. You have a strategy, you stick to it, irrespective of what the sentiments in the market are.

One of my favourite reasons for investing in a debit order approach, is that you are paying yourself first, as Warren Buffett likes to put it. By paying yourself first, you are putting away money for a rainy day and giving yourself a great chance of actually building wealth. After you’ve paid yourself, then you can look at spending in other areas.

Invest Monthly, but adjust according to market conditions

In this approach, you really just make a variation of the above strategy. You choose a minimum monthly investment by debit order, but you increase the amount as market conditions look better for investing. In this approach, you must have a methodology of assessing whether conditions are good or bad for investing. For example, you may apply a simple analysis of the current market valuation (say price to earnings ratio) to the long-term historical average price to earnings ratio.

If the current price earnings ratio is lower than the historical average, you may choose to put more money in every month; but if it is higher, you can choose to lower the monthly payment.

Perhaps the biggest challenge that you will face is that you will likely be going against the general market sentiment, i.e. when all is doom and gloom, you will be investing more; and when everyone is wanting to buy, you will be reducing your buying. If you have the emotional discipline to be able to do this, there’s a good chance that you will do better than most. Remember the saying: Buy when there’s blood on the street (i.e. the market has crashed), and sell when the man-in-the-street is talking about buying in the stock market.

This is also more difficult to execute, as you need to make a decision each month whether you will add to the debit order or not, and if you do think you will add, how much will you add.

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Unless, you really are very close to the investment markets, a good strategy is to invest in the market on a monthly basis, preferably by debit order, i.e. pay yourself first. You can vary it a little. Perhaps after you’ve received a bonus, you can put a portion of your bonus into your investment portfolio if the market conditions are good for investing. Alternatively, you can take that portion and invest it temporarily into a money market account or a call account until such time that market conditions are good for investment. When market conditions are good for investing, you can then transfer from your money market or call account into your investment portfolio.

The worst thing that you can do is to wait for someone to “ring the bell” to signal that you need to start investing. You will watch the market go by and lose a real opportunity to build some wealth for you and your family. Over the past 25 years, equities have returned 9.7% in real terms per annum, bonds 6.6% and cash approximately 0.9%.

What are you waiting for? Nobody is going to ring the bell for you to start investing.