Risk

Howard Marks’ latest memo on risk has sparked interesting conversations on the web. Mr. Marks points out that volatility is very incomplete definition of investment risk:

Risk is something people worry about and therefore demand compensation. What people fear most is the possibility of a permanent loss.

Permanent loss could occur for two reasons:

a) an otherwise temporary blip is locked in when an investor sells during a downswing – whether because of a loss of conviction; requirements steaming from his time frame; financial exigency; emotional pressures or

b) the investment itself is unable to recover for fundamental reasons

We can ride out volatility, but we never get the chance to undo a permanent loss

Howard Marks looks at risk from the position of a long-term investor, not from a trader’s perspective.

A trader is not worried about taking a permanent loss. Permanent loss on some of his trades is part of his process. Sometimes being wrong is not a choice. Staying wrong always is.

A temporary dip could last quite some time and turn into a much bigger dip. A 10% loss takes an 11.11% gain to recover from. A 80% loss takes a 400% gain to recover from. There is an opportunity cost behind every decision you make. A losing asset could manage to fully recover to your initial purchase point, but what is to say that you could not have sold at a small loss and used to proceeds to buy another asset that ends up actually making you money. As a trader, you don’t have to make money in the first one or two stocks or assets you buy. The market is an opportunity machine. It provides a good number of opportunities every single week.

Is uncertainty risk? No, uncertainty is always here. You don’t need to know that something will happen with 100% certainty, in order to take advantage of it. Circumstances will never be ideal, but if you follow a process with an edge you will end up with more than you have began with.

Risk is what’s left after you think about and prepare about anything that could go wrong. If you are prepared for it, is it really a risk or a mere part of the process of trading? Forget about measuring the probability of each scenario that could unfold. If you have an action plan for every possible scenario, then those scenarios are not risk events, but just possibilities. Therefore a good definition of risk is a black swan.

According to Nicholas Taleb, black swans are “large-scale, unpredictable and irregular events of massive consequence”. This definition is a little too grandiose. Black swans could be very subjective. If you don’t know what you are doing or if you are not prepared for a possible event, it could be a black swan for you. It is not a black swan for someone, who is prepared for it. Thanksgiving is a black swan event for the turkey, not for the butcher.

You might know about certain risks, but if you are unprepared for them, they remain risks for you. Sometimes, the cost of insuring against every possible risk is too high and you deliberately decide to take your chances.

Basically, the most practical definition of risk is something you are not prepared for.

About Bulls, Bears and Pigs

There’s a popular Druckenmiller’s quote circling the Internet as of late:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

If you don’t look at it from different perspectives, you might get disillusioned that Druckenmiller recommends to always take very concentrated bets. There are some nuances that you have to consider:

1. He always has an exit strategy. When Soros and Druckenmiller made their famous bet against the British Pound, the knew exactly how much they could lose – their entire YTD gain of 12%.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

2. He says that the right conditions to make a concentrated bet happen only once or twice a year. Not everyone is able to recognize those conditions. Proper Timing is Everything when you trade big. A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

3. You have to earn your right to bet big first.

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

The True Nature Of Predicting

Jon Boorman has an interesting piece on the futility of making market predictions.

Long time ago, Phil Pearlman wrote an insightful post, pointing out the upside of making an outrageous prediction.

Here’s how it works.

If I make an outrageous prediction or label a prediction outrageous and I am wrong, I respond to criticism like this:

“Well, I said it was an outrageous prediction.”

This discounts my responsibility for being wrong to some degree. But if I am right, I will say,

“look how brilliant I am. I made an outrageous prediction and it was dead on.”

Outrageous predictions are used to manage impressions. One defers responsibility if wrong and gloats incessantly if right.

It is a manipulative gambit.

People, who make outrageous predictions know exactly what they are doing. Their potential reward is much bigger than the risk they are taking of being publicly laughed at. Many people have made a career by being right once about a major event that nobody expected (usually a big market correction).

Predicting and speculating have a lot in common, but they are also very different. By definition, predictions are about dealing with factors, you have no control over. When you speculate in the stock market, you also don’t have control over which one of your trades will be profitable and for the most part how profitable it will be. You could improve the odds, but you can’t impact the outcome of each individual trade. When you speculate, you put your own money at risk. You could be right for the wrong reasons and make money (lucky). You could also be wrong despite having an edge and still lose money (no approach has 100% success rate). Since you have very little control on some of the variables that impact your results, it doesn’t really make sense to speculate about only one outcome, because in this case you are getting prepared for only one outcome. The solution – You develop several different scenarios and you prepare for each of them.

A) You could be wrong

  • where is your stop loss?
  • How much of your capital are you going to risk?

B) You could be right

  • Where are you going to exit so you maximize not only your individual return on one particular trading idea, but your overall capital return, which takes into account opportunity cost.
  • Are you going to sell on strength, on weakness (when the trend for your time frame is invalidated).
  • Do you have a time stop in place – it assures that you don’t keep you capital in a non-performing assets.
  • Do you have a plan where to add to you position? One of my favorite market insights from George Soros says that “it doesn’t matter if you are right or wrong, but how much money you make when you are right and how much money you lose when you are wrong”.