Credit: Shutterstock photoOne of the most quoted sayings in investing goes like this: "If you take care of the downside, the upside will take care of itself."
This sounds so simple. People say they control risks by considering the downside in every investment and they make decisions based on the so-called risk-reward ratio - risk being the downside and reward being the upside. Very few investors appropriately implement the idea of taking care of the downside. Even many of the gurus listed on this forum failed to heed this piece of timeless wisdom.
Thera are a few reasons which make it difficult to implement an effective risk control system.
First of all, the definition of downside can be vague. Some use the phrase "worst case" and some use the phrase "potential loss." But either way for us to define downside, we have to define risk first. Howard Marks ( Trades , Portfolio ) has the best definition of risk I have ever seen -"risk means uncertainty about which outcome will occur and about the possibility of loss when unfavorable ones do." If we take a step further, what Marks implies is there are essentially a number of elements involved:
- Assessment of the range of outcomes.
- Assessment of the probability of each outcome and which outcome is most likely to occur.
- Assessment of the probability of loss when unfavorable outcomes occur.
- Assessment of the magnitude of loss with each unfavorable outcome.
While I like Marks' definition, it's missing a very important element - time horizon. The probability of a certain event varies enormously with different time horizons. Sometimes the longer the time horizon, the less likely an event will be to happen. Sometimes the shorter the time horizon, the less likely an event will be to happen.
Combining Marks' definition with the added variable of holding period, perhaps we can come up with the following definition of downside: the maximum magnitude of loss when the most unfavorable outcome occurs, given a certain holding period.
But even this definition has drawbacks - what about probabilities? Should we use a 1% likelihood of an unfavorable event? 10%? Or 50%? There is no definitive answer, but it's a call we have to make. Making things more difficult is the fact that knowing the probabilities doesn't mean you know what's going to happen. In investing, very frequently less likely events happen and likely events fail to happen.
Investors often fail to recognize the inherent unknowability and unpredictability of a business and hence, the unanalyzability of the downside risk. They often overestimate their ability to analyze a business. To quote Mark Twin - "It's not what you don't know that gets you into trouble. It's what you know for certain that just ain't true." I've seen so many times that catastrophic loss happened because people thought they knew something, acted with high conviction and turned out to be wrong; that's how you lose a lot of money. The common factor is failure to recognize the edge of one's circle
Charlie Munger Current Portfolio
This Powerful Chart Made Peter Lynch 29% A Year For 13 Years
Charlie Munger Current Portfolio
This Powerful Chart Made Peter Lynch 29% A Year For 13 Years
Read More:
About GuruFocus: GuruFocus.com tracks the stocks picks and portfolio holdings of the world's best investors. This value investing site offers stock screeners and valuation tools. And publishes daily articles tracking the latest moves of the world's best investors. GuruFocus also provides promising stock ideas in 3 monthly newsletters sent to Premium Members .
This article first appeared on GuruFocus .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
