Cognitively Yours 1.26

 

Raja R, Author

"Avoiding the losers is an important part of every great investor’s game. Defensive investing with a margin of safety will ensure that your portfolio is prepared for things going wrong"

When you plan long-term especially for your retirement or any other long-term need, it is quite hard to predict one’s changing goals and desires as well as the changing environment and landscape. Unknowns are present in life. As Warren Buffett puts it “For a piece of information to be desirable, it has to satisfy two criteria: it has to be important, it has to be knowable”. In many factors entailing great uncertainty, agnosticism is probably wiser than self-delusion, as Howard Marks mentions in his latest memo.

Need for Margin of safety

Benjamin Graham known for his concept of margin of safety mentions that the purpose of margin of safety is to render the forecast unnecessary. A very simple yet powerful statement.

Margin of safety or room for error or redundancy - is the only effective way to safely navigate a world that is governed by odds, not certainties. And almost everything related to money exists in that kind of world.

Forecasting with precision is hard. What is the stock market return in the next ten years? What returns will I get on my retirement corpus for the next ten years? These are like predicting where a particular card lies in the deck of cards. The best we can do is think about the odds.

Graham’s margin of safety is a simple suggestion that we don’t need to view the world in front of us as black and white, pursuing things where a range of potential outcomes are acceptable - is the smart way to proceed.

Why we shun or avoid margin of safety

People do underestimate the need for room for error in almost everything that involves money. Target price of a share is more welcome than ranges, exact predictions are preferred to broad probabilities. Those who speak a language of unshakeable certainties have a larger following than predictions and estimates in probabilities

Two things cause us to avoid room for error.

One is the idea that somebody must know what the future holds, driven by uncomfortable feeling that comes from admitting the opposite. The second is that you are therefore doing yourself harm by not taking actions that fully exploit an accurate view of that future coming true. Though room for error is widely misunderstood and viewed as a conservative hedge, used by those who are not confident in their views and estimates and who do not want to take risk. In fact, when used appropriately, it’s quite the opposite.

How margin of safety or room for error helps in investing

Room for error lets you endure a range of potential outcomes, and endurance lets you stick around long enough to let the odds of benefiting from a low probability outcome fall in your favour. The biggest gains occur infrequently. Therefore, the person with enough room for error in part of their strategy (cash) to let them endure hardship in another (stocks) has an edge over the person who gets wiped out as he has invested when they are wrong.

Combating volatility

How do you survive the volatility? When your portfolio declines by 30 per cent? True. On paper you may be able to survive the decline but what the decline does to your psyche is tough to estimate. The gap between what you can technically endure versus what is emotionally possible is something which is overlooked.

The solution is simple: Use room for error while estimating your future returns. The future returns which I earn will be 50 or 75 bps less than the historical average. True, no margin of safety or room for error gives 100 per cent guarantee but gives lot of mental peace.  And if the future resembles the past you can be presently surprised.

“The best way to achieve felicity is to aim low.” Charles Munger.

“You can be risk-loving and yet completely averse to ruin” Nassim Nicholas Taleb.

Room for error helps you from events which is beyond your realm of imagination

Room for error does more than just widen the target around what you think might happen. It also helps to protect you from things you’d never imagine, which can be the most troublesome events, we face.

The Battle of Stalingrad, in 1942, out of the 104 tanks in the unit, fewer than 20 were fit for operation. Engineers found during the weeks of inactivity, field mice had nested inside the vehicles and eaten away insulation covering the electrical system. Despite having the most sophisticated equipment in the world, they were defeated by mice. You can plan for every risk you can imagine, but some obscure risk may happen which you could not have imagined and you have no plan to deal with them. Avoiding these kinds of unknown risks is, almost, impossible. You can’t prepare for what you can’t envision. If there is one way to guard against their damage, it’s avoiding single points of failure.

Helps to plan for the unplanned

The biggest single point of failure with money is sole reliance on salary or pension to fund short-term spending needs, with no additional savings to create a gap between what you think your expenses are and what they might be in future. You do not need a specific reason to save - say buying a house, car etc. You have to save for things that you cannot possibly predict or even comprehend. You have to plan for your planning not going accord to the plan.

The teams competing in the limited overs of cricket do have at least five full time bowlers to bowl the full quota of overs. However, most of the teams ensure that there is one additional bowling option to ensure that he pitches in if one of the regular bowlers is off colour on a particular  day.

What should be the margin of safety?

Howard Marks asks a question “Which do you care about more, making money or avoiding losses?”. The answer invariably is “both”.

The best way to put this decision into perspective is by thinking in terms of offence versus defence. Charles Ellis article titled “The loser’s Game” provides insight through a metaphor of sports. He observes that tennis in not one game but two: one played by the professionals and other played by rest of us. In the expert tennis, the ultimate outcome is determined by the actions of the winner. There are seldom unforced errors. Amateur tennis is one where outcome is determined by the loser. Very few aces, few brilliant rallies and few miraculous recoveries. The ball is too often hit into the net or out of bounds, and double faults are not uncommon.

Amateurs seldom beat the opponents but instead beat themselves. The victor gets a higher score because the opponent is losing more points. The choice between offence and defence investing should be based on how much the investor behaviour is within one’s control. Investing does entail a lot that isn’t it.

In short, avoiding the losers is an important part of every great investor’s game. Defensive investing with a margin of safety will ensure that your portfolio is prepared for things going wrong. And if nothings does go wrong, surely the winners will take care of themselves.

References: The Intelligent Investor by Benjamin Graham, Winning the loser’s game by Charles D Ellis and The Most Important Thing by Howard Marks

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