I had been investing for a number of years before I learnt how to deal with risk. By solidly identifying some market opportunities I had achieved good results, but I treated finance as a game of chess, an exact discipline, where I expected to benefit from good decisions and suffer from poor ones.
1. How to deal with risk
This over-ambitious approach occasionally caused some bad habits. For instance, when I was not performing well, I made three basic mistakes:
- I let losing positions drag on for longer than I should, as I hoped that eventually, I would be proved right.
- I was a bit harsh on myself, and I assumed that to make a loss, must have missed something obvious.
- I let it depress me that many hours of work on research and analysis could actually lead to failure.
Equally, when I made profits, I was over-ambitious and assumed that my reasoning had been right. I thought I was a hero!
Backgammon rather than chess
Fortunately, it didn’t take long before I evolved a different way of thinking. I realised that luck plays a role in the investment world. Profits can be simply due to good luck, and losses simply due to bad luck. Financial markets are more like a game of backgammon than a game of chess, because unpredictable events in the markets simulate the involvement of the dice.
With this discovery I started treating markets as partly random and accepted that there was always going to be risk. There is no perfect investment or trade. This approach helped my trading enormously.
- I stopped blocking the possibility of losses out of my mind like some dark fear, and I began to consciously anticipate them.
- I accepted that it would not always be possible to find a reason for a trade going wrong, apart from just chance. So I gave up over-analysing losses with endless post-mortems looking for my mistakes.
- I learnt to assess risks and look at factors like correlation and liquidity.
- Having consciously recognised risk, I reasoned that it was not always a good idea to try and minimise it. I knew that having identified some comparative advantages, I had to trust them to work over time.
- I accepted that even good ideas can lose money. That helped me to get better at cutting losing positions. Being wrong did not mean that I was a lousy trader. Even a trader with a comparative advantage will often make what is later found to be the wrong decision.
This attitude to risk is worth adopting. Accept that trading is unique�– a doctor or a lawyer would quickly be out of business with the number of failures that are part of a trader’s life.
2. Good ideas can lose money
In 1999 and early 2000, Warren Buffett was very sceptical about the rising valuations in the stock market, particularly those in the tech sector. Consequently, he didn’t invest as aggressively as many other fund managers. Then, of course, in mid-2000 the share prices of many tech stocks collapsed to a fraction of their boom value.
It was a massive market crash, and the so-called ‘Sage of Omaha’ was proved right (yet again!). I’m sure, however, that even he must have felt some pressure when prices were relentlessly rising and his funds were under-performing. With his reputation though, his investors stuck with him through this difficult period, and he held firm. They believed that he had the right approach, even though he was not getting immediate results.
Analysis after a loss
If you’ve lost money on an investment, ask yourself questions such as:
- Were you pursuing a genuine opportunity?
- Did you understand how the market usually works?
- Did you back a big idea or market anomaly that you had identified?
- Was the potential reward worth the risk?
If you have let yourself down, learn from the experience and try not to do it again. But if the investment looks like it made sense, then try not to be put off. Accept that you cannot judge the quality of a single trade or investment by whether you made a profit or loss.
This approach is very disciplined. You do not want to change your investment style on the back of just a few disappointments.
The outcome of an investment or trade is not necessarily a true reflection of the merits of the original idea. Good ideas can lose money.
3. Wild swings and losses are uncomfortable, but they may offer the best rewards
While the markets have evolved and become increasingly sophisticated, there has been enormous scrutiny of just about every possible opportunity. Any obvious and reliable way to make money has now probably disappeared.
This means that there are fewer opportunities which offer smooth above-average returns. In fact, the opportunities likely to last longest are those which are the most uncomfortable. Would you be prepared to back an idea that would probably lose money eleven months out of twelve, even if it would probably pay off in the other month?
A lot of traders don’t want that life. A lot of funds would be hammered with capital withdrawals by their investors. We live in a quarterly or annual reporting world. People evaluate performance over a given period and take action if results are not up to scratch.
By careful management of risk, however, you may be able to take on these uncomfortable types of investments. In the mid 1990s, I had “retired” and I only wanted to invest my own money. I continued to trade currencies and futures on my own account, and I also decided to start investing in early stage companies.
Early stage companies are often private companies which are not listed on any share market, although that is normally their aspiration. There are many of these little unlisted companies searching for financial backers, and they usually find it very difficult, since few investors are interested in them.
4. Opportunities may be found in areas that others find uncomfortable
One of my reasons for moving into this high risk sector, was that many people find the risk profile too uncomfortable. The majority of the companies fail, and the investor needs to select his investments extremely carefully, and trust that the winners will more than compensate for the losers.
Investors also have very little liquidity, and they may have to wait years for a chance to get some money back when the company floats on the share market or is acquired by another company.
This is why I came to the conclusion that good, small companies can be underpriced. This can be an advantage for anyone investing in start-ups if they are able to sort through the many companies looking for money and to choose the good over the bad. I have found the process is not that different to looking at the fundamentals driving currencies, interest rates or other markets, and over a ten year period, I have managed to achieve well over a 20 per cent�annual return despite the market collapse in 2000.
Not everyone though, can invest in unlisted companies. The minimum investment needed is at least 50 grand, and you probably need a network to make the introduction. However, I have also been able to apply the experience I have gained from dealing with unlisted companies to help me evaluate small companies which are already listed on the share market.
These are accessible to all investors. In a later chapter I will explore the fundamentals of small companies which I think are important for investors to assess. The small listed companies are also generally riskier than the big solid blue chip stocks, but by making an effort to investigate these opportunities and by managing your risk, you may find that these more uncomfortable investments offer a better price.
In general, keep a lookout for investments and trading styles that others don’t like. It is logical that it may be here that you find the winners.
The benefits of diversification are very well-known. There is a famous expression saying that diversification is the one “free lunch” for the investor. No collection of strategies would be complete without a mention of this easy meal. The world is risk averse. People want to avoid nasty surprises. Investors would prefer to have steady reliable returns, rather than potential wild swings of wins and losses.
Diversification can allow investors to reduce their risk without reducing their overall return. The idea of diversification is that it smoothes out the flow of wins and losses. It is unlikely that a variety of separate trading ideas will all win or lose at the same time. So even if we are placing riskier trades, it may not result in a riskier total portfolio.
I have discussed how I believe that uncomfortable trades with the big swings in wins and losses may offer the best rewards. So diversification is especially useful, because it may be possible to have a more comfortable existence, and still pocket the high return.
There are a few points to note about diversification:
- You can diversify within an asset class. For example, a stock portfolio can have a mix of some blue chips with some small stocks.
- Diversification across all asset classes (stocks, bonds, cash, gold, property, etc.) is more effective though, since the positions are less correlated.
- You shouldn’t keep a losing position simply because another one is doing well. I was once very sloppy with a losing currency position, because I had a bond position that was profitable, and in aggregate I wasn’t losing money. I realised later, that had I used my usual discipline I would have cut the losing position and been much better off.
- Every position in the portfolio should be based on its own merits.
- Remember that you can keep cash as one component in a diversified portfolio.
- Diversification is not an exact science. Since it is difficult to accurately measure risk, so for diversification a rough mix, based on instincts, is probably adequate.
(Excerpt from Taming the Lion: 100 Secret Strategies for Investing by Richard Farleigh, who made millions before he was 35 through shrewd investing. Published by Vision Books.)