One of the most important lessons I learned early in my investing career was how to deal with loss. Everything I read in those days emphasized that as long as I could get a handle on losses, the gains would take care of themselves. Learning by example has always been my strong suit, so I promptly made some bad investments, lost what was a painful amount of money at the time, and took that lesson to heart. Eventually it found its way to the absolute core of our investment process. As long as we reduce unforced errors, keep our mistakes manageable, and operate with a stable margin of safety, we will end up with strongly positive performance over time.
Even though we operate with this discipline, and we know that we will be wrong from time to time, losses still don’t feel any better than they did back then. The biggest difference, however, has come in better understanding the hurdles we face when dealing with loss – namely the ability to differentiate risk from volatility, and our ability to be patient. The combination of these three elements has undone more investment plans than all the market crashes combined.
Risk is the possibility of permanently losing capital. This is what happens when investors get involved with lottery-ticket type investments, certain investments with fixed maturity dates, when odds are out of favour, when investments or business models tend to have too many moving parts, when business models are unproven, or when a business is simply of poor general quality. Volatility is a very different concept -- it is the ups and downs we have to put up with along the way, regardless of the underlying quality of the investment. High quality and poor quality investments will both experience the ups and downs of volatility, however only poor quality investments will experience the true risk of loss.
Risk and volatility are easily confused because their effects look the same to inexperienced investors. Short term loss is hard to distinguish from long term loss because they both appear as negative numbers on a monthly statement. However we know that by using a disciplined and proven investment process that the negative effects of volatility diminish over time. For example, our three-month returns of the Growth Portfolio can and will be far more negative than our long term returns. Our more important concern, then, is avoiding the permanent loss of capital. Since our discipline ensures we buy only simple high quality companies with a well-understood margin of safety, we significantly minimize the likelihood of permanently losing capital. I cannot over-emphasize how important that is, nor how good that feels.
As long as we follow our process, the only hurdle left to deal with is patience -- our collective ability to sit through the volatility so we’re still around to experience the gains. Investing is a longevity game that rewards the most patient and reasonable players. The tough part is that patience cannot be taught, although its lesson will certainly be imparted. We don’t make money when we buy. We don’t make money when we sell. We make money on the waiting in between.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.