When I was starting out as an investor my primary goal was earning the highest return possible. Following this path I got into all sorts of troublesome stuff like options and other high risk strategies in pursuit of the golden goose. Needless to say, none of these approaches worked out. There were brief spurts of joy, and a couple +100% gainers in the mix, but overall it was a bust. What I later discovered was so counterintuitive that I literally had to rebuild the entire way I looked at investments. I found out that you don’t get better than average returns by trying to get better than average returns. That was the fool’s way of building temporary wealth. It turns out that earning better than average returns is only a by-product of seeking out lower than average risk.
There’s this mythical investing paradigm that says high risk equals high reward and low risk equals low reward, I’m sure you’ve heard it. But what they don’t tell you is that relationship has never actually been proven. Instead, the evidence points in the other direction – it is the lower risk stocks that produce the higher returns, and higher risk stocks that produce the lower returns. Intuitively, this makes a lot of sense. There are old investors and there are bold investors, but there are no old bold investors. That’s because as you get more of it, you realize that capital is a responsibility and not a reward. So if you have a lot of capital, and you need to find something to do with it, lowering your risk is not just a choice, it’s the only choice. That’s one of those common sense ideas that’s not so common.
So how does one go about lowering risk? Below are some ideas that have worked around here:
First off, the simplest idea: be careful with cash. For many people, cash might appear to be the lowest risk investment around. But earning near-zero percent interest while inflation ticks along at over 1.5% per year is actually a guaranteed loss. You don’t have to get fancy with cash, but there are plenty of options that can be competitive with the rate of inflation.
Be selective and say “no” more. I’ve never tracked it, but I would guess that I say no to about 99% of the investments I look at in a given year. If I get a call out of the blue from a stock pitcher or a mutual fund salesperson, the automatic answer is no. A close friend of mine sent me an email recently about the hidden powers of no -- say no to everything. That way you can easily tell who’s passionate and who isn’t – the passionate ones will spend the time to follow up. Whether its investing or life, without passion, there is no return.
Buying companies with growing cashflow reduces risk. Growing cashflow allows more wiggle room on your mistakes, so if you buy something at too high a price, the cashflow growth will eventually make up for the gap. For this to work the company should have a long history of sustained cash flow growth that you can see in the financial statements. History is only half of the future, so you should also have an idea of the sustainability of that growth. Could you see people still using the company’s products in their current form five years from now? Usually only the most boring and run of the mill products pass this test. These companies are the ones with staying power and make good long term holds.
Buying companies that are cheap also reduces risk. No secret sauce here, just a lot of statistical evidence showing that if one makes a habit of buying unloved stocks, they will likely earn better than average results. Of course the main issue with this approach is you need guts of steel to buy companies that everyone else is getting rid of, and sometimes cheap stocks can get even cheaper. Goes without saying this route is not for everyone, which is one of the reasons it works so well. Another thing to keep in mind is these companies usually have very short staying power, so once they revert back to normal it’s time to sell and find the next one.
By combining the previous two ideas of growing cashflow with cheapness, you get a twofer. These unloved compounders are the things low risk dreams are made of.
One of my first clients, a very wise man, once told me, “Ben, don’t lose my money”. His success has inspired me many times over, and so in heeding his advice, I avoid situations that can result in the permanent loss of capital. If the economics become dim enough, any individual company can go bankrupt and any individual trade can result in a loss. But it’s quite rare, even in the dimmest of times, that a basket of companies all go bankrupt, or that a basket of companies fail to recover from a bad market. This is not an argument to put fifty stocks in a portfolio, but it’s not an argument to put only two stocks in a portfolio. Like jam on toast, spread it out but not too thin.
The final point is something I found out from a CEO with a reputation for building good teams. Before hiring a new person, consider if he or she brings the team’s average knowledge up or down. In similar terms, before adding a new company, consider how its risk compares to the risk of the existing portfolio. Add a new company only if it lowers the average risk of your holdings, otherwise keep what you have.