Few people understand risk in a way that makes it actually rewarding. That’s the message offered in The Zurich Axioms. The book lays out 12 Axioms that play off this idea.
In some cases, the Axiom runs counter to typical investor behavior. In others, it runs counter to popular thinking. And some are obvious. I guarantee you won’t agree with all of them, but it should, at least, give you something to think about.
These are the lessons from a few Axioms that stood out (check out the notes linked below or read the book for the full list).
Axiom #1: Worry is not a sickness but a sign of health. If you’re not worried, you are not risking enough.
In investing, most people want a risk-free reward. Yet, risk and reward are intertwined. No matter how hard you try to remove one, it affects the other. Not many get that.
Everybody wants to win, of course. But not everybody wants to bet, and therein lies a difference of the greatest magnitude. Many people, probably most, want to win without betting.
They also want to win without worrying. Most people strive for a “sleep well at night” portfolio because it offers security.
The Axioms propose the opposite. Worry is part of an adventurous life, one that takes personal risks. Put another way, an adventurous life is a rich life. A life avoiding worry is boring or poor.
Managing money is no different. To get rich, you must take risks. The price of risk is worry. If you’re not worried, you’re not risking enough.
A play off of this is excessive diversification. Meaning, your positions are likely too small to be meaningful.
So all else equal, a 1% position halved drops to 0.5%. Despite a 50% loss, the impact is insignificant to your returns. That probably sounds great to some people, but if a 50% loss barely moves the needle, any sizable gain will be insignificant too. So a 1% position doubled only become 2% of your portfolio. Despite a 100% gain, the impact is minimal.
If it doesn’t move the needle, why bother? Any position should be big enough to be rewarding but not so big to be devastating.
Axiom #3: When the ship starts to sink, don’t pray. Jump.
Not every investment works out. You should expect things to go wrong from time to time and have a plan for when it does. That means expect mistakes, expect bad luck, expect to be wrong about investments, but don’t let it debilitate your ability to invest.
When things go wrong, with little possibility of improvement, learn to cut your losses. To do that, you must be willing to take a loss. Of course, a few obstacles could stop you from doing that:
- Fear of Regret: Taking the loss, only to watch it recover, and miss out on the recovery. Recoveries will happen but not very often or quickly enough to wait. Investments gone bad often have problems that “are slow to develop and slow to go away.”
- Too Painful: Avoiding the pain of taking a loss, by holding and hoping, to break even. By avoiding the pain, you also avoid other opportunities that could get you back to even sooner. No rule states that you must make your money back the same way you lost it.
- Admitting You’re Wrong: Protecting your ego is a foolish reason to lose a pile of money. Markets humble everyone. Expect it to happen to you.
The goal of cutting your losses is to avoid watching a small loss turn into a big loss. However, some small losses are temporary blips. It’s the price of admission. Small losses “are part of the cost of speculation. They buy you the right to hope for big gains.”
Axiom #5: Chaos is not dangerous until it begins to look orderly.
A large part of investing is attempting to create order out of chaos. So you create plans, build strategies, and look for formulas to get rich off the patterns in market history. The trouble is humans are pattern seekers, who often confuse randomness for order.
The historian’s trap is a common example. You see a recent event, that looks eerily similar to some past event, and assume it must follow the same path. Unfortunately, history is only a guide, it’s not set on repeat. Most events rarely work out the way you expect.
And what about those formulas?
A formula that worked last year isn’t necessarily going to work this year, with a different set of financial circumstances stewing in the pot. And a formula that worked for your neighbor won’t necessarily work for you, with a different set of random events to contend with. The fact is, no formula that ignores luck’s dominant role can ever be trusted.
Luck, or chance, plays a bigger role in investment outcomes than most will ever admit. You can study the market, you might even be able to tilt the odds in your favor, but you’ll never find a formula that produces a sure thing. Despite better odds, chance exists because markets are chaotic.
Axiom #6 Avoiding putting down roots. They impede motion.
Avoid latching onto the familiar because familiar things in investing often offer comfort that can lead to emotional attachments. You end up with a feeling of loyalty or nostalgia, making it harder to sell.
In reality, no investment is too good to ever sell. Even the best investment has a price where selling it makes sense. The downside of an unwillingness to sell is missed opportunities which may be better than your current investment.
Axiom #10: Disregard the majority opinion. It is probably wrong.
Rene Descartes was a French mathematician and serial doubter. The lesson from Descartes is to doubt but verify:
The trick, he said over and over again in any number of contexts, is to disregard what everybody tells you until you have thought it through for yourself. He doubted the truths alleged by self-styled experts, and he refused even to accept majority opinions. “Scarcely anything has been pronounced by one [learned person] the contrary of which has not been asserted by another”, he wrote. “And it would avail nothing to count votes . . . for in the matter of a difficult question, it is more likely that the truth should have been discovered by few than by many.”
The easiest thing you can do is accept the words (opinions) — of experts, gurus, brokers, forecasters, rules of thumb…it’s a long list — as absolute truth. A harder way would be to question, examine, and verify.
Unfortunately, in investing, that’s harder than it sounds because markets are largely opinion-driven machines. That makes verifying more difficult. Then there’s the emotional side of taking an unpopular position. Going against the crowd can create doubt, making it easier to cave to pressure, even when the majority is wrong.
The mantra buy low, sell high is the perfect example. It’s simple and makes perfect sense, yet so few follow it:
As a general rule, the price of a stock – or any other fluid priced speculative entity – falls when substantial numbers of people come to believe it isn’t worth buying. The more unappetizing they find it, the lower the price drops. Hence the great paradox that isn’t taught in seventh grade: the time to buy is precisely when the majority of people are saying, “Don’t!” And the obverse is true when it comes time to sell. The price of a speculative entity rises when large numbers of buyers are clamoring for it. When everybody else is screaming, “Gimme!’ you should be standing quietly on the other side of the counter saying, “Gladly.”
The final lesson is that the idea of contrarianism can get distorted and taken too far:
The trouble with contrarianism is that it starts with a good idea and then hardens it into a grandiose illusion of order. It is true that the best time to buy something may be when nobody else wants it. But to buy automatically and unthinkingly for that single reason – to buy solely because the entity is unwanted – seems almost as silly as to bet unthinkingly with the herd.
Doubt but verify because sometimes the majority is right, just not always.
The Zurich Axioms
Notes: The Zurich Axioms by Max Gunther