One of the principles of Seth Klarman’s investment strategy is risk aversion. He’s not alone. Buffett uses it, who learned it from Ben Graham, along with several others because they place capital preservation above high returns.
In a paradoxical sort of way, Klarman has achieved higher returns, while focused on preserving capital, as a result of his highly disciplined strategy. That, of course, does not mean high returns are guaranteed. Rather, it only means that there’s a higher chance of avoiding big losses when you manage for risk.
During an MBA lecture, Seth Klarman gave his take on risk aversion:
Risk aversion is an interesting concept. The way I would think about risk aversion is most people would not want to toss a coin for their entire net worth. If you had a million dollars and I said, “Right now, we’re going to flip a coin – heads or tails – for your net worth. Do you have any interest in doing that?” I think most people would say no. And the reason they’d say no is it was hard to get to where they are today. That the incremental value of another million dollars to them emotionally, is a lot less than the cost of losing what they had and starting back at zero. And I think this is true for almost all individuals, almost all institutions, that almost everybody is risk averse.
A value investing philosophy squares with risk aversion. That value investing is basically the process of buying bargains – dollars for fifty cents or whatever you want to call it. And it involves the same kinds of principles that I think most of us would employ in our ordinary lives anyway. That if you went shopping for something, you went shopping for a car or you went shopping for groceries, and you found that the price of everything you were expecting to buy had just tripled overnight, that you would leave your money in your pocket and say, “I’ll come back another day,” or “I’ll go to a store down the street.” You don’t just buy it because it’s trading there.
So these risk averse principles have led us, as we looked out at the world, to think hard about being value investors.
So as we’re starting Baupost in 1982, we established several principles, that then and still today, set us a little bit apart from the rest of the crowd. One of the principles was we were going to focus on risk before we focused on return. That because of the risk aversion, because a lot of people weren’t doing that, and because, frankly, because we didn’t want to screw up and our clients didn’t want us to screw up. That our clients had worked hard to get to where they had, they didn’t want to slip back a lot. We were going to focus on the risk of what we were doing and specific investment by investment risks and in addition portfolio risks.
When I say that, it may sound like common sense. Like how could you invest without thinking about risk but the odd thing is, if you read Wall Street research reports from that era, perhaps even up till today but certainly from that era well on for many many years, they never talked about risk. They talked about the stock’s trading at $30. It’s worth $40. It’s a buy. They almost never…one or two percent of reports said sell. And even then, it was only a temporary sell or it’s fully valued sell. It was never, “It’s trading at six times what it’s worth. You better get about before you turn the lights off.”
So our focus was let’s not lose money. As I guess Ben Graham says in The Intelligent Investor – Warren Buffett requotes it, I’m pretty sure – rule number one in investing is don’t lose money and rule number two is never forget rule number one. And I think those are really important words. If you walk away with one lesson, remember that. That there’s plenty of investments. If they’re not great ones today, they’ll be great ones tomorrow or the day after. You don’t have to do anything. Losing money is very hard to get back to where you were, let alone to end up doing better.
Risk aversion is something everyone should think about. However, I’m not convinced it’s a strategy for everyone.
If you’re managing a portfolio based on risk, you’re steering away from the assets with the higher risk and toward assets with lower risk (In this case, risk is not beta. The goal is to avoid big drawdowns). But just the fact that tweaking is allowed, introduces the chance of misreading or ignoring risks.
The benefit of a risk-averse strategy is it tends to set up you up as opportunities arise, but it requires a willingness to act when risk is low. Which is exactly why it’s not the easiest thing in the world to follow.
Typically the times when real risk is lowest is exactly when perceived risk is highest. In late 2008 – early 2009, people saw the stock market as extremely risky, but hindsight shows that perception was wrong. It was the best time to buy. It also happened to be the hardest time to buy.
Risk aversion means having the emotional discipline to act when perceived risk conflicts with real risk. Without that, a risk-averse strategy becomes a bond-only strategy.
The reason Klarman and Buffett perform so well is that they have the fortitude to act when most investors won’t. There’s some skill involved too, but it’s their discipline that allows their skill to shine.
The Art of Losing Money
Seth Klarman on Absolute Returns, Risk, and Timing
Seth Klarman on Value Investing