Saturday, March 19, 2016

If You Want Profit, Prepare For Loss

It's that time of year in the US Northeast where the weather is changing from bitter cold to more bearable temperatures. Unfortunately, something about the shift in weather seems to make people more susceptible to coughs and colds. I readily confess to being a bit of a germaphobe, so it's hard for me not to cringe when people are coughing or sneezing around me. It certainly seems like I use even more hand sanitizer than normal this time of year. But sometimes I meet people who are even more militant about hygiene:

Me: *Cough*
Them: "ARE YOU SICK?"
Me: "No, I'm choking on something."
Them: "Oh, that's fine then."

Charming, to say the least! Lack of empathy aside, it struck me that you can really take the whole hygiene thing too far. No-one wants to get sick, but there's a point when it become unhealthy to obsess over every sniffle around you, and when hyper-vigilance probably detracts from your overall health and well-being. This is especially true since common coughs and colds, while unpleasant, are usually short-lived.

Much of this applies to investing. No-one wants to lose money, but it's bound to happen at some point all the same. Despite the analyst's best efforts, markets occasionally sell off, taking good companies with them. Maybe a company's fundamentals change. Or sometimes - again, despite one's best efforts - the original analysis is proven flawed. There is an optimal level of insecurity analysis that should occur when investments go sour: too little, and you risk missing important feedback; too much, and you turn yourself into the very bag of nerves that characterizes Mr. Market.

The second part of this is ensuring that you can bounce back from losses, whether temporary or permanent. At a recent investor presentation, ExxonMobil CEO Rex Tillerson said that in his 41 years in the oil business, he hadn't learned any more about his ability to foresee the price of oil. Instead, he has learned more about how to deal with the market's gyrations. Similarly, a robust investing philosophy ensures that no one event can knock you out of the game, as unpredictable as that event may be. Reasonable diversification is one solution. Avoiding leverage is another. I'm a huge fan of the Buffett admonition: "If you're smart, you don't need it, and if you're dumb, you have no business using it." 

The final piece of this is committing to learning from losses, whether temporary or permanent. Nassim Taleb coined the term "antifragility" to describe things that gain from disorder. This is an even higher bar than merely being robust to disorder. Few securities, other than US Treasury bonds, seem to meet this criterion. Nevertheless, the investor who learns from mistakes over time is in fact benefiting from that disorder, and is thus long-term antifragile.

There's a saying: "If you want peace, prepare for war." I happen to think that rings true, even if it's often misused by people who have no desire for peace. I would paraphrase it this way: if you want profit, prepare for loss. Recognize that losses will happen at some point, and (1) prepare to approach them with equanimity and clear thinking, (2) prepare so that losses will be manageable, and (3) prepare to learn from the episode. This is the foundation for dealing with, and ultimately benefiting from, adversity in the investing arena.

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