Margin of Safety
Markets can stay irrational longer than you can stay solvent.
Ben Mezrich’s book Bringing Down the House: The Inside Story of Six MIT Students Who Took Vegas for Millions details the story of Massachusetts Institute of Technology (MIT) students who used card-counting techniques to beat the odds at blackjack in Las Vegas. The story was later adapted into movies: The Last Casino and 21.
A valuable takeaway of this story is not that you need to be a maths genius or enlist a good team to get a leg up on the casino, but really that some of the techniques used by those students can be adapted to invest better.
The students used statistics to their advantage at the tables
They bet more when they realised that the odds were on their side and put less money at stake when they felt it was against them.They understood that the game was not based on certainties, but probabilities and possible outcomes
While they knew that they had a good chance to win based on their techniques, they were also cognisant of the fact that there was a chance to be wrong.They operated with a margin of safety
There was a particular passage from the book where the main character narrated: “Although card counting is statistically proven to work, it does not guarantee you will win every hand — let alone every trip you make to the casino. We must make sure that we have enough money to withstand any swings of bad luck.” So while they knew they had an edge, they understood that like Keynes’ quote at the beginning of this article — they could be hit with a string of bad luck, and so prepared a sufficient buffer to withstand this.
There Are No Certainties
These concepts are actually extremely relevant and applicable to investing. There are absolutely no certainties to making money. When someone tells you to “buy this stock because its earnings will be good” or “sell your bonds because the Fed will raise rates.” These are forecasts, not statements of fact, which may or may not pan out.
This is why diversification works, while it reduces the chance that you may make it big with a one-hit wonder, it also reduces the chance that you lose it all with that bet. Diversification helps to reduce the volatility and company-specific risk in your investment portfolio that can turn out to be disastrous especially if your portfolio is not constructed in a proper manner.
The diagram above shows that allocating to a broader universe of stocks helps to reduce the diversifiable risk — leaving you purely with market risk (i.e. the risk you take when investing in stocks). With this margin of safety, your money would not be unduly affected if the companies you invested in run into trouble.
Managing Expectations
As investors, we tend to focus only on the headline numbers. “This strategy should give you 15% gains” or “Make 40% from trading this way!”. Unfortunately, this is the fallacy of marketing and sales — the risks and possible negative outcomes are never clearly highlighted.
When dealing or planning anything, from an overseas trip to your finances, it is good to always cater for the possibility that something will go wrong. Take your holiday for example; it is likely that you would at least buy some form of travel insurance for your trip. This is to buffer some of your possible losses in the event your flight is cancelled or you encounter an accident during your trip etc. Additionally, if you are headed to a beachside resort to enjoy some sun, you might also want to plan some contingency indoor activities, in case you get hit with a sudden unpredicted wet weather surge.
Likewise for your finances, if you are saving up for something big like your retirement and are planning on your investments returning 15% annually over the years, you may be in for a rude shock when you finally reach your designated timeline only to find that you made far less than expected. There is no way to turn back the clock. That is why for a lot of our own simulations on portfolio returns, created during planning sessions with clients, we include the lower percentile returns (see diagram below).
The chart shows the possible outcomes from a $100,000 investment in one of GYC’s all-equity portfolios. Using the upper percentile returns may be good for boasting rights or an advertisement but serves little purpose for planning. What we really want to do is to ensure that in the event your returns fall below even the average outcome — the lower percentile returns do not scuttle or torpedo your entire financial plan.
Leveraging Reduces Your Safety Buffer
Leverage, in an investment sense, is the use of borrowed money to increase the potential return of whatever asset you are buying. The issue is that most people focus only on the gains and do not properly account for the downside risk. They may even be totally oblivious to it.
Leveraging can be like having superpowers, acting as a multiplier for the amount of rewards you can get. But if movies and literature have taught us anything, it is that superpowers used wrongly and carelessly can cause mass destruction.
The simple example below aims to illustrate this point. Without even catering for borrowing and transactions costs (which can be substantial) and other friction that comes with real-life investing; assume that you had $100 and wanted to play a simple game — double or nothing. Using your own money, you either end up with $200 or $0. Mentally we frame it as a 2x gain. What we fail to recognise is that the winnings also include our original $100.
So what happens when we use borrowed money to play the game? This is shown in the diagram below. You borrow another $100 to bet, and when you succeed it earns you $100 on your original money and another $100 on the borrowed money. This looks like a 4x gain but don’t forget, you need to return the borrowed money and account for your original $100. However, if you lose, this lands you you in the negative territory, possibly with some loan sharks on your tail.
Using leverage to invest reduces your margin of safety — while it can make the boom times better, it also can make the busts very much worse. The sell-off in 2022 coupled with rising rates have imploded many investment strategies which relied heavily on borrowing and large concentrated bets. As one of Warren Buffett's famous quotes goes: “Only when the tide goes out do you learn who has been swimming naked.” Unfortunately, this year has exposed many of those in the water without swimming costumes.
Unfortunately when it comes to money, many don’t cater enough margin of safety often enough. When economists or strategists give forecasts, they often express it in absolute terms: “Growth will be around 3.5%” or “the price target is $15”. These forecasts phrased as statements of fact are more commonly seen than the more accurate statements of “anywhere between 0% to 5%” or “we really cannot predict what the share price will be, but this is our best guess”. The problem lies in a behavioural bias where our brains crave some form of certainty, shunning anything which appears vague and undetermined.
Don’t think about your investments in black and white but instead, as various shades of grey with a range of possible outcomes. This will help you plan for unforeseen circumstances which could pop up along the way. If nothing happens, great — you would be sitting more comfortably on a larger financial buffer. But if something bad and unknown happens, you would be thankful that you prepared for it.
We have a vast and deep expertise helping clients and investors plan for the unknown when generating long-term investment goals and plans. Come and chat with us to find out more.
