As part of a recent project I have been working on, I have been looking back at some of the lectures Seth Klarman (Trades, Portfolio) has given over the years. These lectures are full of insights from the value investor, and a few key themes run through all of them.
One of these themes is the benefits investors will see if they follow a set plan. Investing isn't a precise science, but an art, and we never really know what is around the next corner. With this being the case, Klarman believes it is vital for every investor to prepare for every eventuality, no matter what the current market environment or outlook is.
Prepare for everything
For many investors, this might seem like a waste of time in a bull market. If the market is continually rising, what's the point of preparing for a fall or an increase in volatility?
This overlooks a crucial part of investing: the fact we don't know what is going to happen next. The next crisis could be just around the corner.
This is something Klarman tried to get across in a lecture at the Massachusetts Institute of Technology in October 2007. After discussing the nature of the market at the time, the "Margin of Safety" author went on to say:
"Many investors lack a strategy that equips them to deal with a rise in volatility and declining markets. Momentum investors become lost when the momentum wanes. Growth investors - who pay a premium for the fastest growing companies - don't know what to do when the expected growth fails to materialize. Highly leveraged investors, like some quant funds in the headlines, were recently forced to sell regardless of value when their methodology produced losses rather than gains. Counting on a government bailout for every market crisis seems a dicey proposition, especially when supposedly impossible events happen on Wall Street every few years."
This simple quote outlines the importance of having an investment strategy designed to work in both of the good times and the bad. Klarman went on to say that "by the time the market drops and bad news is on the front pages, it is usually too late for investors react." As a result, he said, "It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy."
Klarman is trying to make it clear that having an investment strategy built for all environments is critical for long-term investment success. That does not mean it is essential to develop investment strategies for all market environments. Doing so would be extremely time-consuming and complex, and wouldn't guarantee outperformance or even market-matching performance when the crash eventually arrives. Most of the time, you will not have space to implement a strategy even if you wanted to.
Risk reduction
The key is to build risk avoidance into your strategy from the very beginning. This means concentrating on risk and downside protection from the very start and not relying on the market to give you indicators.
Risk reduction and analysis is at the core of everything Klarman does, which is why he has been able to achieve such a consistent record. The same can be said of Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio). They are long-term investors and want to make sure their money is always invested in opportunities with a near-zero risk of capital loss.
Put simply, to achieve investment success over the long term, you need to prepare for every eventuality. The best way to do so is by building risk protection into your strategy from the very beginning and avoiding investments that might suffer in a downturn because trying to predict when the next decline will occur is virtually impossible.
Read more here:
- 3 Deep-Value Stocks Trading at a Discount to Book
- How to Identify Frauds: A Framework
- What We Can Learn From Bill Ackman's Comeback
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