Investing, as many of us have unfortunately come to know well (with the “war stories” to prove it), is far from foolproof. It is an inherently risky endeavor in the sense that any investment, no matter how well thought out the thesis and no matter how attractive the future prospects seem to be, requires an investor to accept some degree of risk. The degree of risk that is accepted by an investor may vary wildly from extremely low to extremely high, depending on the nature of the specific financial asset and the circumstances surrounding it. Investments in very short-term United States Government Treasury bills and FDIC-insured bank deposits, for example, are generally and conventionally considered low risk and reside on one end of the risk spectrum per “prevailing wisdom,” whereas other investments in, or perhaps more appropriately worded in this case, bets on highly speculative and risky securities such as microcap penny stocks, for example, reside on the other end. Most assets fall somewhere in between those two extremes, but the point is that every investment, by its nature, includes some degree of risk, simply because nobody knows with 100% certainty what tomorrow, let alone three years from now, holds for any given investment.
Alas, the future is uncertain. We’d bet that watching ten minutes of the evening news or casually thumbing through your preferred daily newspaper would be more than enough to fill you with anxiety, dizziness, nausea – you name the reaction, but it’s likely unpleasant. Yes, it is obviously true that investing has, on average and over most timeframes, proven far more lucrative than not investing at all; if it didn’t, why would anybody invest? Still, that fact probably has not provided much consolation to anybody who, for example, was heavily invested during the run-up to the 1929 stock market crash, in Japan in the late 1980s, or in U.S. subprime mortgage-related securities prior to 2008 and the onset of the Global Financial Crisis. In each of these as well as many other cases throughout financial history, extended periods of prosperity morphed into excessive optimism, the belief that “this time is different,” the irrational overpricing of stocks, and the gross underestimation of risk. As you know, none of those stories ended well.
A prudent, level-headed assessment of downside risk is essential to the long-term success of any investment program. Debacles such as the three listed above are debilitating to the long-term returns of any and all who are heavily exposed at the time the bubble inevitably bursts, often impairing the wonderful process of compounding by which investments grow in value over time. It might take years or even decades for an investor caught on the wrong side of a bubble to recover; Japan’s TOPIX and Nikkei-225 Indices, for example, have failed to come near revisiting their December 1989 peaks in the 26-plus years since. Although prolonged bull markets may occasionally seduce some investors/traders into thinking otherwise, the future is uncertain and risk is ever-present, perhaps most so at the very times when risk is perceived by many to be lowest.
So how do we grapple with this inconvenient truth and invest anyway, in spite of the uncertainty that the world brings? We certainly do not have a crystal ball in our office here at Moerus and because of that, we do not spend much time attempting to forecast and predict the future. Instead, we cope with investing’s inherent uncertainties by spending an awful lot of time thinking about risk in its various forms, and how to mitigate its presence in our investment portfolios. In truth, we believe that uncertainty should not only be coped with, but also embraced as a source of opportunity to invest in well-financed assets and businesses at prices that we think are compelling relative to underlying, intrinsic values. But how do we think about risk, and how do we strive to mitigate the impacts that risk has on our investment portfolios?