HUMMONEY - The Risk of Interesting Investing (Perspective)

-- BY GREG LEWIN               

Research recently produced by Munich Re (a reinsurance company whose job it is to study risk) and reported in BusinessWeek reveals that traffic fatalities have dropped sharply with the introduction of safer vehicles with modern safety features.  However, the rate of serious accidents has not dropped. Their conclusion was that “We introduce risk-mitigation devices that are supposed to make life safer and then we change our behavior to make life more interesting.”   

Well, in investing risk is not interesting and seeking it without a meaningful change in reward is insane. The business of investing is very straightforward:  the goal is to acquire as much reward with as little risk as possible, and when you have unearthed the great anomaly in these two factors, place a meaningful amount of capital in this investment because these opportunities are rare. Investing is very cold.  It is simply about this ratio of risk and reward.  But the subtlety which will determine success and failure is all about the confidence you have in your assessment of this ratio and the probability of the outcomes of each factor.

In the extreme, confidence and capital commitment can be more important than being right or wrong. As an example, let’s say you make 100 investment decisions in which you are right the first 99 times, but each time you only invest $1. You only are wrong regarding the 100^th investment but you invest $100.  You lose. I understand this is an extreme example, but my experience has shown me that conviction plus capital commitment have consistently been more important decisions than wrong or right. However, it is also my experience that judging risk is infinitely more complex than evaluating reward. Let’s be honest - reward is all about the fun parts.  This is the path of fantasy and fiction where all your dreams come true, products sell, research succeeds, the economy grows and management plays it all perfectly. Risk, however, is the salt on the wound, competition, management mistakes, closing capital markets and business and consumers retrench.  All of this should change our behavior and not because it is interesting.

Finding a very attractive risk/reward ratio is important, but again my experience has shown me that only when the risk is low will you find an investment worth serious capital commitment and that is where the real money is made.  Now if you consider that the financial industry of any country is populated with reasonably bright, overly aggressive and hardworking people, it is reasonable to assume that when your assessment of risk and reward is very attractive, something is probably wrong because everyone is looking for this same anomaly and by definition have crowded out this exceptional return. There are exceptions, of course, but when you find them make sure you examine them extra carefully. As a rule, if you can find an investment that offers 3 times the reward of the estimated risk and can realize that result in the next 2 years, this may be worth your investment of time and energy. I share these proportions and timeframes for specific reasons derived from my experience because inevitably investors are overly optimistic in assessing the parameters that create reward and not adequately pessimistic about those which form the basis of judging risk.  To ensure a margin of safety it is good to start with a disproportion of risk to reward. Secondly, the further out in the future you are forced to forecast the less likely it is that your accuracy will remain true. Therefore, it is best to create a series of shorter term plans with embedded risk and reward parameters rather than longer term which may provide for a loose examination of performance leading to unmanageable losses.

The game is simple and sterile:  risk, reward and capital commitment. But the important nuance is managing behavioral disposition toward risk because investing shouldn’t be about making life more interesting, but rather about possibly facilitating a more interesting life.

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.