Survive and Thrive – Long Term Investing in Certainty

Would you prefer to choose a safe stock that can earn consistently, or take a risk for higher than expected earnings? You might be thinking taking risks is okay, but in the long run, it can be quite damaging.

How does one even begin to decide what they’ll choose?

The following is a robust discussion of core concepts that are intended to serve as anchors for your investing philosophy and reminders to stay focused on following your investing rules. Don’t get led astray from your path to financial freedom by the snare of distracting thoughts of huge returns.

This is a lesson in thinking in terms of probabilities and outcomes. These ideas are meant to enable you to understand 4 important concepts:

1. Survival is key
2. Focus only on investing for long term
3. Invest in certainty
4. Luck vs. Skill

The Long-Shot of Risky Stocks

Let’s begin our discussion by looking closer at a probabilistic outcome that demonstrates why we invest in the safe – not the risky.

We have chosen 101 stocks. One of these is “safe” and the other 100 are considered “risky.” Through our research, we know exactly which one is safe, while we know the other 100 are risky.

The one safe stock will grow at a respectable rate of 10% per year. Every year. And there’s nothing uncertain about it.

The 100 risky stocks are much more uncertain. However, they (appear) to offer a much greater upside to make up for their associated risks. Every year, each of these 100 stocks will either double in price or have zero value (worth nothing). There’s a 50/50 chance of this happening each year. It’s impossible to predict what will happen in advance, which is the risk associated with risky stocks. It’s a coin toss.

By choosing the safe stock, we are assured our continued growth of 10% each year. But there’s also the dilemma of choosing a risky stock, because there’s a chance, we could double our money in only one year. However, we may also lose our entire investment. This is the trade-off in which we must decide.

For the sake of simplicity, we will assume that the 100 risky stocks are “uncorrelated.” I have an article discussing diversification here. This means, in terms of a stock doubling or going to zero, it does not affect the odds of another stock doubling or going to zero.

Here’s what the outcome would look like over 2 years:

• After Year 1, ~50 of the 100 risky stocks will now be worth double their original value. The other ~50 risky stocks would be worth 0.

• So, after the first year, about 50% of our risky stocks have failed, and the other surviving stocks would have doubled. The survivors have increased in value far more than the 10% of our safe stock. Remember, these are simply probabilities, but it’s also possible that all 10 risky stocks could have doubled or even all failed – but the odds are extremely low.

• After Year 2, we’ll have ~25 risky stocks doubled, and the other ~25 would be worth 0.

The Safe Stock Wins in the End

There’s something we should begin to notice here. The longer we wait, the more of the risky stocks begin to fail, and it’s only a matter of time until nearly all of 100 of them fail. The unlikely safe stock being the lone survivor and top performer at the end of all the carnage.

Let’s break down the odds of the safe stock being on top:

• After 8 years – 66%
• After 10 years – 90%+
• After 11 years – 95%
• After 14 years – 99%

After seeing this, do risky stocks still seem enticing? We all want to double our investment, but patience is key! Even if there is only a small chance of a company failing on a year-to-year basis, eventually it will happen – this is what we want to avoid at all costs.

Our goal as investors, is to avoid these large risks and temptations. Sure, it’s possible that you may get lucky along the way, but eventually that luck will run out. It is best to stick to safe investing practices and avoid the allure of the illusion.

Let Wall Street Play Their Game

If you lose your money, you’re out of the investment, there’s nothing left to compound. Our aim is to get a “good rate of return,” while taking a minimal risk in doing so.

Leave this risky investing to the money managers. They have incentive to be top performers on a yearly basis. A top performer will receive much higher investors or “inflows” into their funds when they are recognized as managers that greatly outperform the markets. Most of these managers are compensated based on the amount that they manage, rather than their performance, so they’re incentivized to take high risks and attract more investors to their fund.

There’s also venture capitalists (VCs). They take huge risks on startups hoping to outperform the market with their technical expertise. Even these investors experience a 90%+ failure in their investment companies and are simply hoping to land one “unicorn” (a company that becomes worth more than $1B), to make up for all the losses.

You can look at fund managers like authors that get acclaimed as New York Times Bestsellers. Even if they don’t stay on the list for long periods of time, they will still get the publicity to sell more books.

These top performing fund managers work in the same way which can result in millions of dollars of additional income for the manager with all their fees. So, for them, it’s extremely important to try to become a top performer. And in the end, it’s usually not their own money that they’re managing, so if they lose it, they can close down their fund and start another. It may seem hard to believe, but this is extremely common practice.

In an interview on Invest Like the Best podcast: NYU Professor Aswath Damodaran discusses the risks when investing with a fund manager. Here’s what he had to say:

“I think the way we rank managers based on NAV (net asset value – how much their portfolio is worth) encourages them to be not just risk takers, but reckless risk takers.

Because that’s how you end up being at the top of the alpha list or the best performer.

I would NEVER invest in the best performing manger, in any year or even over a five-year period, because I can almost wager that the best performing manager has a much greater chance of being the WORST performing manager, in the future periods than being in the middle of the group.”

You can listen to the entire 2 hour podcast here: Invest Like the Best – Aswath Damodaran

Is it Skill or Luck for the Risk Takers?

It might be difficult to determine if a fund manager’s success is the result of real skill or just a few years of luck. If it’s mostly luck, then it’s only a matter of time until their portfolio implodes. The best managers are able to outperform the market average for decades, but they are never the top performer on a year-to-year basis.

Warren Buffett wrote an article discussing the behaviors of fund managers in terms of flipping a coin and some similar qualities that a few successful fund managers have. It was published at Columbia University in 1984. Check it out: The Superinvestors of Graham-and-Doddsville.

In brief, he talks about the luck factor that many portfolio managers have, and they go onto selling their services as if they’re some kind of geniuses. He then shows the returns over longer time periods of successful managers and explains that they all follow the investing philosophy of Buffett’s professors at Columbia University – Benjamin Graham and David Dodd. This is the same ‘value investing philosophy’ that Warren Buffett uses today. If you’re interested here is the book: Security Analysis: Principles and Technique

Conclusion

Always stay mindful of your goal to survive and thrive while making long-term investments that are certain to secure your future. The next time you’re thinking about taking a large risk with your investments, review the following 4 concepts and keep them on the forefront of your decisions:

1. Surviving the market is imperative to continue compounding your portfolio over time.
2. We’re in it for the long haul – not a 1- or 2-year success. Generating a good return over a long period of time will get you the results you desire, which is what all great investors strive for.
3. Focus on investing in what you deem a sure bet. In the long run, sure bets will typically play out in your favor. There’s no need to take a big risk in hopes of getting ahead – this type of psychology can put a huge dent in your portfolio for a long period of time.
4. Distinguishing skill from luck in terms of investment outcomes is extremely hard. I’m sure you’ve heard of plenty of success stories and brilliant ideas that made a lot of money, but are you sure this was a brilliant plan or simply being in the right place at the right time? It will be really hard to distinguish to the two.

Stay patient, take a methodical sure-thing approach, be consistent, and in the long run it will surely pay off.

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