Reward-Risk or Risk-Reward?


AJ is a reader of Old School Value and was kind enough to allow me to post his thoughts regarding the email communication we had over my behaviour with EMAG. I attributed most of the problem to greed but he noted that although greed had something to do with, the underlying issue was that I and most other investors, seek rewards from risk. That is, we are categorised as “reward-risk” investors.

On the other hand, if we look at Seth Klarman, he has an AMAZING record. Throw in the fact that he is a master mind, but also because he always looks at risk and then reward. He discusses this in his book Margin of Safety, which you can find online if you look hard enough. Seth Klarman could be categorised as a “risk-reward” investor.

By focusing on the risk and investing only in situations where it is minimized to the fullest extent, he is getting an additional margin of safety. Also, by focusing on risk, the reward will take care of itself. It certainly is true according to his 20%+ annualized performance since inception.

This brings to mind Monish Pabrai. Another guru with a tremendous record but 2008 proved difficult for him as he bets heavily when the reward is high. One performed excellently in 2008 by focusing on risk to reward, one performed horribly by focusing on reward to risk.

If preservation of capital is not foremost on your mind each and every time you purchase securities, you are a “reward-risk” person. – AJ

This new framework is something that I must adhere to. Out with the old, in with the new.

Preservation of Capital

Presevation of capital is not just limited to the downside. I’ve never felt the need to take profits because I’ve always geared towards buy and hold. AJ puts it nicely.

by keeping risk-reward firmly in mind, especially in arb situations, you will realize you need an exit plan on the upside as well. When you buy you need to have pre-planned exit points on the upside (and downside). You won’t make as much, but you will have preserved your principal. For example, if the stock went up 40% on your original purchase price, sell 70% of it and ensure the safety of your principal – if the stock later crashes, you can cash out and still come out ahead – perhaps not 50%, but 5% for 2-3 months is nothing to sneeze at AND you sleep soundly at night … the 1% chance of killing your principal is not worth the upside – you have many years to invest, but you cannot invest money you have lost – slow and steady wins this race.

Benchmarking

Klarman also states in his book that he focuses on absolute returns. We’ve been trained to focus on IRR and benchmarks against the market, but what good is that it if the market loses $10,000 and I lose $8,000. I still lost $8,000. In a market such as what we have now, there’s no end to the surprises and the amount of money we can lose.

For AJ

Should something ever happen to me, how about taking over Old School Value :)

But in all seriousness, the email was too good to just keep to myself. Thanks.

  • You’re getting at something interesting here. Because the reward is the knowable thing (merger price minus market price), and the risk the difficult-to-know thing, it may be easy to fix on minds on the reward.

    In this market though, where stocks will sell off 50% or more when a deal falls through (BCE, EMAG, perhaps ROH?), the implication of your schema seems to be that risk arbitrage shouldn’t be used at all. If the reward is 10%, but the downside could be 40%-50%, you need to have VERY HIGH odds that the deal will close to justify the risk. If we concentrate on risk in this market, merger arbitrage may not make sense. If so, have we gotten too fearful? Or perhaps just smarter?

    Wide Moat’s last blog post..Warren Buffett on Moats

  • AJ

    Happy to be of service Jae :-)

    Thanks for the offer as well!

    In all seriousness – I have learned a lot from you and your blog, so I am more than happy to share!

  • Very good post. Thanks. I’m looking at ways of minimising risk too. You might be interested in this post: http://bit.ly/9UWA0

    Richard Beddard’s last blog post..The UK’s riskiest big companies

  • AJ

    WideMoat – you make some great points that I want to build on:

    First, our minds shy away from tough questions and latch on to quantifying things that we can grasp (50% upside). This perhaps is the reason we look at reward first … Quantifying risk IS the HARDEST thing to in any purchase, not least because it implies a thorough understand of the company, the situation, and the potential pitfalls. Nonetheless, this is exactly the moat we build to protect principal (Graham’s numero uno rule!). I personally feel that by not striving to measure risk rigorously we turn, as per Klarman’s definition, from investors into speculators.

    Second, on arb situations specifically – they are inherently risky, and if you read WEB’s partnership letters he says so repeatedly. What is great about them is their value in forcing you to be disciplined – because you might lose 50% on a given date, your brain will be scared into running the risk scenarios properly, losses will be keenly felt (e.g. Jae’s EMAG), and lessons will be learned more swiftly.

    Moreover, arb situations can serve as a wonderful training tool to improve our recognition patterns of uncertainty and risk and their separation, which is what Pabrai correctly tells us to do. In EMAG’s case, uncertainty and risk were intimately tied – we all figured that if the deal fell through, EMAG’s survival was questionable. However, the proposed Pfizer/Wyeth deal still provides great uncertainty (e.g. time, egos and antitrust), but the risk is much smaller – first, Wyeth is currently trading at $43, while before the deal’s announcement it traded at about $39, so conceivably downside is 10%; second, Wyeth is a strong company – 2008 Operating Cash Flow was $5.9 billion and they have a good pipeline – so the stock might rebound from any drop (should the merger fall through) swiftly or not drop at all (assuming the market agrees that it incorrectly valued Wyeth before…).

    Now to your point – should we be in these arbs? My answer is – if you find a high uncertainty, low risk arb with enough upside, bet big. If not, walk away having developed more discipline – this is Pabrai’s “Tails I win, heads I don’t lose much”. Even in such a situation I urge you to remain dynamic in your analysis of the arb situation – if the share has gone up 90% of what it can (the target price), the upside, downside and odds are now different – then I say sell all of it – I would rather have 90% of the gain for sure than 100% of the gain with a 90% probability …

  • JJ / AJ: Excellent differentiation between “rewards from risk” vs. “risk and then reward”. I couldn’t agree more.

  • Ken

    I really enjoyed this post. On the subject of risk arbitrage I would suggest reading “Den of Thieves” by James Stewart. It covers among other things the massive insider trading that took place during the M & A boom between Milken, Boesky, Levine, Spiegel and others. I think after reading this book it will give you a new outlook on the factors that go in to deals that we will just plain never know about. In retrospect with EMAG one thing I think I overlooked was how small the deal was and my lack of knowledge to the parties involved. I had no sense of how honest the management of either company is and feel that smaller deals will probably get less regulatory oversight with regards to insider information leaks.

    Ken’s last blog post..Risk Arbitrage & EMAG Post Mortem

  • @ Widemoat,
    If a merger has a 10% upside with a 40% downside, I would like now like to see the money guaranteed before investing in the deal. The BUD deal was a good example. Not much of a spread but the financing was guaranteed without the fishiness of SIBL.

    @ Richard,
    Thanks for the comment and the link.

    @ AJ,
    Good point about PFE deal.

    @ Ken,
    Will have to try and get a copy of that book. I’ve got 6 books I have to finish first though. The current one I’m reading is a complete loser.. don’t know why I’m still trying to read it.

    @ All,
    I still intend to participate in mergers but am now much more willing to sell and lock in profits rather than go for the whole prize. Profit is only a profit if it’s locked in.

  • This is really an interesting article. However, I would disagree with you on one point. You have mentioned that you believe and buy and hold. But money is made only when stocks are sold, and not while we are holding them.

    http://SaveFewBucks.Blogspot.com

  • You’re right about that. Unless you sell, its only theoretical money that’s in the air.

  • MKL

    Madoff’s clients had a lotta theoretical money.

  • Jae

    Great article, with some very good input from your readers here.

    STOCKMANMARC’s last blog post..$NYT, Railroads, And Lumberjacks?

  • o.O

    ^
    um.. there is something called dividend or is that all just an illusion now?

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