Reward-Risk or Risk-Reward?


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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.

Busy value investors take the hassle out of screening, valuation and grading stocks with Old School Value. Try the live demo today.

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