4 Things Billionaire Investors Have In Common – Part 2: Asymmetric Risk/reward by Lars Christian Haugen

This is part 2 of a four part series of short articles (click here to read part 1). Each article sets out to explain an important trait that billionaire investors have in common. The goal of these articles is to explain simple concepts that the best investors in the world use, that you can implement today. Success leaves clues and one of the best ways to learn is to deconstruct and reverse engineer what the best in the world do. So let’s get to it.

 

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

“Superficially, I think it looks like entrepreneurs have a high tolerance for risk. But one of the most important phrases in my life is ‘protect the downside’”. – Richard Branson

[drizzle]“To make a lot of money, you have to take a lot of risk”. How many times have you heard that phrase?

It’s something I had heard often and I accepted it because it seemed to make sense. However, I realized that billionaires don’t think this way. They are obsessed with risking a little to make a lot, so-called asymmetric risk/reward. Warren Buffett has a different way of explaining it: only swing at the fat pitches. And it’s what famous fund manager Mohnish Pabrai quips “heads I win, tails I don’t lose much”.

This is a simple, yet very important concept, so I thought it deserved some looking into.

Below I will show you three examples of billionaires who risked a little to make a lot. My goal is that after reading these examples you will change the way you look at risk/reward and consequently make better investing decisions. This thinking has helped me because I found myself making bad investments because I was impatient and wasn’t willing to wait for the fat pitch.

The first example is of a guy who made $4 billion personally on what has been called “the greatest trade ever”.

The Greatest Trade Ever

In 2009 Greg Zuckerman published a book called "The Greatest Trade Ever" where he chronicled how hedge fund manager John Paulson made out like a bandit during the subprime mortgage crisis.

According to Zuckerman, Paulson’s hedge fund made $15 billion in 2007. Paulson made nearly $4 billion personally. Apparently, it was the largest one-year pay out in the history of the financial markets. Below is a chart showing the monthly return of Paulson’s hedge fund. You should note that in the investing industry, a 15% annual return is seen as very good. A 20% annual return is extraordinary:

Billionaire Investors, Asymmetric Risk-Reward
Source: Wall Street Journal
Billionaire Investors

In July of 2007 Paulson made 76% alone! And in several of the other months his return was multiples of what a great hedge fund can hope to make in a year. You might think that he had to risk a lot to get these returns, but that’s not the case. According to Zuckerman he only had to risk 8% per year to enter the trade. His downside was 8%, while his upside was several hundred per cent.

Zuckerman tells a funny story about Paulson’s analyst who discovered the trade (it was not Paulson himself who discovered it). After the dust had settled from the subprime crisis and Paulson’s fund made all that money, the analyst was on vacation with his wife.

His wife stopped by an ATM and checked the balance of their checking account. The number that appeared on the screen was a handsome $45 million. The money had recently been deposited in their account and it was the bonus for discovering the trade.

Not a bad payday for finding one trade.

A very impressive part of Paulson’s accomplishment was that he wasn’t even a real estate investor. And he didn’t even discover the trade, it was his analyst. So how the hell was a guy who didn’t even specialize in real estate able to pull off the greatest trade in history?

It’s because he looked at the world differently, and he sought out to structure trades that would limit his downside, and give him a huge upside. Most of the people he presented the idea to did not believe in the trade. Some even considered pulling their funds. The trade and its structure were too unconventional for normal investors to accept. But by definition asymmetric risk/reward trades need to be unpopular, or else they would not be asymmetric.

The Billionaire Who Bought 20 Million Nickels

Another hedge fund manager that made his name during the subprime crisis is Kyle Bass, who reportedly made a return of 212% in 2007. He was actually one of the people that Michael Lewis interviewed for his book “The Big Short”, but Bass was left out of the book in the end (however, he was portrayed in Lewis’ next book “Boomerang”).

Bass is another billionaire who looks at the market differently than the average investor. On his subprime trade he reportedly only risked 6 cents to make 100 cents. That’s almost a 17-1 risk/reward. I have to admit that I didn’t even know those type of investments existed.

After his subprime success he took it one step further. He asked himself “how can I find an investment that has no risk”?

He found it in nickels…..yep, nickels. He reportedly made a $1 million investment in nickels, i.e. he bought 20 million coins.

You’re probably wondering: “how in the world is that trade supposed to pay off”?

Well, according to Bass it takes the government almost 10 cents to produce a nickel. And the material that is in the coin is worth 6.8 cents. He concluded that eventually the government has to stop producing these coins, because they can’t continue making something that costs twice as much as it’s worth.

Bass makes the point that from day one the asset you are buying is already worth 36% more than you paid for it (it costs 5 cents, but the value is 6.8 cents). And there is no downside because a nickel will never be worth less than 5 cents.

And when the current version of the nickel is eventually stopped being produced, these coins will increase in value (because of scarcity). This apparently happened with the penny.

According to this article almost all pennies made before 1982 are made up of 95% copper and 5% tin and zinc. In 1982 the US Mint changed the composition of the penny because it was too expensive to produce the penny from copper. Pennies now have the current mixture of 97.5% zinc and 2.5% copper. Today, the amount of copper in an old penny is worth a little more than 2 cents. That’s a 100% premium on the face value of the penny.

Apparently pennies that are out of date can be worth quite a lot of money. According to this list, pennies can fetch anything from $1 to $1,200 (a value that is 120,000 times the original value!).

Most people would probably not look for trades that have no downside risk, while having a guaranteed upside. And they would definitely not go out and buy 20 million nickels. But that’s what sets billionaires like Bass apart from the rest of us.

The Greatest Money Making Machine In History

Stanley Druckenmiller and

1, 2  - View Full Page