In the recent movie Free Solo, professional climber Alex Honnold gets his brain scanned. He’s on a quest to perform a free solo climb of the 3,000-foot-high face of El Capitan, an immensely technical, dangerous, risky feat. During this thriller of a movie, we see the climber’s meticulous preparation. He also gets his brain scanned. It turns out he is completely immune to risk.
RISK: Living on the Edge by Michael Tennenbaum
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Risk is a subjective term. Sixty years ago, risk-avoidance meant investing only in high-grade bonds, and getting a career with a large company. But notions of risk have changed. Many investors think that risk is volatility. In my experience, it’s not. It’s akin to a free climb, albeit without extreme physical danger, and those who attempt it may reap incredible rewards — so long as you’re well prepared.
There are not too many Honnolds or J. Paul Gettys (the financial equivalent) in this world. When the price of something varies a great deal, it scares lots of investors. They get caught between Getty’s approach and that of John Maynard Keynes. As Getty said, “If you want to make money, really big money, do what nobody else is doing. Buy when everyone else is selling and hold until everyone else is buying.” On the other hand, according to Keynes, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
In my business of investing, I view not being contrarian as being "risky." In fact it can bring tremendous rewards, so long as you’re mindful and well prepared. Here are five ways to start embracing risk’s investment potential:
Don’t shy away from volatility: High price volatility creates opportunity for the adept and disciplined investors. Recent research has shown that higher price volatility in traded securities has correlated with higher investment returns. Forget the experts: volatility usually is your friend.
Recalibrate your view of illiquidity: Most investment experts view illiquidity as risk. But no one quantifies the degree of illiquidity. Many publicly traded securities become hard to trade in during market convulsions. This has become worse with the increase in index funds, together with open-end mutual funds. Both are equity investments with overnight funding, and must buy and sell at the caprice of their investors. Many non-publicly traded investments can be bought and sold within 30 days, albeit with disadvantaged pricing. Yet, private investments usually offer higher returns and more control. Especially if you can buy larger investments, illiquidity is your friend over the long term.
Understand operational change: Certainly in my business, operational change is a risk. When an enterprise must change management, product or processes, predicting the future requires great humility. Given how rapid the pace of change is in technology, in consumer preferences, and in markets, all successful enterprises must plan for the unknown. As the Nobel prizewinning physicist Niels Bohr noted, “Prediction is very difficult, especially if it’s about the future.” I deal with this omnipresent risk by selecting opportunities that are confronted by major change risks — particularly business turnarounds — in which a positive outcome seems likely but the price of the investment reflects mostly the uncertainty, rather than the upside potential.
Learn, then learn more: The biggest risk in my business is investment error: buying the wrong thing, buying at the wrong price, or selling at the wrong time. Everyone makes some of these mistakes, whether or not they’re willing to admit them. One cannot acquire too much current information, or have too much training and experience, or try too hard in this relentless business. Now, all one needs to take a shot is some cash and a computer or phone. But all over the world, countless very smart, very experienced, totally dedicated people, with almost unlimited information flow, are devoting themselves to selling over-priced investments to you. As the late Cy Lewis, famed trader and Senior Partner of Bear Stearns, said, “An investment bought right is half sold.”
Avoid being your own biggest risk. Due to how our brains are wired, we can be our own biggest risks when it comes to investing. The primal, ancient part of our brain functions to warn us of threats. When investment prices surge, it warns us not to miss out, and when these prices plummet, it warns us to bail out. Far too many investors operate this way. While there are some of us wired to remain dispassionate about risk — and I know that, as I’m one of them; for the rest of us, it’s a matter of developing the mindfulness of when you are truly in over your head. Be aware of when your investments are making alarm bells go off that can’t stop going off — and take on less risk if you can’t gain any critical distance.
With preparation, self-awareness, and courage, you can consider more investment risks while minimizing investment errors. Just make sure that you’re ready to do so. It’s a life that’s not for everyone.
Michael Tennenbaum is the founder of Caribbean Capital & Consultancy Corp., a co-founder of Tennenbaum Capital Partners, LLC, and a former general partner of Bear Stearns, who introduced innovations in investment banking, risk arbitrage, and options during his Wall Street career. His book, RISK: Living on the Edge, will be published in August 2019.