Posted on by CTKS · 3 Comments

The Resilient Investor

Black Swans are events that come as a surprise but have a major and disproportionately huge effect. In his book, “The Black Swan”, Nassim Nicholas Taleb argues that in today’s increasingly winner-takes-all world, Black Swans are becoming more frequent. Though not always bad, some Black Swans can lead to severe market crashes (most notably the Global Financial Crisis and the Covid-19 Pandemic). Somewhat related to my previous article on change and uncertainty, in this article, I will cover how investors can remain resilient in the face of volatility and uncertainty which is characteristic of our world today.

1. Respect uncertainty

While it is impossible to reliably predict recessions and market crashes, we can prepare for them by removing our vulnerabilities. As Charlie Munger once said “all I want to know is where I’m going to die, so I’ll never go there”. By reflecting on our potential pitfalls, we can become more financially resilient to crises. This applies not just to our portfolio but to almost all areas of life.

The most straightforward way to respect uncertainty is to have enough cash in reserve to act as a cushion because we never know what the future may hold. This is a point that I often repeat because having an adequate emergency fund is crucial. Having sufficient cash will help tide us over in the event of a prolonged downturn. For instance, if we did not have an adequate emergency fund during the Covid-19 Pandemic and were one of the unfortunate people who were furloughed, we would be forced to dip into our portfolio to tide us over. However, that period also coincided with a severe market downturn. Thus, we would have wound up selling some stocks at a significant loss. This highlights the importance of having sufficient cushion to avoid such a precarious situation which will require us to liquidate our portfolio at a loss. While this will mean that we will have idle cash on hand, this is the price to pay to be resilient, and one that we should be willing to pay.

2. Never depend on the kindness of strangers

Next, as resilient investors, we should never depend on the kindness of strangers. This means that we should avoid being in a spot where we are at the mercy of someone or something that is completely out of our control. A good example of this is to avoid excessive borrowing. While leverage can boost our returns in the short term, it diminishes our ability to stay afloat when disaster strikes. In other words, debt erodes our “staying power”. This is because when we take on debt, we are essentially promising the bank, or whoever we borrowed from, that we will consistently make a series of payments no matter whether times are good or bad. Thus, during periods of downturn when we may not have a stable source of income and our portfolio will likely be performing poorly, we will still be obligated to make payments. This is one scenario where we will be at the mercy of the creditor. More often than not, one will be forced to liquidate his assets at a loss just to meet the obligations. Thus, during the good times, take the opportunity to reduce and eliminate bad debt and avoid excessive leverage.

A corollary to this is that we should also avoid investing in businesses that take on excessive debt and/or are capital intensive. Such businesses have high fixed costs that need to be paid no matter whether times are good or bad. For instance, airlines consistently incur high fixed costs in terms of aircraft maintenance and typically have a debt-laden balance sheet. This means that even during periods where few planes are being flown (such as the past year and a half), cash is continuously being burnt. A company with high fixed costs will require a constant cash flow just for survival, making them more risky as they are more likely to go bankrupt during a severe crisis.

3. Instead of fixating on short-term gains or beating benchmarks, we should place greater emphasis on becoming shock resistant, avoiding ruin and staying in the game

As previously covered in my article on diversification, a certain degree of diversification can reduce the risk of our portfolios as the complete failure of a single holding will not lead to financial ruin. Indeed, doing so will incur an opportunity cost in terms of potential returns forgone. For instance, instead of having a hundred percent of our portfolio in cryptocurrencies that can potentially return 2x, 3x, or even 10x our money, we may be holding blue-chip stocks or making contributions to CPF that have lower returns. While I agree that diversification will mean that we will not be maximising our returns, I would argue that a sufficiently diversified portfolio is necessary to avoid financial ruin.

In fact, maximising returns should not be the goal if you are looking to create long-term wealth for your family and retirement. The goal should be wealth preservation and growing your savings at an adequate rate so that you can enjoy your golden years. If you are looking to create long-term, resilient wealth, you cannot operate like a heat seeking missile. Always be wary of greed.

This will also mean that there will undoubtedly be times when you may lag the market, but you must have the resilience to stay the course and trust in your framework.

4. Beware of overconfidence and complacency

During a bull market such as the one we are in the midst of now, we may be seduced by a false sense of safety. With every stock taking off to the moon, we may fall into a state of complacency and be overconfident of our ability to pick individual stocks. During such instances when the entire market seems to be defying gravity, we as investors should be keenly aware that this may signify excessive optimism in the market.

This quote from Warren Buffet can provide insight into how we should behave, “be fearful when others are greedy, and greedy when others are fearful.” When the market seems to be obsessed with chasing high returns, driving the valuations of companies sky high, all the more should we be wary of chasing fads.

This is not to say that we should attempt to time the market. We should stay the course and continue to dollar cost average. At the same time, abide by the timeless laws of the stock market which act like the laws of gravity. Continue to follow sound principles and invest in great businesses at a cheap prices. This will protect us from permanent loss when disaster strikes.

5. Always require a margin of safety and be keenly aware of your exposure to risk

Last but most definitely not least, the fifth method of being resilient is to always demand a margin of safety. A margin of safety in terms of investing can be seen as the percentage difference between the stock price and what each share is actually worth. A company selling at a price significantly below the intrinsic value of the company is said to provide a margin of safety. As resilient investors, we should demand an adequate margin of safety which acts as an insurance against mistakes, which are bound to happen. It is said that we should expect to be wrong a third of the time. Having a margin of safety means that even when we are wrong, we will not be severely wrong such that we will incur devastating losses. Shoot for the stars and land on the moon. On a similar note, we should focus on our exposure to risk. Always ask yourself “what could go wrong?” and “what is the consequence going to be?”. A margin of safety will help reduce the consequences of mistakes on our portfolio.

Similarly, the concept of a margin of safety applies to life as well. When we are making plans, we should also factor in a margin of safety. For instance, if we want to retire with a million dollars at 65, aim to hit a million by 55 and everything else will be icing on the cake. This way, even if we suffer a setback such as getting retrenched or falling severely ill, we have sufficient cushion and may still be on track to hit our goal. Shoot for the stars and land on the moon.

I find this quote from Jeffrey Gundlach, a successful investor and businessman, apt to sum up this article on how to remain financially resilient: “Make your mistakes nonfatal. It’s fundamental to longevity. And ultimately, that’s what success is in this business: longevity.” In essence, limiting our downside is key to building long-term wealth.

Posted on by CTKS · 4 Comments

Change And Uncertainty

“The only constant in life is change.” – Heraclitus, Greek philosopher

The everchanging and unpredictable nature of markets is a going concern that stresses many investors out. Perhaps we have an innate desire for order and predictability, which explains why uncertainty and change make us uneasy. Whatever the reason, given that change and uncertainty is inextricably tied to investing, we investors can do better if we face the truth. In this article, I will share three main ideas pertaining to change and uncertainty.

1. Everything changes, embrace the idea of impermanence

For how much the world changes, it is unexpectedly difficult to visualise how quickly the world changes. A simple experiment borrowed from Warren Buffet illustrates this perfectly. Below is a list of the top 20 companies by market cap as of March 21st, how many companies do you think will remain in this list 30 years from now?

Surely Apple, Alphabet (Google) and Facebook will still be here, there is no other company like them!

Now, let’s take a look at the same list in 1989, 30 years ago…

You will see many familiar names on this list in 1989. However, what is striking is that none of these companies remain in today’s list. Zero. This goes to show how hard it is to predict the trajectory of businesses. This is not to say that it is impossible for the 20 largest companies today to remain on that list in 30 years time but whatever number we think it will be, chances are it is less. It is thus foolish to believe that certain things will NEVER change.

As investors, we need to be realistic and doing so will involve admitting that we cannot predict or be certain about the future. Instead, we should view the world through a probabilistic lens. Some companies have a higher probability of doing well and becoming successful, while others have a higher chance of failing. There is no such thing as a sure win. In fact, if anyone tells you that a company is sure to return you many times your money, take your money and walk away.

Looking at investing in terms of probability can help us make better decisions. As uncertainty cannot be completely eliminated, we should accept that there will always be a certain degree of risk in investing (i.e. there will always be a chance of failure). The goal is to find investments that has a high probability of working out and even if it does fail, the loss is marginal. In other words, a huge upside and limited downside. Therein lies the argument for having a certain degree of diversification. By having our eggs in different baskets, we significantly decrease the probability that our entire portfolio will go to zero. Even if the worst happens (the business fails due to low cost competitors or lawsuits or another recession hits), and it will, we can avoid crippling losses.

2. Even in an unpredictable world, certain things are surprisingly predictable

The future may be extremely unpredictable but history repeats itself. In the markets, cycles are surprisingly predictable. In the business and credit cycles, period of expansions are followed by periods of contraction. Likewise, in the stock market cycle, periods of euphoria are followed by periods of depression, which are then followed by periods of optimism again.

Thus, it is possible to study patterns in the past and use them as a rough guide for what could happen next. One such example is the stock market cycle.

As seen in the S&P500 chart above, a period of euphoria (from 1997 to 2000) is followed by one of despondency (2000 to 2002), which is then followed by another cycle of extreme optimism and greed (2002 to 2007) which is followed by severe pessimism (2008-2009). More recently, the Covid-19 pandemic resulted in a huge market sell off in March of 2020. Soon after, the markets rebounded to all time highs. Thus, it is inevitable that cycles will reverse and reckless excess will be punished, and vice versa. Therein lies a possibility of turning cyclicality to our advantage by behaving countercyclically.

However, this is not to say that we should start timing the market and enter at the bottom to sell at the top. After all, it will be foolish to think that we can predict when the tides will turn.

Since we cannot change the environment or predict it, we have to adapt to the prevailing climate by being more aggressive or defensive. Instead of thinking of whether to invest or not as a binary decision, we should see it in terms of a spectrum. When the market crashed in March of 2020, wise investors would have acted counter cyclically by deploying their cash reserves and picking up more shares in great businesses. At times like today when the markets seem to be approaching dangerous levels, we can perhaps hold back a little and start to accumulate some cash, waiting for opportunity to present itself. Some may even consider trimming their positions. However, I personally would never completely sell out of my holdings in expectation of profiting from a market crash. The expectation of successfully doing so is simply unrealistic in my opinion. As Warren Buffet puts it, “be fearful when others are greedy and greedy when others are fearful.”

3. First be lucky, then be humble

In being honest with ourselves about our limitations and vulnerabilities, we will come to appreciate the role of luck and risk in our lives and investing. Regardless of whether we like it or not, the two cousins play a role in every part of our lives and even more so when the markets are concerned. Where there is luck, there is also risk. From the lottery of birth to the successes in life, luck plays an elusive yet decisive role.

Thus, we should always remain humble and never get ahead of ourselves. We may make a series of successful investments/bets, but never take it for granted that our future endeavours will see the same success. As quickly as luck can bestow us with an obscene fortune, risk can take it all away.

It also follows that we should be grateful and contented with what we have. Do not succumb to greed and take riskier bets or taking on too much leverage such that when the unexpected happens, we will be in financial ruin and unable to climb back.

Exercise adequate scepticism and prudence in this uncertain world. Do not take anything for granted, be it that Apple will continue its dominance or that a company will continue its growth trajectory linearly. Yes, this may mean that we will miss out on some of the explosive returns we are witnessing in meme stocks today. However, it also means we are protecting ourselves from financial ruin and remaining in the game, making sure that we always have another chance for luck to be on our side. This is perhaps the only way to deal with luck and risk.