Another factor that is very important to me in any investment decision is downside risks. I wrote about an overlooked concept of the geometric mean applied to probabilities and returns here
. In summary, if you invest $100 and can either win $55 or lose $45 (50/50 chance), then after two rounds you can only be up in 1 out of 4 possible scenarios. In other words, in 3 out of 4 cases you lose money!
Yet, your gain in only one scenario is so large relative to losses in the other 3 cases, that your mean outcome is positive (your original $100 investment could be worth $240.25 if you win two times in a row and your average value in 4 scenarios is $110.25). This can be said about the overall stock market which rises over time increasing the total wealth of stock market participants but these gains are spread very unevenly with very few collecting most of the wealth at the expense of the majority of participants.
This simple math example shows that avoiding losses is often more important than achieving short-term gains. Another example is this: if you earn 50% on $100, you are worth $150. But if you lose 50%, you would then need to earn 100% to just break even.
One of the key principles of value investing is Margin of Safety introduced by Ben Graham (see my review of his book here
and my article on Value Investing here
Using this principle, I think it is important to have the biggest weight in your portfolio in positions with the highest margin of safety (lowest risk). This principle was mentioned by Joel Greenblatt in the 2020 interview when he attributed his long-term success to his position sizing based on downside potential, whereas most people put most money in stocks with the highest upside.
Buffett has highlighted many times his focus on quality of the underlying business, integrity of management and generally minimising risks to Berkshire by maintaining a very conservative capital structure. Almost all of his and his family net worth is in just one stock – Berkshire Hathaway. Charlie Munger's portfolio is equally concentrated.
Moreover, by being very open about his investment strategy Buffett has managed to bring investors with a similar mindset into Berkshire. Unlike a typical corporation, most of Berkshire shares are held by individual investors, not professional money managers. I don't think you can find many speculators among Berkshire shareholders or investors with a short-term horizon. Other companies may have to choose options with short-term gains at the expense of long-term success due to pressure from shareholders.
This defensiveness and long-term focus can be seen in Buffett's patience with spending cash (over $161bn in 2Q21). Facing competition from a wave of money raised by Private Equity funds, Hedge Funds, SPACs and others as well as indirectly from the Fed, Buffett is willing to step aside and keep waiting for the 'fat pitch' rather than invest in a market that is expensive, yet continues to rise.
Berkshire's cash position accounts for over 15% of its total assets – one of the highest among large companies. I don't want to say that having a huge cash pile is an advantage and I would much rather see it invested in a productive and growing asset, but what is important is that Buffett is not affected by the Fear-of-Missing-Out syndrome.
During a 2021 annual meeting, Buffett said that Berkshire would never go below $20bn, although he raised this estimate to $30bn in a quarterly report for 2Q21 period. As Buffett explained, this cash position is needed to allow Berkshire to withstand any calamity and never have to tap emergency funds.
Such focus on protecting downside risks is quite rare. Most executives are willing to borrow to expand their operations or reduce share count which allows them to report better results almost immediately. This can last for a while until some emergency takes place, which sometimes wipes out all the equity (think of airlines in 2020 or banks in 2008).
But great companies can enjoy support of shareholders in their pursuit of long-term value creation at the expense of short-term losses or underperformance. Amazon is probably the best example, but so is Berkshire Hathaway.
By owning Berkshire shares you join the group of like-minded partners with controlling shareholders treating everyone as a partner regardless of their stake, on fair terms.
In his 2018 shareholder letter Buffett wrote: "A Russian roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company's upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don't risk what they have and need for what they don't have and don't need".