SWI's Framework: Understanding Risk and Taking Risk
Preserving capital vs. growing capital.
When it comes to risk management and capital preservation, investor giants Seth Klarman and Howard Marks are the first names that come to mind.
‘Playing safe wins matches’
Howard Marks’ four questions when entering a trade are gold:
How much money can I make if things go well?
What will happen if events don’t go as planned?
How much could I lose if things get bad?
And how bad would things have to get?
He compares investing to tennis and says playing safe wins. In most amateur tennis games and even professional tennis, the play style that minimizes errors (instead of going for winners - riskier shots) often wins Grand Slams (the biggest prize in tennis). Risk control wins.
However, investing is different.
Both Seth Klarman and Howard Marks' recent 10-year returns are less impressive (-10% and +200%, respectively), given their ultra-focus on risk management.
Hence, playing it safe doesn’t always win.
SWI’s approach - balanced
We also focus on protecting wealth, but we also want to position ourselves to participate in above-market gains.
Our 13 holdings have an average annualized return of 51% (ranging from 40% - 60% depending on the month). That didn’t come from playing ultra safe. It comes with buying enduring niche leaders, averaging up, paying up, and having a buying plan.
The latest one, Intellego, a niche leader in UV disinfection and curing validation [deep dive, 1st buy, 2nd buy, risk management, 1st live event], however, is down 39% after just 2 weeks of buying. But we are not panicking at all.
This is an excellent case study to help you understand why Intellego’s share decline/volatility doesn’t mean it’s risky (yet) and how we position to win.
Of course, we are ready to admit our mistake. For now, the facts suggest that we are not [1st live event], and we have a good plan in place to limit our losses. Let me explain.
What is risk, and why does it matter?
Investing horizon
Focus on facts
Allocation
What is risk?
Risk is losing your capital permanently (locking in losses). Risk is not understanding the business you own as well as the market. If you buy, why are others selling? If you sell, why are others buying? Can you make your case and provide evidence?
Why does it matter?
Understanding the level of risk you are involved in allows you to take the right amount of risk.
Not taking risks at all means you are not gaining anything (financially or intellectually). Taking too much risk means not understanding why your holdings are rising or falling in value.
Balancing it is key to learning and growing wealth.
To help you, consider the following aspects to know how much risk to take.
Investing horizon
When do you need the money you invested?
If it’s 10-15 years, buy stocks of great companies; valuation today matters less. You will have time to understand the business and take advantage of dips/volatilities.
If it’s 1-3 years, put your money in ultra-safe companies/index funds/interest-paying bonds. You won’t gain much, but you most likely preserve your capital.
Anything in between, and you can employ a mix of both.
Focus on facts
Volatility of the stock can indicate risk or uncertainties, but it is not risk. Importantly, it can be significantly different from the volatility of business performance (sales, profit, cash flow, product value, customer stickiness, competitor actions, and industry trends).
If you focus on the stock price, your thesis will be wrong one day and right the next. You become a slave to the market.
If you focus on facts, you will know the trajectory of the business, what value it is creating, and crucially, which business is not. Hopefully, as a result, you become a better investor.
Allocation
Allocate the ownership according to the level of your knowledge of the business and the likelihood of you being wrong.
For example, 24% of the SW portfolio is in Sea Limited, 15% in Mercado Libre, 11% in Grab, 9% in Wisetech, and 6-9% in Veeva, CrowdStrike, and Fortinet. Meanwhile, 3% is in the 21st pick and 5% in the 22nd pick, Intellego.
I know the top allocation very well, and I am comfortable letting them run and add more in dips. However, I need time for the more recent picks to prove themselves. When given the chance and it can’t, I will cut with no regret. The lower allocation and buying in stages will limit my financial losses.
Current performance means little. I’m learning and appreciate your feedback and advice. Please leave a comment by clicking the button below.
If our approach aligns with you, read more about us here, and our latest portfolio review here. We aim for above-market returns while taking low risk. You can read our Sleep Well Manual to gain a deeper understanding of our investment process.
