Don't Worry About Being 'Right'; Focus On Risk Vs. Reward

by: Jake Huneycutt

"You were wrong!"

How many long-time investment authors have received this comment? I'd wager to say virtually all of us. Sometimes, the commenter cannot even wait a single day to make the declaration. Once, I published an article on a Wednesday morning, the stock fell 2% by noon, and a brash commenter declared me "wrong" by 2 PM, even though my investment timeframe was measured in years, not hours.

My most recent "you were wrong" moment came from an article I wrote back in June on "5 Inexpensive Stocks in an Overheated Market." I'll at least give the commenter credit for waiting all of six months to make the declaration, but the amusing part is that even if you ignored all nuance in the article and created an equally weighted portfolio with all 5 stocks on that day, you would have generated a 15.4% return, versus the 11.6% return on the S&P 500. In that article, I mentioned that Genworth Financial (NYSE:GNW) and BP (NYSE:BP) were my highest confidence picks. GNW was up 105% in 2013 and 37% after the article's publication. If that's the definition of "wrong," I'll gladly take it.

It wasn't all roses for me in 2013. As the market has pushed upwards, I made more attempts to hedge my portfolios. The restaurant sector, in particular, looked overheated to me and I shorted 3 companies in that sphere. Back in May, I decided to write about one of those companies: Sonic Corporation (NASDAQ:SONC). My thesis was that franchisee ROE had plunged in the past few years, and that franchisee growth would stagnate, as well. Since I published my first article in the series till the end of 2013, Sonic was up 64%. Somewhere, Nelson Muntz is pointing his finger at me, saying "HAHA!" Yet, strangely, I got the "you were wrong!" comment on Genworth, my big success story, and not Sonic, my big flop.

That leads to a critical insight: "right" and "wrong" are very subjective and emotionally charged distinctions in investment. I can think of plenty of times when my investment thesis was "wrong," but that the investment worked out well anyway, because I bought in with a significant margin of safety. Conversely, I've seen cases where investors have been "right" about a thesis, but lost money because they paid too high of a price to get in. This is one of the many reasons why worrying about being "right" or "wrong" is a poor way to think about investing.

Moreover, there's no shame in being "wrong" in investment. Even the best public equity investors are normally outright "wrong" at least 30% - 40% of the time and very few investors are right more than 60% of the time. That's because public equity investment is a realm rife with uncertainty, and none of us could possibly predict everything with anything close to total accuracy (that is, without engaging in activities prohibited by the SEC).

The real secret to being a great investor isn't being "right." It's shifting the odds in your favor. You want to be the casino, rather than the dopey gambler. Being "right" or "wrong" isn't ultimately that important; but focusing on risk versus reward is vital.

Being Wrong 90% of the Time and Being a Great Investor

There's a lot of variation in the investment world. There are certain areas of investment where one cannot afford to be wrong more than 10% - 20% of the time. For instance, a high-grade corporate bond investor, or an LBO (i.e. leveraged buyout) private equity fund, generally needs to be "right" on most of their investments.

At the other extreme, there are some investors that can be wrong 90% of the time and still do quite well. Venture capital is one such area. If you don't believe me, check out the model below of a venture capital fund.

In the model, the VC firm invests in 20 different companies, over a 5-year timeframe, putting $1 million in each. For 18 out of the 20 companies (i.e. 90%), the VC ends up losing 100% of his or her initial investment. That's a worst case scenario! And yet, our VC still comes up with a spectacular 27.9% annualized return over 5 years. The secret is that investments "D" and "R" were so wildly successful, that it more than made up for all the other 18 duds.

This is not that atypical of a profile for a successful venture capitalist. I use this extreme example to make a point. Our venture capital investor was wrong an awful lot, but he fared very well. He was swinging for the fences and he hit two grand slams with investments "D" and "R" which had 5-year returns of 2,450% and 6,200% respectively. All of these VC investments were extremely high-risk, but the evidence also suggests that at least some of them had a very high upside, too.

Unfortunately, as public equity investors, we probably can't afford to lose 100% on 90% of our investments, but the broader point remains. While being "right" or "wrong" isn't completely irrelevant (after all, our VC needed to be "right" on two investments), it's not the most important thing in investment. A successful investment manager understands risk and reward and how to play them in his or her own favor. Sometimes, the best investment is one where if you're "wrong," you still come out in good shape.

The Emotion of "Right" and "Wrong"

When you focus on being "right," you focus on the emotional aspect of an investment. When I was 16 years old, I worked at a Domino's Pizza (NYSE:DPZ) in East Tennessee, answering phones, slapping out pizzas, and tending to the ovens. I also had another speciality: I knew virtually every street in my hometown. For this reason, I was often the "go-to" guy when it came to directions and I got to know most of the delivery drivers very well.

One of my favorite drivers spent his days working in manufacturing and his weeknights at Domino's. Every Saturday night, however, he would visit Harrah's Cherokee Casino to play video poker.

One Monday night at Domino's, he bragged to me about how well he played, saying that he had won $350. He'd tell the other drivers about his experience and his winnings. The next week, he'd come back and I'd ask him about his weekend and he'd tell me he lost $300. He was honest, but he'd always downplay it a bit, and wouldn't tell much of anyone else unless they asked about it.

Over the course of about 10 trips to Harrah's, he probably had 3 nights where he won quite a bit, and 4 nights were he lost quite a bit, and maybe 3 nights where he broke even. But he'd always triumphantly sing the praises after the winning nights, and downplay the losses. Sometimes, even on the "break-even" nights, he'd brag a bit about how he was down a bunch, but got back up to $0.

Ultimately, what I think my friend displays is that we really like being "right." Being "right" feels good. But in the case of video poker, so long as you're a halfway decent player, you're probably going to come out ahead at least 30% of the time. The problem is that you'll come out behind more often than that. Indeed, if we analyze the "Jacks or Better" game, we'll find that for the average $5 bet, the weighted average most likely outcome is a 2.2 cent loss.

Gamblers often feel really good when they win, but over the long-haul, they will almost inevitably come out behind. The odds are rigged against them. From an investment perspective, playing video poker is always a bad decision, because the odds favor the house, and not you.

The Martingale Roulette Betting System

While the poker example may seem obvious, let's do another casino example that is less so. When I was 10 years old, I rented a casino gambling game called Caesar's Palace on the Sega Genesis. While I was a bit young to be playing a video game on gambling, I was really fascinated by the math behind all the casino games.

In the game, I came up with a roulette betting system, where I would always bet on black, and then double-up when I lost. The odds of winning a single bet on black are 18 in 38, or about 47.37%. I would start by betting $5. If I won, I would then make another $5 bet. If I lost, then my 2nd bet would be $10, rather than $5. If the 2nd bet didn't work, then I would bet $20 on the 3rd bet. Then $40, $80, $160, $320, and so on until I finally won again. The idea behind the system is to always recoup your initial loss, and then make a $5 profit on top of that.

As I discovered later in life, this is a rather common strategy called the Martingale system, and it doesn't really work. It increases one's odds of winning in the short-term, but over the long-term, you'll still come out behind. The Martingale system can be analyzed under Nassim Taleb's "black swan" theory. Under Martingale, gamblers will win virtually all the time, making small profits, but eventually, a low probability chain of events occurs that causes extraordinary losses greater than all of the gambler's winnings.

That's exactly what happened to me playing the Caesar's Palace video game at 10 years old. Over the course of several hours, I had decided to up the initial bet to $50 had made profits of over $15,000 using this little system. But it all came to an end dramatically, after a streak of 10 consecutive non-black results, in which I ended up losing $25,600. The odds of that event were very low; about 1 in 613, or 0.16% to be precise. Eventually it happens, though, and the gambler loses everything. With a bigger starting pot, one can delay the reckoning even further, but the odds still catch up eventually.

So in my scenario using Martingale, I had created a system where I was right 99.84% of the time, and still came out behind. I can think of no better example of why "being right" or "wrong" isn't the most vital consideration in investment. Risk and reward is everything, and no matter what "system" you come up with, if the risk / reward balance disfavors you, you'll likely come out behind in the long-term.

The Best Investments Involve a Margin of Safety

If risk and reward are what matters, then what constitutes an ideal investment? My answer would be one with a high upside and a large margin of safety. Two of the best examples from my own investment experience were Stillwater Mining (NYSE:SWC) in late 2008 and Pulte Homes (NYSE:PHM) in mid 2011.

In November of 2008, Stillwater Mining fell below $3. Stillwater, at the time, was a platinum and palladium miner in the Western United States. It had always been a volatile stock, reflecting the constantly shifting prices of the platinum group metals ["PGMs"]. While I had no idea when palladium or platinum prices might rebound, I thought it would eventually happen, and that the upside for the stock was easily in excess of $15, and potentially over $25 in a supply-constrained PGM market.

I bought the stock based on a simple rationale: even if I had to wait 5 - 10 years for a price rebound in PGMs, it'd still probably be worthwhile, since the stock would likely return anywhere from 300% - 1000% in such a scenario. Given that the stock was selling well below the book value of the company's assets at that time, and I saw no reason to be highly skeptical about those valuations, I also viewed the downside risks as low.

Imagine if you will a scenario where the stock price for Stillwater stagnated for about 5 years, then began a climb upwards in Years 6 through 8, eventually hitting $15. In that scenario, I would have made a 400% return. Even though I had to wait 8 years on it, my annualized return would have still been a very impressive 22.3%. That was precisely my rationale in making the investment. Even if I ended up being "wrong" about a price rebound for several years, the odds (i.e. the risk / reward balance) heavily favored me over the long-term. Fortunately, I didn't have to wait 8 years and the stock was selling above $16 in 2010, when I sold off.

My other favorite investment of all-time was homebuilder Pulte Homes in 2011. I had established a small position in Pulte in November and December of 2010, even writing about it on Seeking Alpha. The stock was selling at around $7 at the time, and I view fair value to be in the $15 - $25 range. In a bull market, I could even envision the stock shooting back up over $40.

Pulte fared poorly over the next eight months, falling below $4 by July 2011. That same month, I penned an article postulating that the housing market rebound would be much larger than expected, and why it would benefit the homebuilders. To say that I doubled-down on PHM would be an understatement, as it became close to a 10% position in my portfolio, the largest position I had ever taken.

At the time, the stock was selling well below book value. It got to the point where I could envision no scenario where PHM's net asset values could possibly be lower than market value of the stock. Moreover, if there were a housing rebound, PHM would be highly leveraged to it, and have huge upside. If PHM were to rise to $20 from that level, I would see a 400% return.

Very similar to the SWC investment, I viewed PHM as a stock that even if I had to wait it out 5-10 years, it would still be worthwhile. Once again, I was fortunate the rebound came much sooner, but if I had been "wrong" for 4 or 5 years, before being "right," that would have been fine, because the risk/reward balance was heavily tilted in my favor.

These two investment opportunities were quite extraordinary and don't come along all the time. Indeed, this is quite rare, but I use it to provide clear examples of how investors can rig the odds in their own favor, by buying an investment with significant upside, and a margin of safety.

Measuring Performance

One common issue in investing is how to assess performance. Many investors (including myself) compare their performance to the S&P 500 but this method has both benefits and detriments. I won't provide detailed advice on this issue, except to say that if you compare your performance to an index or an investment product, don't "chase returns." That is, don't become too worried because you are underperforming a benchmark on a daily, monthly, or even yearly basis.

Once you begin to "chase returns," you lose focus on the risk / reward balance. It doesn't matter if the average investor (via the S&P 500) outperformed you over the past two years if those investors were taking on too large risks for too little return.

Let's go back to the Martingale betting system example. A gambler using this system is often able to make many small profits over an extended period of time, before finally hitting a low-probability event that causes them to lose everything. Sometimes, investor managers embark on similar strategies that make their performance look great for a period, before the inherent risks in their strategy are exposed.

While I do like to compare my own performance to indexes, I am more concerned about outperforming over a very long-term timeframe (a minimum of 5 years), rather than beating the "average investor" on a daily or even yearly basis. It's more important to keep one's eyes focused on risk and reward, rather than on how everyone else is doing.

Have The Right Mentality

There are many important attributes to being a great investor and I couldn't possibly claim to have insight into all of them. Two different investors can have completely different styles and both be highly successful, even within the realm of value investing. As a value investor, however, I do believe that having the "right mentality" is important. My advice is thus:

1. Don't worry about being "right" or "wrong,"

2. Always focus on risk versus reward,

3. Invest with an adequate margin of safety,

4. Don't chase the returns of others or "the market,"

5. Concern yourself only with the long-term

These are maxims that I personally live by when it comes to investment.

Disclosure: I am long GNW, BP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short on SONC.

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