The Asymmetry of Ruin

I read this sto­ry in Tobias Carlisle’s lat­est book, “Sol­dier Of For­tune” (by the way, we inter­viewed him this week, should be out soon).

In Octo­ber 1998, War­ren Buf­fett stood in front of a room of busi­ness stu­dents at the Uni­ver­si­ty of Flori­da and offered them a deal.

Imag­ine I hand you a revolver, he said. A mil­lion cham­bers. One bul­let. Put it to your tem­ple, pull the trig­ger once, and I’ll pay you any­thing you want. Name the fig­ure.

He said he would­n’t do it for any amount of mon­ey because the upside did­n’t jus­ti­fy the down­side.

“I’m not inter­est­ed in that kind of a game.”

And I think that’s one of the most impor­tant lessons about invest­ing I’ve learned from Tony over the years we’ve been doing the pod­cast togeth­er. Invest­ing suc­cess­ful­ly for the long term requires a phi­los­o­phy of risk tak­ing. There have to be cer­tain risks you are will­ing to take, and ones you aren’t. It’s a mind­set. It’s an atti­tude. It’s a dis­ci­pline.

But it’s an idea almost nobody both­ers to talk about, because it does­n’t sell newslet­ters and it does­n’t make for an excit­ing hot tip. It isn’t about returns at all. It’s about not get­ting wiped out.

Rule #1: Never Lose Money

Temp­ta­tion is a won­der­ful thing. We’re all still tempt­ed by “the grass is green­er” even though we’ve been warned about it for thou­sands of years. Eve wants to eat the fruit of the Tree of Knowl­edge. King Midas gets exact­ly what he opti­mised for — every­thing he touch­es turns to gold… includ­ing his food… and he died of star­va­tion. Anakin want­ed to save Padme and gave him­self over to the Dark Side.

It’s easy to get sucked into the hot, new girl in the red dress (or, not to be sex­ist, the hot guy in the red shirt) — Mag7, SpaceX IPO, cryp­to, BNPL, what­ev­er the lat­est hype is.

But that’s why you need to have rules.

We always ask our­selves the same few ques­tions.

What is the val­ue of a sin­gle share (or coin) today?
And can I buy it at less than that val­ue?
How do I know what it will be worth a year from now?
How do I know when to sell?

Because there will always be anoth­er red dress. The mar­ket lives to pro­duce them. And if you chase after one, why not chase after all of them? How much time and mon­ey do you spend chas­ing them? When does it stop? Where does it end?

His­to­ry says… it usu­al­ly ends in ruin.

You can have nine bril­liant years in a row chas­ing hot young things, and a sin­gle year where you lose every­thing. Up 30%, up 25%, up 40%… then one ‑100% and you’re back to noth­ing, no mat­ter how good the sto­ry was up to that point. Gains add up. A wipe­out does­n’t sub­tract — it resets you to zero and takes the com­pound­ing with it.

Buf­fett wrote about exact­ly this in his 2010 let­ter to share­hold­ers, look­ing back at when he first took con­trol of Berk­shire:

“Even in 1965… per­haps we could have judged there to be a 99 per­cent prob­a­bil­i­ty that high­er lever­age would lead to noth­ing but good. Cor­re­spond­ing­ly, we might have seen only a 1 per­cent chance that some shock fac­tor, exter­nal or inter­nal, would cause a con­ven­tion­al debt ratio to pro­duce a result falling some­where between tem­po­rary anguish and default. We would­n’t have liked those 99:1 odds, and nev­er will.”

And then the line that should be tat­tooed on the inside of every investor’s eye­lids:

“A small chance of dis­tress or dis­grace can­not, in our view, be off­set by a large chance of extra returns.”

That’s the asym­me­try. The upside and the down­side are not play­ing on the same field. A big chance of a bit more mon­ey is sim­ply not worth a small chance of being car­ried out. You only get one port­fo­lio, and you only get one life to spend it in. The arith­metic of ruin does­n’t care about your bat­ting aver­age.

If we’re going to take a sto­ry about risk from lit­er­a­ture, we want to think of Icarus or Odysseus. Don’t try to fly too high. Don’t lis­ten to the song of the Sirens. Block your ears. Focus on your goal. Have some dis­ci­pline.

When genius failed

If you want to know how seduc­tive the oth­er side of this argu­ment is, look at the smartest peo­ple who ever fell for it.

Because we all think “I’m too smart to get caught out — I’ll sell in time if things go tits up.” But are you smarter than the Nobel Prize win­ners at LTCM?

In the mid-90s a hedge fund called Long-Term Cap­i­tal Man­age­ment opened its doors with what was, on paper, the great­est brains trust in the his­to­ry of mon­ey. Two Nobel Prize win­ners on the mast­head — Myron Scholes and Robert Mer­ton, the men who lit­er­al­ly wrote the equa­tions mod­ern finance runs on.

Their risk mod­els told them they were safe. Prop­er­ly safe. Accord­ing to LTCM’s own num­bers, for the fund to lose all its cap­i­tal in a sin­gle year would require a ten-sig­ma event — odds of rough­ly one in a sep­til­lion. That’s a one fol­lowed by twen­ty-four zeros. An event so rare it should­n’t hap­pen once in the life­time of the uni­verse.

So they did what the maths invit­ed them to do. They geared up — about 50 dol­lars of bor­rowed mon­ey for every dol­lar of their own.

Then the Asian finan­cial cri­sis began in 1997 and in August 1998 Rus­sia default­ed on its debt, and the impos­si­ble turned up right on sched­ule. LTCM lost around 44% of its cap­i­tal in that one month. About US$4.6 bil­lion gone in under four months. The Fed­er­al Reserve had to march four­teen banks into a room and arrange a US$3.6 bil­lion res­cue, not to save LTCM, but to stop the wreck­age tak­ing the rest of the finan­cial sys­tem down with it.

The event their mod­els said could­n’t hap­pen in the age of the cos­mos hap­pened inside four years of open­ing for busi­ness, not exact­ly any­one’s def­i­n­i­tion of “long term”.

Here’s the les­son buried in that. Mar­kets do not fol­low the neat bell curve the text­books draw. They have fat tails. The “six-sig­ma” cat­a­stro­phe that’s sup­posed to show up once every few mil­lion years actu­al­ly wan­ders past every decade or so — 1987, 1998, 2008, 2020. The bell curve isn’t a slight­ly-wrong map. On the days that mat­ter most, it’s the wrong map entire­ly.

You’re not running 50 to one. So what?

Okay so maybe you aren’t bor­row­ing fifty dol­lars for every dol­lar you own to invest. So how does this sto­ry apply to you?

It’s the prin­ci­ple of risk and reward. It’s the mind­set. The slip­pery slope of “too good an oppor­tu­ni­ty to miss out on”.

The ques­tion is nev­er just “what’s the upside?” The ques­tion Buf­fett actu­al­ly asks is “what hap­pens if I’m wrong at the worst pos­si­ble moment, with the most mon­ey on the table?”

And what is my dis­ci­pline? What am I pre­pared to walk away from?

As val­ue investors, we choose to stick to a plan — buy­ing high qual­i­ty com­pa­nies at a dis­count to their intrin­sic val­u­a­tion and then hold­ing them as long as our rules will let us. And say­ing “no thanks” to every­thing that does­n’t fit that theme.

A system that won’t hand you the gun

This is where hav­ing a process earns its keep, and where QAV does its qui­et, bor­ing, unglam­orous work.

The whole appa­ra­tus is built to sur­vive first and opti­mise sec­ond. Posi­tion siz­ing, so no sin­gle stock can sink the ship. Sell rules that get you out before a loss turns per­ma­nent — rules that fire whether or not you’ve fall­en in love with the com­pa­ny. Qual­i­ty and val­ue, spread across the buy list rather than bet on one roll.

None of that is designed to catch the absolute max­i­mum upside. It’s designed to make sure you’re nev­er the poor soul stand­ing there with the revolver against your tem­ple, doing the expect­ed-val­ue sum.

That’s the part peo­ple miss. A sys­tem isn’t there to make you a genius. The genius­es had a fund, and a Nobel Prize each, and they blew up any­way. A sys­tem is there so that being wrong — and you will be wrong, often — nev­er becomes being fin­ished.

The mar­ket will hand you the revolver even­tu­al­ly. The red dress will always show up.

But like Odysseus, we plug our ears, put our blind­ers on, and remem­ber the words of Syrio Forel, Arya Stark’s danc­ing mas­ter — “there is only one thing we say to Death: ‘not today’.”

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QAV Myth Killers is a week­ly col­umn in the QAV newslet­ter, tak­ing apart a piece of
invest­ing con­ven­tion­al wis­dom. Read the series, or
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