The Greater Mistake: Buying High or Selling Low
What is the greater mistake: buying at a peak and seeing a decline, or selling at a low and missing a recovery?
Itâs clearly the latter. If you buy at a peak and experience a downturn but remain calm, the next peak is usually higher than the previous one. You can return to your original value and perhaps even earn more.
Risks of Selling at the Bottom
If you sell at a low and miss the recovery, it means youâve deviated from the path of investing and may not return. This is one of the biggest sins in investing.
Mastery of Managers and Risk Assessment
Risk is not just about volatility. True risk is the probability of losses. For example, a manager whose assets grow by 10% when the market grows by 10% and declines by 10% when the market falls by 10% does not demonstrate skill. Such results can be achieved simply by investing in an index fund.
Asymmetry in Asset Management
Itâs important to find a manager who shows asymmetric results: when the market rises by 10%, they earn 15%, and when it declines by 10%, they lose only 5%. This added value demonstrates professionalism.
Probability of Losses and Risk Calculation
Risk is the probability of losses, and it cannot be accurately assessed beforehand or even retrospectively. A profitable investment may be tied to luck rather than low risk.
Risk of Insufficient Risk-Taking
One of the key risks is missing opportunities. If you are not willing to take risks, you may miss a significant market recovery or growth potential.
Probabilities and Combinations
What are probabilities? Each die has six sides, and there are 36 possible combinations of these six sides. We know that, for example, a sum of 7 is the most likely outcome, as there are 6 combinations (1+6, 2+5, 3+4, 4+3, 5+2, 6+1) that total 7. This is 6 out of 36, which is about 16.7%.
Excluding Numbers
But what if you want to exclude the number 6? Then we have fewer possible outcomes, and for a sum of 2 out of 36, there is only 1 combination (1+1). If you want to exclude 12, thatâs also one combination (6+6). Thus, the probability of both happening is about 3%.
Knowledge of Probabilities and Uncertainty
We know what the probability distribution looks like, we know what is most likely and what is unlikely, but we still donât know what will happen. Knowledge of probabilities does not eliminate uncertainty. As my professor Chris Gatsby said, âwe live in a sample, not in the universe.â Statistics defines what might happen, but in reality, there is only one outcome, and thatâs where uncertainty lies.
Super Bowl and Risk Perception
An example of this is the situation during the 2016 Super Bowl. A former football player was asked who would win the game between Denver and Carolina, when Carolina was leading strongly. In such cases, there can only be one of two possible outcomes. If the probability of something is 80%, many think itâs certain to happen. However, an 80% probability means the other team wins one out of five games.
Risk and Expected Value
Thus, risk means that more things might happen than will actually occur, and even if many things might happen, in the end, only one will. The expected value, the weighted average of the probabilities of possible outcomes, is often how decisions are made, but it can be misleading. People take each outcome, multiply it by its probability, add them up, and arrive at the expected result. Many people say, âLetâs act to achieve the highest expected value,â but sometimes the expected value isnât even one of the possible outcomes.
Errors in Expected Value
Letâs consider an action that has four possible outcomes: 2, 4, 6, and 8. Assume the probability of each outcome is equal. In this case, the expected value would be 5. But 5 canât happen because the outcomes can only be 2, 4, 6, or 8. This demonstrates the potential error of relying on expected value.
Nature of Risk
Now, letâs move to the nature of risk. People conducted an experiment in Drachten, Netherlands, where all traffic lights, road signs, and markings were removed. The level of accidents and fatalities decreased. This happened because, without road signs, drivers became more cautious. In contrast, despite improvements in mountaineering gear, the level of accidents did not decrease. People, seeing new equipment, become more reckless, which keeps accident rates steady.
Attitude Towards Risk
These examples show that risk depends not only on the activity itself but also on how participants view it. The degree of risk in the market or investments depends not just on the market itself but also on investor behavior. Even if investments become safer, this can lead to more risky behavior.
Awareness of Risk
I believe that risk is the belief that it doesnât exist. A high level of risk awareness usually reduces it. When assets increase in value, investors say they are great assets, but the price increase actually makes them more risky.
Hidden Risk and Losses
Itâs crucial to understand that risk is hidden and deceptive. Losses occur when risk meets negative events. As Ren Buffett said, âOnly when the tide goes out do you discover who has been swimming naked.â Investors and their strategies are tested by what risks they actually carry.
Quality of Assets and Investing
Every investor should remember that risk does not depend on the quality of assets. In 1969, I worked at a bank that invested in the 50 best companies. If you had bought shares in those companies at that time, you would have lost over 90% of your money. This demonstrates that the quality of assets does not guarantee safety.
A Rational Approach to Risk
When I transitioned to the world of high-yield bonds, I invested in riskier assets and earned steadily. This taught me that itâs not about what you buy, but what you pay. Investment success comes not from buying good things but from making good purchases.
The Risk-Return Relationship
Letâs examine the relationship between risk and return. Many believe that risky assets have higher returns. But this can be misleading. If risky assets truly offered more profit, they wouldnât be considered so risky. The upward line on the risk-return graph shows that risky assets must offer higher returns to attract investors.
Risk Management
My approach to risk management is based on qualitative assessments. Itâs essential to understand that risk cannot always be measured quantitatively. The primary task of an investor is to control risks and withstand uncertainty while maintaining the potential for profit.
Outstanding Investors and Probability Distribution
Outstanding investors understand the probability distribution and know how to avoid large losses while profiting in favorable times. This is the essence of successful investing â controlling risks while seeking profits.
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