Wednesday, November 11, 2015

The Financier's Roar

Finance is not generally considered a stirring subject. Interesting, maybe. Remunerative, certainly. Complicated, definitely (and don't believe anyone who says otherwise). But stirring?

Well, not often, but occasionally.

2001 was not a great year for Berkshire Hathaway. The firm had experienced its first decline in book value per share (their chosen measure of performance) in their history. This was coming off the back of a very poor 1999 result where their growth in book value per share underperformed the S&P 500 by 20.5%. In 2001, at least everyone else did poorly too, but to a firm that prided itself on consistent results, this was a tough pill to swallow.

The proximate cause of this problem was that they run a huge reinsurance business, and September 11th caused them to have to pay out a ton. And Warren Buffet, in his 2001 letter to shareholders, had the job of fronting up to investors about what was going on.

He began by explaining what he called the three principles of underwriting, which he acknowledged that they had failed to live up to:
1. They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.
2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.
The third one I'm less certain of than the first two. But they all fit a pattern - pick carefully which risks you want to take on. Make sure you can survive them, and pick the ones likely to be profitable.

But having done that, how should one approach the vicissitudes of fortune? How should one weather the storm?

Buffet's answer is perhaps my favourite line in finance. I call it 'The Financier's Roar'.
At Berkshire, we retain our risks and depend on no one.
Just so.

Risk and return are not just academic constructs, but the very stuff on which the economic world is built. The point is not to eliminate risks. If one wants to do that, buy treasury bills, accept a zero rate of return, and don't ever leave your house. You will earn zero, and you will never succeed.

The vast majority of good plans carry a risk of failure. The reason they do is that arbitrage is rare. Sometimes, life hands you a risk-free profit opportunity, but, like the proverbial $20 bill on the sidewalk, they don't stick around for long. And in the space of risky ventures, a similar mechanism holds. If an opportunity has a really high return and very low risk and everyone sees this, mostly the price will get bid up until the expected return has gone back down.

Mostly. But not always. Arbitrage may be very rare, but undervalued assets are more common. Figuring out what they are is the substantive part of the Buffet risk management. Identify things that are good risks, and buying enough that you can take on and survive.

The second part, the Financier's Roar, is the call to courageous decisions. Having selected the right risks to take on, retain them. Be willing to eat the possibility of loss and failure, and don't try to hedge everything out. Have the confidence of your own calculations to hold the portfolio of life's payoffs that you think will work out the best overall. As I have noted before, one does not eat the expectation, but the realisation. No matter how well you calculate, sometimes you will lose. That's life. But at least you won't lose in a stupid manner. Courage, when properly applied, is taking the right risks, though risks they be nonetheless.

The second benefit is the one that's easy to overlook, but is important. When one retains one's risks, one is an island. The universe may deliver success or failure, but the only thing that matters is one's calculations and the roll of the dice. By contrast, the more you hedge out risks by trading with others, the more you rely on the success or failure of others. If you're relying on a counterparty to pay up when the porridge hits the propeller, your risk management now depends on their risk management. Just ask the people who bought credit protection from Lehman Brothers.

Retaining risks leads to self-reliance. Retaining the right risks leads to success or failure with the only tools one has against the cold indifference of fate - one's own wits.

Retain your risks, and depend on no one.

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