When it comes to investing, we often want what we can’t have. We want all the reward with no risk. All the upside with none of the downside.
You want it. I want it. We all want it. Unfortunately, it’s not attainable.
It reminds me of growing up on the farm. We had cattle. To keep the cattle fed when the plants fell dormant in the winter, we gave them a steady diet of hay. Small square bales of hay to be exact.
So in the summer months, we would cut clover, brome and prairie grass, let it dry, and then press it into small square bales. There were thousands of them. They littered the fields.
Our general practice, it seemed to me at the time, was to wait until the hottest days of the summer to gather the bales – or “throw hay” as we called it. Stacking it on a trailer, we moved the bales from the field to the barn. Field, barn, field, barn. All in the blazing heat of summer. The whole process helped build “character,” or so we were told.
But the point is – and I will get to it – all this activity was hard work. It didn’t take long to work up a sweat. The hay was dusty, and every now and then you got an unwanted taste of it. Your mouth would beg for water.
And on those days, water never tasted so good. We would chug it.
But if you drank too much water, you felt sick. You became water-logged. We wanted to drink as much water as we possibly could – it tasted so refreshing going down – but if we overdid it, we suffered the consequences.
Investing is a lot like that. We want returns like a bale-thrower wants water. When the returns are flowing, it feels great. You can’t get enough.
But there is a potential downside to returns, and we call it risk. The higher the returns, the greater the risk. Like the danger of drinking too much water and becoming water-logged, high returns are often accompanied by unpleasant side effects. In investing, that means losses.
Amazon.com is a great example. Since becoming a public company, the online retailer’s stock has returned more than 100,000%, easily making it one of the best-returning investments of all time. If you would have invested just $1,000 on the first day Amazon was traded publicly, your investment would be worth just over $1 million today.
But even if you were wise enough – or lucky enough – to buy $1,000 of Amazon stock in 1997, the odds of you continuing to hold it from 1997 until today are extremely slim. Why? Because the stock was extremely risky.
Amazon’s stock dropped more than 20% in 16 of its first 20 years as a public company. In nearly half of those years the stock fell by more than 40%. When the technology bubble burst in the early 2000s, the stock plunged 95%. Investors were nearly wiped out. In 2008, the stock lost almost 70% of its value. The road to 100,000% returns was full of hazards.
Big rewards are accompanied by big risks.
Seth Klarman is one of the world’s best investors. Most people have never heard of him, but he runs an incredibly successful private investment firm in Boston. Journalists have called him the next Warren Buffett.
Klarman says investors have a choice when selecting their investment portfolios. It comes down to a simple question. Do you want to trail the market when it’s going up or when it’s going down?
You have two choices. You can invest aggressively and beat the market in the good times but incur bigger losses when conditions are unfavorable. Or, you can invest more conservatively and lag the market in the good times but not lose as much as much when things turn sour.
The holy grail is to beat the market when it goes up and not lose as much when it goes down. No one can do that consistently. It may be possible for a time, but eventually luck runs out.
As Klarman wisely advises, your portfolio can outperform when the market is up or when the market is down. The choice is yours. But you can’t have it both ways.