In financial planning and investing, survival is the primary goal. As Peter Bernstein wrote in Against the Gods: The Remarkable Story of Risk: “Survival is the only road to riches. You should try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.” Or, as William Bernstein (no relation) has said, “When you’ve won the game, stop playing.”
The late Charlie Munger (Warren Buffett’s erstwhile partner) advised us to “invert, always invert.” With that in mind, it may be helpful to think about how could we lose (perish financially)? There are four ways. Each is bad enough in isolation, but almost always fatal in combination:
- Illiquidity. Money is life’s Swiss Army knife, and you can be solvent (assets greater than liabilities) but still go bankrupt (or suffer ruinous losses) trying to sell illiquid assets in a crisis. To use another analogy, money is like oxygen – you don’t really notice it until it isn’t there and then it’s all that matters.
- Correlation/Underdiversification. The fastest way to huge losses (and gains!) is one big, concentrated bet. Employer stock, when that employer has been phenomenally successful and the stock price has increased commensurately, is where this frequently arises. (See Enron.) While you can’t generally get higher returns without taking risk, you are not rewarded with higher expected returns from taking risk that is diversifiable. In other words, the expected return from owning one stock in the S&P 500 is not higher than the expected return from owning all the stocks in the S&P 500, but the risk is absolutely higher. The more subtle version of this mistake is making seemingly different bets (investments) without realizing how correlated they are. Owning many different tech stocks in the late 1990s, several rental houses in 2008, and a variety of AI and semiconductor stocks now is not diversification.
- Leverage. Usually leverage means debt (financial leverage), but there are other forms (operational leverage in a business, for example, where the owner has chosen higher fixed costs and lower variable costs rather than the opposite). Levers magnify forces. People often forget that while they are intending to magnify positive returns with leverage, it also magnifies negative returns.
- No margin for error. We all know people who live their lives paycheck to paycheck, who assume there won’t be a recession, that they would never lose their job or be forced to retire early because of poor health or disability, etc. There’s a joke (though it isn’t really funny) that the retirement plan for many baby boomers is to never stop working. This is often called “smoking hope” or being “high on hopium.” Research shows the median expected retirement age is 65 but the median actual retirement age is 62.
So, let’s put these together. We’d have something like this: an investor whose portfolio has just one stock (undiversified), that isn’t publicly traded (illiquid), who borrowed money to buy it (leverage), and whose loan payments are at the limit of what he or she can afford (no margin for error). That might work out, but it’s far more likely to lead to ruin.
Prudent individuals do the opposite: diversify broadly, maintain high levels of liquidity, use minimal debt, and maintain a large margin for error.