Our Partnership Objective
The objective of our partnership is not to generate the best returns in the market at any given time. Instead it is to produce the optimal risk adjusted return over the long term.
This important difference cannot be overstated.
Optimal Risk Adjusted Returns
Most people set out on a fools errand with the impossible objective of achieving relatively short term alpha returns in the market. They benchmark themselves each year against other investors or other indices and this is a fundamental investment mistake.
Sometimes you will beat the market and other times not. That is not a problem. The name of the game is to produce the optimal risk adjusted return over the long term. This important difference cannot be overstated.
So what does ‘optimal risk adjusted return’ mean?
Asset prices are subject to fads and cycles. Irrational exuberance has been seen in the behaviour of investors since the dawn of time. Examples include Tulip mania (1634-37), the South Sea Bubble (1711-1720), the Japanese property bubble (1990s), the Dotcom boom (2000s) and Cryptocurrency mania (2020s).
Each time certain asset prices rose to valuations which could not be justified by any right-minded person. For example, in Amsterdam during the 17th Century the price for a single tulip bulb reached more than one month’s salary! People paid it because they thought that no matter what price they paid, the asset price would keep moving higher. In economics we call this “greater fool theory”: you will make money if you are able to find a greater fool willing to pay a higher price than you did.
More recently we have experienced crytpo-currency mania. Consider that the transaction that first gave Bitcoin monetary value was in October 2009, when Finnish computer science student Martti Malmi, known online as Sirius, sold 5,050 coins for around $0.0009 each (nine ten thousandths of one dollar, or nine hundredths of one cent!) By 2021 one Bitcoin traded for $68,789 (+7,643,222,100%). Yes, in just over a decade Bitcoin was up over seven and a half billion percent!
During these booms, some people made out-sized returns. It was pure luck as these asset price bubbles are entirely unforeseeable. It is also a zero-sum game because the large gains of the few were financed by the smaller losses of the many.
All of this to say that this is why it is foolish seeking to out perform others. There will always be someone who achieves a better result than you. Always. Without exception.
There may be investment fads which others are following which you are best advised to avoid. You may see friends and family making short term gains as the result of speculating and for a short period their returns may exceed yours. That’s fine!
Now I shall show you the winning investment strategy and explain why it works.
Be Smart, Think Different
The next few paragraphs may change the way that you think forever.
Imagine a four horse race.
| Horse | Probability of Winning |
|---|---|
| Golden Bullet | 50% |
| Silver Steed | 25% |
| Bronze Bronco | 20% |
| Lead Balloon | 5% |
Which horse would you bet on?
Take a moment to consider the question before reading on.
The vast majority of people will choose Golden Bullet. Not only does it have the most appealing name, but it is statistically most likely to win. However, for that very reason it is the wrong answer. The more people that bet on Golden Bullet, the worse the odds on that horse will become.
A smart person will bet on the odds, not on the horse.
Allow me to explain.
| Runner | Win Probability | Breakeven Odds | Odds at the Track |
|---|---|---|---|
| Golden Bullet | 50% | Even (1-1) | 1 – 2 |
| Silver Steed | 25% | 3 to 1 | 2 – 1 |
| Bronze Bronco | 20% | 4 to 1 | 5 – 1 |
| Lead Balloon | 5% | 19 to 1 | 15 – 1 |
The chance of winning on Golden Bullet is the same as winning on the flip of a coin. You need at least an even money bet just to breakeven because if you win you receive $1, but if not you lose $1. Do this multiple times and you’ll win as often as you lose, so you come out flat on an even money bet. Yet at our hypothetical race track the odds are not even because so many people are attracted to that horse which skews the price, and so you risk losing $2 to win only $1 on a 50:50 probability. That’s a terrible bet. Nonetheless, that’s where most of the bets will go (human nature is a peculiar thing!)
The odds on Silver Steed and Lead Balloon are also lower than is acceptable.
On Silver Steed you would win, on average, once every four races. But based on the odds at the track you would lose 3x $1 bets for every $2 that you win. Said differently, you are transferring your wealth to the bookmaker. That is plain foolish!
Similarly, for Lead Balloon you would only win once every 20 races and at 15-1, you would lose $19 for every $15 that you win.
Now look at Bronze Bronco. It is the only horse in the race that is offered at an attractive price. On this horse you will lose $4 for every $5 that you win. This is the horse that you ought to bet on because it is the only winning strategy. That is where the smart money goes! This horse offers the ‘optimal risk adjusted return’.
Betting on Bronze Bronco doesn’t make you more likely to win any particular race. In fact, you are highly likely to lose and Golden Bullet is still the most probable winner. The people that spend the day at the track fancying the favourite in each race will invariably win the most races, but they’ll come away losing financially for the reasons given. However, the smart fella who bets based on the price rather than the horse may only win four out of every twenty races, but financially he’ll be the only one to come out on top!
To put this another way: Your opportunity for profit at the racetrack consists entirely of mistakes that your competition makes in assessing each horse’s probability of winning.
The motto of the story is not to look at how many races others are winning, that’s not the name of the game. Never blindly follow the crowd as that’s usually a sure way to lose. And always measure risk against reward!
The same is true in investing. So, circling back to where we started, it isn’t about the best returns in the market over the short term (a single race), it’s about where you end up in the long term (at the end of the day after all the races have been run). This is your risk based return.
“The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agrees about its merits, the investment is inevitably too dear and therefore unattractive.“
John Maynard Keynes
To win you need to adopt a strategy and to play the long game. Said differently, stick with the winning strategy and never deviate from it. Our man at the race track only comes out on top if he sticks with his strategy on every race that day. We know that he will only win once every five races and so if he decides to quit after losing the first three races, then he is destined to fail. This is why most investors lose money. They either don’t have a strategy or else they don’t see it through.
Incidentally, this is why you should never accept a share tip from others or buy a share simply because you heard that Warren Buffett bought it. It is not about a single horse in a single race, it’s all about deploying a strategy across a large number of races.
You need to consider each investment in your portfolio as a horse race on a single day at the track. You may only need five out of a portfolio of twenty stocks to be winners in order to come out on top. Selecting stocks that are attractively priced and which offer you the optimal risk adjusted return is the name of the game. Fill your portfolio with Bronze Broncos and not with Golden Bullets. The really important thing is not leaving the race track part way through the day. If you invested over a five or ten year time horizon, don’t quit and sell out if you happen to be down in year two.
Understand that the long term is the aggregation of lots of short terms so always think long term based on risk versus reward and seek a consistent above average return.
Remember: the best company at the wrong price will always be a poor investment
Our thinking needs to be aligned. Hopefully, now it is.
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