The Spectrum of Concern

Productive worrying and measuring risk

Hey everyone. I am going to start including some “honourable mentions” at the bottom of each essay I send; a couple of things I’ve enjoyed reading.

Thanks, and enjoy.

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Bullshit Detection

A good rule of thumb is that, in markets, the stuff most people are worried about is not what typically brings down the stock market. It’s more often the risks you don’t see coming. You can confirm this by indulging in a retrospective of the headlines circulated from years past. It’s the phenomenon that strengthens the idea that bull markets climb a wall of worry; the tendency in financial markets for stocks to rise in the face of seemingly insurmountable problems. It’s why you see so many intelligent investors and economists constantly making bad market calls. The legitimacy of market forecasting is another conversation, but there is a subtly between intelligence and smarts, and Morgan Housel nails it. He remarks; “Intelligent people understand technical details, good memory, logic, math skills, test-taking ability, rule-following”. He lists a number of traits of smart people but the one I will purposefully select here is “bullshit detection”.

Academia praises and nurtures intelligence. It also neglects smarts, when it’s the smart ones, with their ability to understand empathy, social awareness, and persuasion, that often do well. As Housel suggests; “On rare occasions, you meet people who are both intelligent and smart. They run laps around everyone”.

Unconventional Measures of Risk

In an excerpt from a 2004 Baupost shareholder letter, Seth Klarman discusses measuring risk and the productivity spectrum of worry. Too much emphasis is placed on returns, at the expense of risk. This is because returns are readily quantifiable and it’s harder to capture a numerical value for risk. Nevertheless, the professional convention of measuring risk is a backwards-looking assessment of relative volatility (beta); a derivative of the capital asset pricing theory. Technical as it might be, this means risk can only be quantified effectively in hindsight. Anything forward-looking is a guesstimate at best, but ascribing numbers, or probabilities, on things has a way of putting people at ease. Where the danger lies in looking backwards is that by placing so much emphasis on the past, you forget the future is unknowable, unquantifiable, and unprecedented. I am reminded of Taleb’s turkey. A turkey is fed every day, morning and night, by a butcher for 1,000 days. Analysts conclude that butchers love turkeys. The turkey reads the analyst’s report and smiles as it falls asleep that night. The following day is Thanksgiving.

This bears a stark contrast to Klarman’s approach to measuring risk which he defines as; “how much we can lose and the probability of losing it”. He determines this through both quantitative and qualitative means, but most importantly with a forward-looking perspective. Analysing company-specific risks like earnings power, the competitive landscape, management, regulation, and market-specific risks which encapsulate macro-related variables, and things of that nature. This suggests a level of acceptance that the world is random, and the best thing you can do is position yourself not to be a victim of uncertainty. I believe what Klarman might have been suggesting is that his method encourages perpetual productive worrying while slapping a numerical value of risk on an asset or a portfolio may create a false sense of comfort. Taking a long-term view will also allow an individual to have breathing room when it comes to near-term volatility. You may own a great business. Nevertheless, the pendulum of popularity is bound to swing out of its favour at various points. An individual investor can soak up these intermittent drawdowns. But there is a reason why institutional investors cannot think, or act, this way.

“Most professional investors face significant pressure to generate returns in the near term. They believe their clients demand it. Their internal incentives encourage it. Their psyches need it. Few investors are comfortable taking a truly long-term point of view, no matter how compelling the opportunity, because their results are measured in the very short run”.

The Spectrum of Concern

The relative value of worrying exists on a spectrum from unproductive to productive. There are some who simply don’t worry at all. This tendency for worry to melt away tends to increase the longer stretches of time pass without incident. However, it is precisely this effect that makes the risk of something bad happening rise. It breeds complacency, alleviates paranoia, and soothes productive anxiety.

• “When conditions are generally benign, with markets perhaps even shrugging off bad news, investors tend to forget just how much they can lose and are lulled into sleeping well when they should be tossing and turning”.

• “Oddly, risk moves to the forefront of investor consciousness only when things are already going badly. Losing money is perhaps the only thing that makes most investors worry about losing money”.

We ought to be perpetually paranoid. But only when it matters. Productive worrying is when your actions can potentially eliminate or reduce the cause of concern. Worried you may be overexposed to a sector; reduce the weighting. Worried it might rain; pack an umbrella. Worried you might be gaining weight; change your diet. If you own Starbucks, this doesn’t necessarily mean you need to be glued to a screen checking coffee futures by the hour. Rather, a recurrent assessment of the business, its market, the external forces that rub up against it, and how comfortable you are with its position and size in your portfolio. Asking yourself, where can this turn sour? Where am I wrong? This is a practice that lends itself to both ends of the investment process; in exploratory and maintenance research. So much thought and expression is given to the upside equation of compounding. Find great stocks that will ten-bag and pay for your losers. Less time is given to the idea of simply staying alive and avoiding record-denting drawdowns.

• “While others attempt to win every lap around the track, it is crucial to remember that to succeed at investing, you have to be around at the finish”.

The antithesis of productive worrying is unproductive worrying; the kind where you worry about things you have no control over. Like when you apply for a new job and are waiting to hear back after the interview. The time in between is often spent agonising, and wondering, despite there being literally nothing you can do to influence the outcome. The interview is your time to influence the outcome, when that has passed, so should the worry. The same can be said for exams and dates. Carrying around this kind of mental burden is like holding a glass of water above your head all day. As the minutes tick by, the water glass gets heavier and your arm gets weaker. Like many things in the investment world, and this is partly why I love studying this field, it relates to everyday life. The maxim, “We’ll cross that bridge when we come to it” is another way of expressing that there is no point worrying about things outside our control. An incredible amount of time is wasted by investors on things that have no relevance to them. Time that is stolen from actions that would better serve themselves. I am reminded of this every quarter as people channel their energy into the market’s latest darlings and buzzwords. Most recently, generalists who obsess over companies like Nvidia; their valuation, their growth rates…; getting into heated debates about a company they have never owned, nor have any intention to. They likely don’t even know what a semiconductor does. I certainly don’t. So much of investing is just about successfully ignoring distractions. Distractions that pull you off course and taint your focus.

The short-term pricing mechanism of the market, as well as the thousands of macro data series that are updated weekly, are things we have no control over. Temperament, critical analysis, and the companies we choose to add to a portfolio are things we do have control over. Therefore, I argue it’s more productive to channel energy into matters where you can influence the outcome; like an enduring paranoia the market is about to take what you have earned. That’s not to say you need to go the whole nine yards and start writing a doomporn newsletter. Instead, stay sharp, remain objective, and avoid slipping into the sense of security.

“Successful investing goes hand in hand with productive worrying. Worry enough during the day and you can, in fact, sleep justifiably well at night. All of us are subject to biases that can impair our objectivity in investment decision-making. Have we blindly ignored new information because we are clinging too tightly to our original thesis? Have we held onto an investment because it keeps going up, irrationally ignoring that it has become overvalued? Without a healthy dose of reflective worry, we are unlikely even to identify our lapses in judgment, let alone correct them. In other words, only by actively, productively, relentlessly worrying about what can go wrong can we maximize the odds that things will go right, by doing everything within our control to perfect our decision-making”.

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Honourable Mentions

Here is some other great stuff worthy of your time.

• Todd Wenning, ex-Ensemble Capital analyst and investor of 20+ years recently started a publication called Flyover Stocks. I’ve enjoyed reading his work for years and shared a lot of it here. Check it out.

• Morgan Housel wrote a great essay on the distinction between intelligence and smart; “Intelligent people understand technical details, smart people understand emotional details”.

• Ian Cassel of the MicroCapClub has a new series called Business Breakdowns. It’s excellently done, a source of idea generation, and a refreshing break from the plethora of podcasts that focus on high-profile names. I recommend the episode with Issuer Direct, a disruptor in newswire distribution.

• For those who enjoy cooking, I have started being active on my recipe newsletter again, which 130 read. At least 5 of them are family members. If you like recipes that are simple and slap check it out. I plan to share at least one new recipe each week.

• Klarman’s 2004 shareholder letter excerpt where he discussed productive worry.

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Thanks for reading,

Conor