Imagine hitting a hole-in-one in golf—a thrilling achievement! The odds are daunting, about one in 850,000 for a 150-yard shot, making it a rare occurrence. Yet, during the 2023 LPGA tour, there were 20 recorded hole-in-ones. How is this possible? Simply put, a low probability doesn’t always mean low frequency. Keep that thought in mind.
Now, let’s pivot a bit. Picture two different coin-toss games. The first game uses a fair coin, with an equal chance of winning or losing. The second game features a biased coin, where you have a 60% chance of losing and only a 40% chance of winning. Despite this, both games promise an expected return of 25%.
At first look, one might think the flawed coin equates to greater risk. But let’s dig deeper. If you play these games just once without knowing the outcome, the risk level is the same. The next toss could surprise you by going against the odds. So, risk isn’t solely about the probability of winning—it’s about how severe your loss could be if luck isn’t on your side.
Let’s take it up a notch. Imagine that the fair coin offers a 150% return on a win but results in a complete 100% loss if you fail. Meanwhile, the flawed coin gives you a 135% return on winning and only a 50% loss if you lose. Both scenarios still offer an expected return of about 25%, yet the flawed coin gives the chance to keep playing—a key element in making successful investments.
In the world of investing, assessing risk goes beyond mere probability or expected returns. True risk lies in the chance of enduring a permanent capital loss when the odds are not favorable. Therefore, risk should be evaluated in absolute terms, not just in relation to potential gains.
To cut to the chase, for a minor equity investor, no return justifies the chance of losing capital completely. Given the unpredictability of the future, steering clear of extreme gambles is crucial. Smart investing isn’t about chasing binary outcomes, even with the lure of big payouts. Though this sounds straightforward, reality makes it more complicated.
Let’s put theory into practice. Consider a chemical firm that’s just concluded a major capital expenditure cycle, relying heavily on debt. The management boasts that this new capacity will triple cash flows, allowing them to repay the debt swiftly and hold a net cash-positive position in two years. Plus, the stock is significantly cheaper when compared to both peers and its historical performance.
Tempting, right? But a cautious investor concentrates not on the potential upswing but on the bankruptcy risks inherent in a cyclical industry dealing with commodities, especially one at risk from actions like Chinese dumping.
Now, think about another scenario. A branded consumer firm with a solid history of generating cash. Recently, it’s incurred debt to delve into new related product lines. Even if this new venture fails, the core business remains robust enough to handle debt repayments. This scenario might involve some financial pain, but it would be far from devastating. For a long-term investor, this could still be a rewarding opportunity.
In both examples, what’s key isn’t the success rate but rather the potential impact of failing. Attention should always be on risk management. Returns are likely to fall in line naturally through the miracle of compounding.
To underscore this approach, let’s look at a practical example. I examined the performance of US stocks over the last decade by creating two sets of market-cap-weighted indices. The sole difference? The first set includes companies with net debt to equity below 30%, while the second comprises firms exceeding 70%.
The results make a strong case. Over the decade, the low-leverage index outshined the high-leverage one by a staggering 103% and surpassed the broader S&P 500 by 23%.
Reapplying this analysis in emerging markets (EM) shows similar patterns, albeit on a smaller scale. The low-leverage group outperformed the high-leverage by 12% over ten years, also outpacing the broader MSCI EM by 6%.
These findings emphasize a simple truth: companies with lower leverage—meaning less risk of bankruptcy—are well-positioned to endure downturns and grow returns over the long haul.
When it comes to investing, it’s not about chasing unlikely homeruns or gambling on binary risks with tantalizing rewards. It’s about protecting your investment from permanent losses and letting it grow steadily. Focusing on solid companies with sound balance sheets and low debt minimizes potential pitfalls. This wise strategy allows investors to ride out market swings and profit from the compounding effect. Managing risk is not just defensive—it’s the cornerstone of lasting investment triumph.
