How to think about risk

In the mid-1980s, Howard Marks joined TCW Group. He was in charge of running the firm’s distressed debt fund. It was one of the first distressed debt funds launched by any major financial institution at the time. 

Just one issue.

It’s hard to predict which distressed companies to invest in. (It’s not easy predicting which near-bankrupt companies will recover after all). 

So he came up with an interesting solution. Rather than trying to predict which companies would succeed, he tried to avoid investing in the companies that had a high possibility for failure. 

In other words, he tried to avoid losing companies rather than trying to predict winners. His strategy performed so well that the firm promoted him to Chief Investment Officer. He later went on to raise “the largest distressed debt fund in history,” which “paid off richly for his investors,” according to CNN Money. 

All that success came not from predicting winners–but from avoiding losers. 

There is a concept known as “a winner’s game” and “a loser’s game.” A winner’s game is when someone wins from “hitting winners.” For example, in a tennis match between two expert tennis players, the player who places the best shots that the opponent can’t return will win. Then there is a loser’s game

A loser’s game is when is someone wins by avoiding losers. A tennis match between two amateurs is an example. 

The amateur who wins isn’t the one who places the best shots. It’s the one who avoids screwing up and just gets the ball back over the net. 

It turns out that investing is actually a loser’s game. 

The way you outperform isn’t by finding the next hot stock, but by avoiding stocks that will underperform. 

It’s about consistently not screwing up. 

Although Howard Marks became rich by avoiding losers in debt markets, you can also become rich by applying the “losers game principle” to the stock market. 

For example, Charlie Munger says that he’s rich because he always avoids making bad investment decisions (e.g. avoid losers): 

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead.

When investing, your goal investing isn’t picking stocks that will outperform. 

It’s about avoiding stocks that have the possibility of underperforming. 

Your goal isn’t predicting which company will become successful.

It’s about avoiding companies that have the possibility of failure. Your goal isn’t to find a stock that has positive characteristics. It’s about finding stocks that don’t have negative characteristics. 

Ask yourself, “what’s wrong with this company? Why shouldn’t I invest in this company? Does this company trade at an expensive price? Does it lack a competitive edge? Does it lack talented management?” 

If you can’t find anything bad about the company, then it’s unlikely to be a loser. 

So stop asking yourself, “why is this a great company? Why should I invest in this company? Does it trade at a cheap price? Does it have a strong competitive advantage? Does it have talented management.” Those questions mean you’re trying to pick a winner. 

Donald Trump become a billionaire through real estate investing. It was his bread and butter before he entered politics. In his book The Art of the Deal, he writes one his most important principles of risk management in both investing and life: “if you protect the downside, the upside will take care of itself.” 

Regardless of whether you like Donald Trump, that’s a good quote to live by when picking stocks. As long as you ensure your stock isn’t a loser, it will always turn out to be a winner. 

Catastrophize every single investment opportunity. That’s how you get ahead, by imagining the worst possible scenarios for the company: a disruptive competitor enters the market, generative AI disrupts the industry, the chief executive officer dies, or a competitor comes out with a better product. 

Then you want to ask yourself two questions: “First, is this scenario even possible, or is it too out of the realm of possibilities? Second, if this adverse event occurs, am I still comfortable owning the company?” If you’re investing in Google, imagine a scenario where a startup (such as OpenAI) creates a better version of its search engine. If you’re investing in Coca-Cola, imagine a scenario where a new soft drink is released that’s better tasting and healthier. If you’re investing in ExxonMobil, imagine a scenario where British Petroleum learns how to extract oil at a cheaper cost.

Then ask yourself, “is this scenario even possible, or is it out of the realm of possibilities?” Also ask yourself, “ if this adverse event occurs, am I still comfortable owning the company?” Ask yourself, “is it possible for a start-up to create a better version of Google? Would I still be comfortable owning Google if a start-up creates a better version of it?” Ask yourself, “is it possible for Pepsi to create a better soft drink the Coca-Cola? Would I still be comfortable owning CocaCola if Pepsi developed a better soft drink formula?” Ask yourself, “is it possible for British Petroleum to figure out how to extract oil at a cheaper cost than ExxonMobil? Would I still be comfortable owning ExxonMobil if British Petroleum developed a low-cost advantage?”

In short, investing is about avoiding losers more so than picking winners. This article is an excerpt from Take Stock In This, which people say is the “best book on investing since The Intelligent Investor.” Click here to get a copy of the book today.