High Risk-High Gain. Obvious, isn’t it?
To gain more you have to take more risks!
Have you seen that movie, “The Croods”? The family lived in a cave with the philosophy – Never Leave The Cave. And they lived a seemingly safe but boring life, until the curiosity of the protagonist, Eep, forces them to venture out. Life was now full of thrill & adventure and of course risk, which they overcame!
“Never Leave the Cave” mentality keeps you safe, but does not take you anywhere. If you do not step out of your home, you”ll go nowhere…period!
“Only those who risk going too far can possibly find out how far one can go.”
– T S Elliot
A lot of us suffer from such a syndrome. We curb our natural instincts of curiosity because of the fear of the unknown. In return we chose to live a drab life – a slow death by boredom & mediocrity.
Instead of following our passions, we pick a safe sounding Job in a corporation, a modern day version of slavery. We go through the dull life day after day after day….right to our graves. Such boring life takes, well, life out of our lives!
“Imagine that in order to have a great life you have to cross a dangerous jungle. You can stay safe where you are and have an ordinary life, or you can risk crossing the jungle to have a terrific life. How would you approach that choice? Take a moment to think about it because it is the sort of choice that, in one form or another, we all have to make.”
― Ray Dalio, Principles: Life and Work
A lot of us keep our savings safe in a locker at home or in a bank account at best! This is apparently, to keep it safe. All the other avenues like investments and business are fraught with risks apparently! In the process, the money gets rotten & rusted by a fungus called Inflation. I saw this chart on Twitter recently! Not sure of the source, so don’t know whom to thank. Not sure of the veracity of the data either, but it is intuitively correct.
You money, if left alone loses its purchasing power, thanks to inflation. To prevent this from happening, one has to deploy this in assets that grow.
“Intelligence solves problems and produces money. Money without financial intelligence is money soon gone.”
– Robert Kiyosaki
If you have to cover 94.5 Kms of Mumbai Pune Highway, would you walk because moving at 100 Km/hr is riskier than walking at 2 Km/hr!
You’re thinking…So, where is the dissonance? There has to be more to it to find a place in this section of the blog.
Your suspicion is right. Here’s the interesting part. If you ask any successful business person or investor, she”ll tell you that she hardly takes any risk! This is what “father of value investing had to say about taking risks.
“The essence of investment management is the management of risks, not the management of returns.”
– Benjamin Graham
In life in general and investing in particular, once you properly manage your risk, you are not taking risks anymore. You are taking opportunities. This is what separates the lay person’s perception of risk (as a casual, thrill seeking gamblimg) from a professional’s.
Different successful investors use nuanced versions of risk management. However, the central tenet is the same – take care of the downside, the upside takes care of itself. The most famous expression of risk management is the “margin of safety”.
The “Margin of Safety” concept is about making it likely that you have the odds significantly in your favour by trying to find a substantial cushion in terms of the odds. Charlie Munger does not believe that this happens very often, particular when it is in your Circle of Competence and the other investing filters are in place.”
The other relevant concept is what is popularly known as “Stop Loss”. Technical definition aside, the concept is basically aligning your opinions with the reality. If you see empirical evidence of your investment not turning out to be as good as you thought, you simply get out of it; you do not fall in “love” with it just because you own it.
Of course, stepping out of your cave is fraught with danger. So is riding a car. A skilled driver crosses the Mumbai Pune Expressway in less than an hour by riding a car, as against walking, but with various layers of safety net.
To start with, only experienced & skilful drivers drive on the Expressway. The car is well maintained. The driver uses drives at a speed which is sync with the speed of adjacent vehicles maintaining a safe distance. He is always wearing a seat belt. He, along with fellow drivers, follow lane discipline.
This is “The Swiss Cheese Model of Accident Causation or The Cumulative Act Effect”. This is a model (propounded by Dante Orlandella and James T. Reason) used in risk management – the principle behind layered security.
It is like the risk mitigation system to multiple slices of swiz cheese, stacked side by side, in which the risk of a threat becoming a reality is mitigated by the differing layers and types of defences which are “layered” behind each other. Therefore, in theory, lapses and weaknesses in one defence do not allow a risk to materialise, since other defences also exist, to prevent a single point of failure. An organisation’s defences against failure are modelled as a series of barriers, represented as slices of cheese. The holes in the slices represent weaknesses in individual parts of the system and are continually varying in size and position across the slices. The system produces failures when a hole in each slice momentarily aligns, permitting (in Reason’s words) “a trajectory of accident opportunity”, so that a hazard passes through holes in all of the slices, leading to a failure.
Notice, when Charlie Munger talks about the concept of margin of safety, he is alluding to various layers of risk mitigation. He is talking about dealing only in your Circle of Competence, strong & ethical business promoters, and right price etc. These are the multiple layers of Swiss Cheese Model, that gives an investor protection from risk.
Let’s take things further now…
High risk High gains is correct in the sense that you don’t get to see the world, if you don’t step out of the house. You have to let your innate talents drive your curiosity, your curiosity drive your actions, the feedback from external stimuli drive your course corrections.
However, taking risks does not mean taking blind bets; it means taking calculated bets. The risk-reward ratio needs to be in massive favour. Also, the risk, in case it plays out rather than reward, needs to be nipped in the bud.
Crossing the Mumbai Pune Expressway in car, driven by a skilled & experienced driver, following lane discipline etc etc, is good enough. You don’t have to take it to its illogical extreme, where you take disproportionate risks like driving too fast in order to reach Pune faster! Some of us misunderstand “High Risk High Gain” and take blind risks. The movies often show the protagonist taking a “make it or break it” bet and winning. There may be some real life examples of that as well. However, that’s a wrong example to follow, because for every one such lucky escape, there are hundreds…no thousands…may be lakhs of failures!
“Embrace risk, but be averse to ruin. Recklessness is not courage/risk taking.”
– Nassim Taleb
Clearly, there are cases when High Risks lead to High Gain and cases when High Risks lead to High Pain. What kind of risks to embrace, and what kind of risks to avoid?
I always prefer to first deal with what not to do. Let’s get the risks to avoid, out of our way first!
“All I want to know is where I’m going to die so I’ll never go there.”
– Charlie Munger
High Risk High Pain Strategies
So, let’s find out which roads lead to hell, and avoid them. Characteristics of the Risks to avoid:
- Rewards are limited and decelerating
- Pain or risks are unlimited and accelerating
- One failure is enough to ruin your life
You may have random successes, which can lull you into a false sense of safety. And then suddenly, the luck runs out. You are caught off guard. You would typically feel that you’re hit by a bolt from the blue or a black swan event or a 10 sigma event – You will invariably blame the external circumstances. The reality is that you took a stupid risk and it was only a matter of time before you paid the price!
Some examples of High Risk – High Pain Strategies:
- Quitting a job impulsively without any Plan B
- taking an oversized bet of a particular investment on a tip
- driving too fast
- Corrupt practices & other crimes
- Naked Option Selling & High Yield debt
- Money lending
High Risk High Gain Strategies
Now that the risk of ruin is out, let’s focus on the what’s remaining.
Characteristics of the High Risk High Gain Strategies:
- Pain or Risks are frequent but capped, small and decelerating
- Rewards are unlimited, big and accelerating
- One success is enough to change your life
One should explore as many such propositions as possible. If you create an ensemble of such propositions, your typical outcome will be like this:
| Percentage of Propositions | Success/Failure | Impact / Outcome |
|---|---|---|
| 20% | Abject Failures | Small Losses |
| 60% | Mild success or failure | Small Gains or Losses |
| 20% | Massive Success | Large Gains |
This is a systematic approach to risk taking. This approach has a Darwinian Evolutionary flavour at its core. The first priority is protection from the risk of ruin. Once the risk of ruin is out, what remains is a world full of endless opportunities.
Some examples of High Risk – High Gain Strategies:
- Monetise your hobbies & passions
- taking calculated bets on self researched investments
- Long driving to places
- Startups & Entrepreneurship
- Option Buying
- Networking with great people
- Reading books
To conclude…
Don’t shy away from taking risks. It is by venturing into the unknown that you get to see places you haven’t even dreamt off. But, ensure that you don’t get lost in the woods!