Sunday, March 13, 2011

A tide in the affairs of men...

In my last post, I noted how difficult it is to separate luck from skill in  both investment and corporate finance.  While I remain leery of stock picking success stories (and believe me when I say I hear dozens each week), I continue to admire successful businesses of all stripes, from the bagel shop in my town that manages to sell out every day to Facebook in the social media world.

It is not that luck does not play a role in business success. In fact, most successful individuals and businesses can point to a stroke of good luck that got them started.  Microsoft was lucky that IBM allowed it to write the code that made the first personal computers work and Apple was lucky that music companies were too bullheaded to deviate from their traditional sales model of bundling a dozen songs on an album and forcing people to buy the entire package. It is what great companies do with that initial lucky break that set them apart: when they get lucky, they take that success and build on it. Most other businesses, however, view good luck as a windfall, report higher earnings for the year, but have little to show for it in the long term.

In fact, this was the reason I wrote my book on strategic risk taking. If the essence of risk taking is that you are going to be right some of the time and wrong the rest of the time, here is what I see separating good risk takers from bad ones. When good risk taking organizations get lucky and see upside from risk taking, they find ways to build on that upside. When they are confronted with unpleasant surprises, they manage to minimize their losses and move on. In option terminology, successful risk takers create their own call options to augment upside risk and put options to minimize downside risk. Of course, I am not the first to recognize this. Here is one of my favorite quotes from Shakespeare:
There is a tide in the affairs of men.
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat,
And we must take the current when it serves,
Or lose our ventures.

Brutus had a splendid grasp of risk taking (though I don't quite know where to put the stabbing of Julius Caesar in the risk taking scale).

Put in less lofty terms, each of us will be blessed with good luck in our investment and business endeavors at some point in time. What we do with that luck will determine whether it leaves a lasting mark or not. In the same vein, each of us will also be unlucky at some point in time and how prepared we are for that contingency will determine whether it will bring us down or just dent us.


Krishnan said...

I consider myself a risk taker; for I invest in quite a few small and mid-cap equities, sometimes I have been right and many times wrong. How do I mitigate my risk? Well, first I never leverage any of my investments, the other I invest in companies that have lower operating leverage & little or no financial leverage. Maybe one reason my investments don't tank, but another reason they don't give me great returns! Cheers

Aswath Damodaran said...

Looks like your strategy for minimizing downside risk is in place. Now, it is time to think about upside risk.

Mike said...

Hello Prof,

In my opinion, Kris is not a risk taker, he is a risk averse person, OR a low risk-taker.

If he is a risk taker, he will use some levarage.

What do you say?

Mario V said...

I think the upside risk is inherent in small-cap stocks, isn't it? Tomorrow, Kris may be holding a stock in the S&P 500 instead of the Russell 2000.

Jamie said...
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Jamie said...

You may want to analyze small-caps that no (or few) professionals follow, since the absence of scrutiny allows for some serious deviation between intrinsic and market value. There's your upside... now go find some ten-baggers =)

Mike said...


While confining our analysis to small-cap stocks, probably we should avoid large-cap stocks, as the big investors already would have bid up the prices of large-caps.

Jamie said...

I wouldn't say necessarily avoid large-cap stocks. If an event causes the share price of a large-cap to plummet too much (i.e. the market overreacts), it could be a great time to get in (recently, the resignation of Mark Hurd caused HPQ to dip too much, for instance). Large-caps can also be potential turnarounds, such as Chrysler back in the 80s or GEICO in the 70s.

Oftentimes large-caps are overbought, but the converse can often be true - some of the best investing opportunities arise when large-caps are oversold...

Mike said...

Jamie, well said. I agree.

HonestAdviser said...
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