Your Focus Should Be On Risk, Not Reward

A common theme of this blog has been that the assumption of more risk does not go hand-in-hand with the reaping of greater rewards.  In fact, if anything, the opposite has been true historically, both in equity markets and in fixed income.  Experience has shown again and again that, for example, higher returns have emanated from lower-volatility stocks, and higher quality bonds have tended to outperform those of lower credit quality.  In both instances, – whether risk is defined by volatility (yes, volatility can be a risk), drawdowns, or total loss, – the more conservative option has generally performed better.

This paradox, which in essence is that a defensive mindset often trumps an aggressive one, can be observed elsewhere in life, particularly in many instances throughout military history.  A particularly glaring example comes from the arms race leading up to World War I, when rival nations Great Britain and Imperial Germany focused on very different things as they made trade-offs in the design of their battleships, with stark differences in terms of balance among speed, armament, and armor plating.  The British Royal Navy adopted a very aggressive posture,  deciding to sacrifice armor plating in favor of speed and armament, while the German Imperial Navy’s focus was decidedly defensive-minded, focusing instead on ruggedness and survivability.

In his magnificent The Great War:  A Combat History of the First World War, historian Peter Hart sums up the British attitude by quoting First Sea Lord Sir John Fisher, who was a proponent of speed and hitting power above all else:

The first desideratum of all is speed!  You fools don’t see it – they are always running about to see where they can put on a little more armour!  To make it safer!  You don’t go into battle to be safe!  No, you go into battle to hit the other fellow in the eye first so that he can’t see you!  Yes!  You hit him first, you hit him hard, and you keep on hitting.  That’s your safety!

Mr. Hart goes on to describe how, obsessed with increasing their rate of fire, British naval crews were taking, in Mr. Hart’s words, ‘suicidal risks,’ such as propping open magazine doors and accumulating cordite charges in large piles for easy access, all of which went against basic damage control protocols in the event the ship’s armor was penetrated by enemy shells.

In marked contrast, the German philosophy was focused on armor protection with the idea that the more damage their ships could sustain, the more likely it was that they would outlast their more lightly armored British opponents.  Given the rudimentary aiming technologies of the day, scoring lethal hits was somewhat a matter of volume, so the longer a ship was serviceable in a fight, the more likely it was to deliver knockout blows.

With this in mind, Mr. Hart goes on to say, the German navy was focused on having its ships armored to the maximum degree possible, and crews were drilled not with added emphasis on rate of fire, as were their British opponents, but on damage control.  Mr. Hart captures the German mindset by quoting Admiral Alfred Tirpitz:

So long as a ship is afloat, it retains a certain fighting value and can afterwards be more easily repaired…We soon found that we had to experiment with real explosions in order to gain sufficient experience.  As we could not sacrifice modern ships, and could not learn enough from the older ones, we built a section of a modern ship by itself and carried out experimental explosions on it, with torpedo heads, carefully studying the results every time.

When the two navies clashed during World War I, the merit of the German focus on risk management became obvious, as time and time again its ships proved able to withstand damage and survive to fight another day, while the British system proved to have dire consequences for its crews, many of whom perished in catastrophic explosions after only a couple hits on their ships.

In essence, the British philosophy of sacrificing armor for speed, and safety for rate of fire, was a kind of leveraged risk with the hope of quickly reaping grand rewards in battle.  The German philosophy was focused not on maximizing results by sheer rate of fire, but on surviving the encounter long enough to land lethal hits.  This is, in my opinion, an apt analogy for the investment world, where, as Nick Maggiulli points out, even with a high degree of certainty regarding future outcomes, leverage can lead to catastrophic results.  All too often when investors are behind on savings, or lagging a benchmark, they try to make up ground quickly by taking on more risk, neglecting of course the possibility of being wiped out should things go wrong.

The prudent investor always starts with the end in mind, vigorously testing his assumptions, contemplating worst-case scenarios, and focusing on risk management.  As the example of the World War I naval clashes illustrates, a defensive mindset does not mean that you will come short of your goals for lack of taking on sufficient risk.  On the contrary, a keen awareness of risk will help you achieve your goals by helping you weather the markets when the tide goes out, thus keeping your portfolio intact when it is needed most.

Read Mr. Hart’s book here: