Source: Minimalist Investment
Imagine an investment opportunity similar to flipping a coin: if it lands on heads, you double your profit, but if it lands on tails, you lose 50%. Would you be tempted to play this game?
The arithmetic average return on each coin flip is (100% - 50%)*0.5 = 25%, and in an infinite number of parallel universes, the expected final wealth after playing the game 10 and 50 times in a row respectively would be approximately 9.31 and 7,000 times the initial wealth, making it seem like a highly profitable venture. As you play more and the final return increases, who would refuse such an investment opportunity?
In reality, however, we have only one path for the future instead of countless out of which only one is the most likely, with a single rate of return (compound annual growth rate) ((1+100%)*(1-50%))^0.5 - 1 = 0.00%, which means no loss and no gain, and the expected final wealth after playing the game 10 and 50 times in a row respectively would still be the same as the initial wealth. In a single or only a few investments, we are likely to face tremendous volatility, and even possibly a heavy loss.
If the odds of the coin flip slightly change to 99%/-50% or 100%/-51%, this type of investment would slowly but surely consume our wealth, because their geometric rates of return are -0.25% and -1.01% respectively.
Actually, all you need to do is find an investment opportunity with a 90% probability of earning a 30% return and a 10% probability of losing 10%; then, the most likely future investment portfolio result would be a compounded annual return of 25.31%.
The world is complex, with countless factors intertwined and the future shrouded in impenetrable mist that requires us to predict. This is both the most challenging and most appealing component of investing.
Under such high uncertainty, how can we find a high-probability, low-risk investment opportunity that offers small probabilities and magnitudes for both gains and losses? The answer is to remain within your ability circle and leave a margin of safety.
Buffett added the concept of the circle of competence to Graham's three elements of value investment. This means that investors can predict the future earnings potential of a company within their circle of competence with higher accuracy. The difference between different investors is actually the difference in their ability circles.
The core of being in the ability circle is to minimize mistakes. Doing things outside of one's ability circle will expose you to real risks that will be discovered and punished by the market at some point. Most investors fail because they do things outside of their ability circle, and afterwards it may be difficult to understand how it failed and the failure could be attributed to other factors.
The margin of safety is the key to reducing losses. Even when investing within one's circle of competence, one still needs to be alert to unforeseen events that can cause difficult-to-estimate risks, so a margin of safety is necessary to reduce the probability and degree of loss.
Stick to doing things within your ability circle and constantly expand the scope of your ability circle, leaving enough safety margin to deal with the highly uncertain future.
Editor/Lambor