Two of my favorite investors, Sam Zell and Howard Marks, both have said that understanding risk is the most important thing in their investment strategies. Sam Zell even put it this way: you need to fear, to be respectful of risk.
Here is what Sam Zell said in a podcast:
You had to be realistic. You had to be able to look at it and say, “What could go wrong?” If I learned anything from [Jay Pritzker], I learned that if everything went too well, you could survive. The only time you couldn’t survive is if it didn’t go so well.
So focusing on the upside was interesting, but not productive. Focusing on the downside was what risk was all about.
And to the extent that you could quantify the downside—to the extent that you understood what the risk was you were taking—your chances of survival were much better…. I think a lot of people get in a lot of trouble because they do a transaction and they don’t understand what the risk they’re assuming is when they do the transaction. And what he taught me more than anyone else was [to] look at the deal and figure out: Where is the vulnerability? Where is the assumption you’ve made that has to be right in order for the deal to work?
The best part of working for a company in its poorly performing years (as opposed to its expansion and booming years) is to get to learn from its mistakes. One can avoid those mistakes when it comes to time to build one’s own business or managing one’s personal matters.
A bank that I worked for in the past went through lots of struggle in the last ten years. Some explained that it was all due to bad luck: some bad decision made with poor timing. But the problem is much more than that. The bad luck can come to any company, any individual, no matter how smart how successful, that does not continuously have enough respect or understanding of risk, or does not manage risk well.
When things are going well, we, the decision makers, become increasingly optimistic and, even euphoric: companies expand and stock prices in bull market. That’s when poor risk assessment happens.
Only the paranoid survive.
Some examples (speaking from hindsight):
1. Concentration risk: Ninety percent of the money that the company made was from China (and Hong Kong). Concentration risk is not necessarily a bad thing. However, it becomes a problem when this is in direct conflict with other risks, such as geopolitical risk. Furthermore, concentration in reveue sources such as traditional lending exposes the bank to interest rate risk in a near-zero interest rate enviroment in the US, UK, and Europe.
2. Geopolitical risk: Headquarter in the UK but had operations in over 100 countries. Brexit, Hong Kong unrest, unsettling relationship between countries all contribute to uncertainties of its operations and profit.
3. Regulatory risk: The regulatory risk associated with geopolitical risk means that the bank must follow rules of the PRA (UK) in all locations in addition to local regulatory bodies, such as OCC-Fed-SEC in the US. The bank was fined heavily in the US due to poor AML compliance and had to scale down business dramatically, resulting long-term loss of customers, businesses and reputation.
4. Acquisition risk: If some other risks are out of a company’s control, this one should have been taken care of within control. Mistakes in acquisition can be very costly (tens of billions of dollars in write-down) and can weaken a company significantly. Large acquision without real understanding of the downside risk, and on top of that, fire sell aquired assets during market downturn lead to huge losses of money and customers.