Chapter 4 of The Winning Investment Habits of Warren Buffett & George Soros:

Soros’s ability to handle risk was “imprinted” on him during the Nazi occupation of Budapest, when the daily risk he faced was death.

His father, being a Master Survivor, taught him the three rules of risk which still guide him today:

• It’s okay to take risks.
• When taking a risk, never bet the ranch.
• Always be prepared to beat a hasty retreat.

Beating a Hasty Retreat

In 1987, Soros had positioned the Quantum Fund to profit from his hypothesis that a market crash was coming — in Japan — by shorting stocks in Tokyo and buying S&P futures in New York.

But on “Black Monday,” October 19th, 1987, his scenario came apart at the seams. The Dow dropped a record 22.6%, which still stands as the largest one-day fall in history. Meanwhile, in Tokyo the government supported the market. Soros was bleeding at both ends of his strategy.

“He was on leverage and the very existence of the fund was threatened,” according to Stanley Druckenmiller, who took over management of the Quantum Fund two years later.

Soros didn’t hesitate. Following his third rule of risk management he got the hell out. But because his positions were so large, his selling drove down the price. He offered his 5,000 S&P futures contracts at 230, and there were no takers. Or at 220, 215, 205, or 200. Eventually he liquidated at between 195 and 210. Ironically, once he was out the selling pressure was gone, and the market bounced back to close the day at 244.50.

Soros had lost his entire profit for the year. But that didn’t faze him. He had admitted his mistake; realized he didn’t know what was going on; and, as he always did whether the mistake was minor or, as in this case, threatening to his survival, he went into risk-control mode. The only difference this time was the size of his positions and the illiquidity of the market.

Survive first. Nothing else was important. He didn’t freeze, doubt, stop to analyze, second-guess, or try to figure out whether he should hold on in case things turned around. He just got out.

Soros’s investment method is to form a hypothesis about the market, and then “listen” to the market to find out whether his hypothesis is right or wrong. In October 1987, the market was telling him he was wrong, dead wrong. As the market had shattered his hypothesis, he no longer had any reason to maintain his positions. Because he was losing money, his only choice was to beat a hasty retreat.

The crash of 1987 cast a cloud of doom and gloom over Wall Street that lasted for months. “Just about every manager I knew who was caught in that crash became almost comatose afterwards,” said Druckenmiller. “They became nonfunctional, and I mean legendary names in our business.”

As prominent hedge fund manager Michael Steinhardt candidly admits: “I was so depressed that fall that I did not want to go on. I took the crash personally. The issue of timing haunted me. My prescient forewarnings [recommending caution] earlier in the year made the losses all the more painful. Maybe I was losing my judgment. Maybe I just was not as good as I used to be. My confidence was shaken. I felt alone.”

Not Soros. He had taken one of the biggest hits of all, but he was unaffected.

He was back in the market two weeks later heavily shorting the dollar. Because he knew how to handle risk, because he followed his rules, he immediately put the crash behind him. It was history. And the Quantum Fund ended up 14.5% for the year.

Emotional Disconnect

A mental strategy that sets Master Investors apart is that they can totally disconnect their emotions from the market. Regardless of what happens in the market, they are unaffected emotionally. Of course, they may feel happy or sad, angry or excited — but they have the ability to immediately put that emotion aside and clear their minds.

Being in a state where you are controlled by your emotions makes you vulnerable to risk. The investor who is overcome by his emotions — even if he knows full well, intellectually, what to do when things go wrong — often freezes up; agonizes endlessly over what to do; and ends up selling, usually at a loss, just to relieve the anxiety.

Buffett achieves the necessary emotional distance through his investment method. His focus is on the quality of the business. His only concern is whether his investments continue to meet his criteria. If they do, he’s happy — regardless of how the market might be valuing them. If a stock he owns no longer meets his criteria, he’ll sell it — regardless of how the market prices it.

Warren Buffett simply doesn’t care what the market is doing. No wonder he often says he wouldn’t mind if the stock market closed down for ten years.

“I Am Fallible”

Like Buffett, Soros’s investment method helps distance him emotionally from the market. But his ultimate protection — aside from the self-confidence that he shares with Buffett — is that he “walks around telling whomever has the patience to listen that he is fallible.”

He bases an investment on a hypothesis he has developed about how and why a particular market will move. The use of the word “hypothesis” in itself signifies a very tentative stance, of someone unlikely to become “married to his position.”

Yet, as his public prediction that the “Crash of ’87” would start in Japan, not the US, bears witness, there were times when he was certain of what “Mr. Market” would do next. When it didn’t happen that way, he would be taken completely by surprise.

Overriding all the other beliefs Soros has is his conviction that he is fallible — the basis, as we will see, of his investment philosophy. So that when the market proves him wrong, he immediately realizes he’s made a mistake. Unlike too many investors, he doesn’t say “the market is wrong” and hang onto his position. He just gets out.

As a result, he can step back completely from his involvement, so appearing to others to be emotionless, a stoic.

4. Manage Risk Actuarially

The fourth way to manage risk is to act, in effect, like an insurance company.

An insurance company will write a life insurance policy without having any idea when it will have to pay out. It might be tomorrow; it might be 100 years from now.

It doesn’t matter (to the insurance company).

An insurance company makes no predictions about when you might die, when your neighbor’s house might burn down or be burgled — or about any other specific item it has insured.

The insurance company controls risk by writing a large number of policies so that it can predict, with a high degree of certainty, the average amount of money it will have to pay out each year.

Dealing with averages, not individual events, it will set its premium from the average expectancy of the event. So the premium on your life insurance policy is based on the average life expectancy of a person of your sex and medical condition at the age you were when you took out the policy. The insurance company is making no judgment about your life expectancy.

The person who calculates insurance premiums and risks is called an actuary; which is why I call this method of risk avoidance managing risk actuarially.

This approach is based on averages of what’s called “risk expectancy.”

Even though the Master Investor may use the same, commonly accepted terminology, what he’s actually looking at is average profit expectancy.

For example, if you bet a dollar on heads coming up when you flip a coin, you have a 50:50 chance of winning or losing. Your average profit expectancy is 0. If you flipped a coin a thousand times and bet a dollar each time, you’d expect to end up with about the same amount of money you started with (provided, of course, that an unusual series of tails didn’t wipe you out).

50:50 odds aren’t at all exciting. Especially after you have paid transaction costs.

But if the odds are 55:45 in your favor, it’s a different story. Your total winnings over a series of events will exceed your total losses since your average profit expectancy rises to 0.1 — for each dollar you invest you can expect on average to get back $1.10.

Gambling, Investing, and Risk

Gamble -n. risky undertaking; any matter or thing involving risk

-v.t. risk much in the hope of great gain

-v.i. to stake or risk money on the outcome of something involving chance

Parallels are often drawn between investing and gambling — with good reason: in essence, the actuarial approach means “playing the odds.”

Another (but bad) reason is that far too many investors approach the markets with a gambling mentality: “in the hope of great gain.” This is even more often the case with people entering the commodity markets for the first time.

To make the analogy clear, consider the difference between a gambler, and a professional gambler.

A gambler plays games of chance for money — in thehope of making a great gain. Since he rarely comes out ahead, his primary reward is the excitement of playing the game. Such gamblers keep Las Vegas, Monte Carlo, Macau and lotteries the world over in business.

The gambler throws himself at the mercy of the “gods of chance.” However benign these “gods of chance” may be, their representatives on earth live by the motto “never give a sucker an even break.” The result, in Warren Buffett’s words:

Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.

A professional gambler, by contrast, understands the odds of the game he’s playing, and only makes bets when the odds are in his favor. Unlike the weekend gambler, he doesn’t depend on one roll of the dice. He has calculated the odds of the game so that, over time, his winnings exceed his losses.

He approaches the game with the mentality of an insurance company when it writes a policy. His focus: average profit expectancy.

He has a system that he follows — just like the Master Investor. And part of the system, naturally enough, is to choose the game where it’s statistically possible to win over time.

You can’t eliminate chance from a game of poker, blackjack or roulette. But you can learn to calculate the odds, and decide whether it’s possible to play that game with the average profit expectancy (the odds) in your favor.

If it’s not, you don’t play.

Professional gamblers never buy lottery tickets.

Professional gamblers don’t actually gamble. They don’t “risk much in the hope of great gain.” They invest little, time after time, with the mathematical certainty that they will achieve a positive return on capital.

Investing isn’t gambling. But professional gamblers act at the poker table in the same way Master Investors act in the investment marketplace: they both understand the mathematics of risk, and only put serious money on the table when the odds are in their favor.

Actuarial Investing

When Warren Buffett started investing, his approach was very different from the one he follows today. He adopted the method of his mentor, Benjamin Graham, whose system was actuarially based.

Graham’s aim was to purchase undervalued common stocks of secondary companies “when they can be bought at two-thirds or less of their indicated value.”

He determined value solely by analyzing publicly available information, his primary source of information being company financial statements.

A company’s book value was his basic measure of intrinsic value. His ideal investment was a company that could be bought at a price significantly below its liquidation or break-up value.

But a stock may be cheap for a good reason. The industry may be in decline, the management may be incompetent, or a competitor may be selling a superior product that’s taking away all the company’s customers — to cite just a few possibilities. You’re unlikely to find this kind of information in a company’s annual report.

By just analyzing the numbers Graham could not know why the stock was cheap. So some of his purchases went bankrupt; some hardly moved from his purchase price; and some recovered to their intrinsic value and beyond. Graham rarely knew in advance which stock would fall into which category.

So how could he make money? He made sure he bought dozens of such stocks, so the profits on the stocks that went up far outweighed the losses on the others.

This is the actuarial approach to risk management. In the same way that an insurance company is willing to write fire insurance for all members of a particular class of risks, so Graham was willing to buy all members of a particular class of stocks.

An insurance company doesn’t know, specifically, whose house is going to burn down, but it can be pretty certain how often it’s going to have to pay for fire damage. In the same way, Graham didn’t knowwhich of his stocks would go up. But he knew that, on average, a predictable percentage of the stocks he bought would go up.

An insurance company can only make money by selling insurance at the right price. Similarly, Graham had to buy at the right price; if he paid too much he would lose, not make, money.

The actuarial approach certainly lacks the romantic flavor of the stereotypical Master Investor who somehow, magically, only buys stocks that are going to go up. Yet it’s probably used by more successful investors than any other method. For success, it depends on identifying a narrow class of investments that, taken together, have a positive average profit expectancy.

Buffett started out this way, and still follows this approach when he engages in arbitrage transactions. It also contributes to Soros’s success; and is the basis of most commodity trading systems.

Average profit expectancy is the investor’s equivalent of the insurer’s actuarial tables. Hundreds of successful investment and trading systems are built on the identification of a class of events which, when repeatedly purchased over time, have a positive average expectancy of profit.

Risk versus Reward

Most investors believe that the more risk you take on, the greater the profit you can expect.

The Master Investor, on the contrary, does not believe that risk and reward are related. By investing only when his expectancy of profit is positive, he assumes little or no risk at all. Continued…