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

Nerves of steel? Many people have made comments of that kind about Soros. What they mean is: I would have to have nerves of steel to do what Soros is doing.

Soros doesn’t need nerves of steel: the Master knows what he is doing. We don’t — until we learn what the Master has learnt.

He knows what he is doing. Similarly, there’s bound to be something you do in your life that, to an outsider, seems full of risk but to you is risk-free. That’s because you have built up experience and achieved unconscious competence in that activity over the years. You know what you’re doing — and you know what not to do.

To someone who doesn’t have your knowledge and experience, what you do will seem full of risk.

It may be a sport — such as skiing, rock-climbing, scuba diving or car racing. It may be those instant, seemingly intuitive judgments you make in your business or profession.

Let me give you a personal example. Since it’s in a field you probably know nothing about, I’ll have to give you a little background first.

When I published my newsletter World Money Analyst, profits from mailshots — solicitations to gain new subscribers — were a regular source of income for me. There were times when I spent hundreds of thousands of dollars I didn’t have putting a promotion into the mail. Yet I never felt I was taking a risk.

To send out a mailing, you have to pay for printing, lettershopping (putting everything into the envelopes), renting the mailing lists — and postage. Only the postage has to be paid up front; for everything else you can get 30 to 90 days’ credit.

From records I’d kept of every mailing I’d ever done I knew that by the seventh day of response I would have received about half the total revenue I could expect. Since that was more than the postage, I could start paying the other bills as they came due.

Ah, you might ask, but how do you know that money is going to come in?

The level of response depends on three variables: the headline, the copy (the text of the advertisement), and the mailing list. When you create a new advertisement, you don’t know for sure that it will work. So you test: mail out 10,000 or 20,000 pieces to the best mailing lists available. Unless the copy is complete drivel, you’re unlikely to lose very much money. (And if you lose the lot it’s only a couple of thousand dollars, so why worry?)

If the test mailing works (that is, if it’s profitable), you “roll it out” to other mailing lists. Because I was mailing regularly, I knew which mailing lists worked, which didn’t, and which worked sometimes. So I could select which mailing lists to roll out to, based on the profitability of the test. When the test was highly profitable, I could mail half a million pieces or more…if all I had to pay initially was the postage.

Still think I was taking unnecessary risks? I imagine you do. I’m not trying to convince you otherwise. But because I knew what I was doing, to me there was no risk at all.

Think about it for a while and I’m sure you’ll find several similar examples where you feel you are taking little or no risk — but it’s impossible to convince an outsider that there’s no risk involved.

Risk declines with experience: there are many things you do today which you think of as risk-free. But at one time in your life, before you built up the necessary knowledge and experience, they were high-risk activities for you.

When George Soros shorted the pound sterling with $10 billion of leverage (as he did in 1992), was he taking a risk? To us, he was. But we tend to judge the level of risk by our own parameters; or to think that risk is somehow absolute. On either of those measures, the risk was huge.

But Soros knew what he was doing. He was confident the level of risk was completely manageable. He’d calculated that the most he could lose was about 4%. “So there was really very little risk involved.”

As Warren Buffett says: “Risk comes from not knowing what you are doing.”

The highly successful investor simply walks (or more likely runs) away from any investment that is risky to him. But since risk is relative and contextual, the investment that Warren Buffett may shy away from can be the one that George Soros scoops up with both hands. And vice versa.

Risk is Measurable

Restricting his investments to those where he has unconscious competence is one way the Master Investor can be risk-averse and, at the same time, make above-average profits. But how did he build that unconscious competence in the first place? By discovering that risk is measurable — and by learningwhat to measure.

The Master Investor thinks in terms of certainty anduncertainty, and his focus is on achieving certainty. He isn’t really “measuring risk” at all. He is measuring the probability of profits in his continual search for, as Warren Buffett puts it, “high probability events.” And he finds them by answering the question:

What Are You Measuring?

I once asked an investor what his aim was. He replied: “To make 10% a year.”

“And what’s your measure of whether you’re achieving that?”

He answered: “By whether I made 10% or not.”

This investor is rather like an architect who measures the quality of his building by whether or not it stands up when it’s finished. Whatever result you are trying to achieve can only be the measure of whether youhave achieved it; not the measure of whether youwill.

A good architect knows that his building will stand up while it’s still a blueprint. He knows this by measuring the strength of the materials, the loads they will have to bear, and the quality of the design and construction.

In the same way, the Master Investor knows, beforehe invests, whether he is likely to make a profit.

Profit (or loss) is a residual: the difference between income and expenditure. As a result, it’s only measurable with the benefit of hindsight.

For example, a business does not make profits by aiming to make profits. It must focus on the activities that are measurable in the present, and later result inprofits: in other words, activities that increase sales and income and/or cut costs. And by only undertaking activities where the managers are confident that income will exceed costs.

Investment Criteria

Master Investors focus their attention not on profits, but on the measures that will inevitably lead to profits: their investment criteria.

Warren Buffett doesn’t buy a stock because he expects it to go up. He’ll be the first to tell you the price could just as easily drop the moment after he’s bought it.

He buys a stock (or the entire company) when it meets his investment criteria, because he knows from experience that he will ultimately be rewarded by either a higher stock price or (when he buys the whole company) rising business profits.

For example, in February 1973 Buffett began buying shares in the Washington Post Co. at $27 a share. As the price fell Buffett bought more and by October was the largest outside shareholder. To Buffett, theWashington Post was a $400 million business that was on sale for just $80 million. But that’s not what Wall Street saw — even though most publishing analysts agreed with Buffett on the company’s valuation.

Wall Street saw a collapsing market. The Dow was off 40%, and the “Nifty Fifty” stocks such as IBM, Polaroid and Xerox — which only a few years before Wall Street had been happy to buy at 80 times earnings — were off 80% or more. The economy was in recession and inflation was rising. That wasn’t supposed to happen: recession was supposed to send inflation down. To Wall Street, it looked like the “end of the world” might be coming. This was definitely not a time to buy stocks; and with inflation rising you couldn’t even find safety in bonds.

When they looked at the Washington Post Co., investment professionals saw a stock that had fallen from $38 to $20 a share and which, like the market, could only go down. The “risk” of buying was far too high.

The irony is that the Post could have sold its newspaper and magazine businesses to another publisher for around $400 million — but Wall Street wouldn’t buy it for $80 million!

To Buffett, when you can buy a sound, attractive business at an 80% discount to its value, there’s no risk at all.

Buffett wasn’t looking at the market — or the economy. He was using his investment criteria to measure the quality of the Post’s business. What he saw was a business that he understood; that due to its effective monopoly in the Washington area had favorable economics that were sustainable (and because of its “monopoly” could raise prices in line with inflation and, so, was an inflation hedge); wasn’t capital-intensive; was well-managed — and, of course, was available at a very attractive price.

While Wall Street was driven by fear of loss, and called it “risk,” Buffett and other investors who knew what to measure were cleaning up. Intriguingly, often when the market is collapsing investment professionals suddenly discover the importance of preserving capital, and adopt a “wait-and-see” attitude…while investors who follow the first rule of investing, “Never Lose Money,” are doing the exact opposite and jumping in with both feet.

After Buffett had made his investment the price of the Washington Post Co. kept falling. Indeed, it was two years before the market came back to his original average purchase price of $22.75 per share. But Buffett didn’t care about the share price; his focus was on his investment criteria, on measuring the quality of the business. And that quality — to judge by earnings alone — was improving.

In the investment marketplace, you are what you measure.

Risk is Manageable

Soros achieves investment certainty in a very different way. Like Buffett, he measures his investments — all successful investors do — but Soros applies very different investment criteria.

The key to Soros’s success is to actively manage risk, one of the four risk-avoidance strategies Master Investors use:

• Don’t invest.
• Reduce risk (the key to Warren Buffett’s approach).
• Actively manage risk (the strategy George Soros uses so astoundingly well).
• Manage risk actuarially.

There’s a fifth risk-avoidance strategy that’s highly recommended by the majority of investment advisors: diversification. But to Master Investors, diversification is for the birds (see Chapter 7).

No successful investor restricts himself to just one of these four risk-avoidance strategies. Some — like Soros — use them all.

1. Don’t Invest

This strategy is always an option: Put all your money in Treasury bills — the “risk-free” investment — and forget about it.

Surprising as it may seem, it is practiced by every successful investor: when they can’t find an investment that meets their criteria, they don’t invest at all.

Even this simple rule is violated by far too many professional fund managers. For example, in a bear market they’ll shift their portfolio into “safe” stocks such as utilities, or bonds…on the theory they’ll go down less than the average stock. After all, you can’t appear on Wall Street Week and tell the waiting audience that you just don’t know what to do at the moment.

2. Reduce Risk

This is the core of Warren Buffett’s entire approach to investing.

Buffett, like all Master Investors, invests only in what he understands, where he has conscious and unconscious competence.

But he goes further: his method of avoiding risk is built into his investment criteria. He will only invest when he can buy at a price significantly below his estimate of the business’s value. He calls this his “Margin of Safety.”

Following this approach, almost all the work is done before an investment is made. (As Buffett puts it: “You make your profit when you buy.”) This process of selection results in what Buffett calls “high probability events”: investments that approach (if not exceed) Treasury bills in their certainty of return. Continued