Thinking like Pabrai, Marks & Buffett
Risk, Uncertainty and the Secret of Successful Investing
In the high-stakes world of Wall Street, a peculiar phenomenon often unfolds - it’s a confusion between risk and uncertainty that savvy investors can exploit for substantial gains.
Eminent investor, Mohnish Pabrai, in his book "The Dhandho Investor," unveils this paradox with the finesse of a master storyteller.
Picture a bustling trading floor, screens flashing red and green, where the slightest whisper of uncertainty sends ripples of panic through the market. Where Wall Street trembles at the unknown, Pabrai sees a chance to strike. Here he is explaining it:
His strategy is elegantly simple, yet profoundly effective. He seeks out companies built on solid foundations, yet momentarily obscured by the fog of uncertainty. As others flee, marking down stock prices in their haste, Pabrai moves in. With the calculated precision of a chess grandmaster, he acquires shares at bargain prices, knowing that the mist of uncertainty will eventually clear and the true valuation will ultimately prevail.
Pabrai compares this scenario to a coin toss with highly favorable odds. On heads, he stands to gain significantly as uncertainty dissipates and the market corrects its misjudgment. On tails, the loss is minimal, buffered by the company’s intrinsic value and the advantage of having achieved a discounted entry price. It’s a game where the odds heavily favour the patient and perceptive investor.
“Wall Street sometimes gets confused between risk and uncertainty, and you can profit handsomely from that confusion. The low-risk, high-uncertainty gives us our most sought after coin-toss odds. Heads, I win; tails, I don't lose much.”
Monish Pabrai
Pabrai's approach isn't mere theory; it's a battle-tested strategy that has reaped real-world rewards for him and his fund over the course of many years. From a man who migrated from India to the U.S. with nothing, today he is a self-made billionaire. It’s the American dream; it’s the tale of wealth created by those who dare to think differently.
Howard Marks, another eminent investor, has a perspective on risk that aligns closely with that of Mohnish Pabrai. He emphasizes that risk is often misunderstood and misinterpreted by Wall Street and investors alike.
Marks defines risk as "the possibility of loss" - he says that true risk isn't about short-term price fluctuations, but rather the chance of a permanent loss of capital.
Conventional economic theory often equates risk with volatility, measured as the standard deviation of a stock price. Yet uncertainty causes share price volatility, not risk. Uncertainty arises when more things can happen than will happen. The larger the number of possible outcomes, the greater the uncertainty, introducing anxiety into the pricing equation and fueling volatility. So standard deviations don't tell us anything about risk, merely about uncertainty.
Consider further the Capital Asset Pricing Model (CAPM), widely taught in business schools as a framework for valuing securities based on volatility. CAPM uses Beta as an input coefficient, yet Buffett has consistently argued that beta, which measures price volatility, is not an accurate measure of investment risk.
Beta implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower risk after it falls in value.
"Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland."
Warren Buffett, 1984, Columbia University
It becomes clear that conventional economic theory is flawed: risk and volatility are not the same thing.
Howard Marks expresses his thoughts on the matter it in this short video:
However, because the market misconstrues volatility as risk, it often overreacts to share price movements, which may simply be a product of short-term market sentiment, creating mispricing opportunities. These often result in an asymmetry in investment returns which is the situation leading investors are hunting for.
Marks points out that investors erroneously chase outsized returns, and in so doing often disregard the risk that they are taking. As a result they often suffer a permanent impairment of capital when an unfavourable outcome leads to a large loss. He counsels that the proper approach is not to chase outsized returns, but to chase situations where the downside is very limited. This, he says is the secret of successful investing. This mirrors Pabrai's "coin-toss" analogy, where the potential for significant gains coexists with limited downside.
It isn’t difficult to make money in the market, especially in good years, and most years are good years. The challenge requiring real skill is to make money with the risk under control so that when a bad year arrives, you aren’t hit too hard.
Marks advises that the best foundation for above-average returns is the absence of disaster. While most people seek phenomenal returns that outshine every other investment, a little above average is the secret. He says that investing is a long-term game. It takes time to build wealth and one shouldn’t expect to get rich quickly. Investing requires patience and discipline - deploy them both and you will be rewarded. If you want to avoid high risks, you have to be willing to accept lower returns. Investing is not about beating the market. It's about controlling risk. If you can do that, you'll be a successful investor.
Marks notes that what distinguishes a great investors from the rest is their ability to understand the range and likelihoods of possible outcomes better than others and they play defensively. Buffett and Munger are exemplars of this philosophy as they explain themselves:
Buffett has always said that his first rule is not to risk losing money, and his second rule is not to forget the first rule.
When all of the best investors say the same thing, the market ought to sit up and take notice, but they don’t. Yet the majority of investors run discounted cash flow models designed to forecast the upside potential of an investment, with little or no consideration given to the risk of loss. It’s upside down, back-to-front thinking.
In 2021, Tesla, an electric vehicle company, produced just 1% of the world’s private vehicles. Yet, its market capitalization soared to surpass the combined value of all other major automakers, despite these companies collectively producing 99 times more vehicles and often being far more profitable. Think of industry giants like Toyota, Ford, Volkswagen, Audi, General Motors, Nissan, Renault, Fiat, Chrysler, Jaguar Land Rover, Aston Martin, Rolls Royce, Mercedes-Benz, BMW, Ferrari, Porsche, and Lamborghini. It is unfathomable that anyone could believe that Tesla is worth more than all of them combined. Clearly the market wasn’t thinking straight, if at all.
The momentum of the company’s stock price drew in investors and fund managers eager to seize a quick profit, chasing potential upside while seemingly disregarding the inherent risks of loss. On November 1, 2021, Tesla's share price reached a peak of over $401, only to plummet to $111 by January 2023—a staggering 72.4% decline in just 14 months.
A similar pattern of speculative frenzy is now evident with AI-related stocks like NVIDIA and various crypto assets, whose valuations are driven not by intrinsic worth but by sheer speculative fervour.
“Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.”
Howard Marks
Howard Marks points out that most people in the market are dazzled by the prospect of making a fast buck and this blinds them to the risk that they are exposed to. He argues that investors should always be cognizant of the risks that they are taking, but on the evidence available suggests that they rarely are.
Marks’ investment firm, Oaktree Capital, puts risk before all else. It aims to create alpha, or outperformance from the wider market, not by achieving better returns in good years, but by suffering smaller losses in down years - as he explains:
Marks recounts the story of a well-regarded investment firm that experienced an abysmal year. The firm’s head dismissed the situation with the remark, “If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%.”
Marks found this perspective deeply unsettling, thinking to himself, ‘I don’t care about being in the top 5% in any single year, and neither I nor my clients are willing to endure being in the bottom 5% either.’
Shortly after, he encountered the manager of General Mills’ pension fund. Over a 14-year tenure, the fund’s performance consistently fell within the second quartile, never exceeding the 27th percentile or dropping below the 47th. Surprisingly, over the entire period, the fund ranked in the 4th percentile.
How could a fund that never broke into the top quartile in any single year, achieve such a stellar long-term ranking? The answer lies in discipline: most investors eventually sabotage their own results by chasing outsized returns. One or two disastrous years will irreparably damage long-term performance. It's not about chasing short-term market outperformance at any cost, but rather achieving long-term market outperformance while prioritizing the preservation of capital under management.
“Prioritize the downside of every investment. With limited downside, the upside will take care of itself.”
Howard Marks
Long-Term Capital Management (LTCM), a hedge fund founded in 1994 by former Salomon Brothers executive John Meriwether, highlights the risks of financial overconfidence and poor risk management. The firm attracted brilliant minds, including Nobel Prize-winning economists and exceptional mathematicians, like Myron Scholes, co-creator of the Black-Scholes option pricing model, who served on its board of directors.
LTCM initially delivered stellar annualized returns of 21%, 43%, and 41% in its first three years. However, the firm’s heavy leverage, which magnified gains during strong markets, left it dangerously exposed to downturns. External shocks, such as the 1997 Asian financial crisis and the 1998 Russian financial crisis, tested these vulnerabilities.
The tipping point came in 1998, when LTCM suffered a catastrophic $4.6 billion loss in under four months. With positions totaling 5% of the global fixed-income market, its collapse threatened the stability of the entire financial system. To avert a potential meltdown, the Federal Reserve Bank of New York facilitated a $3.6 billion bailout orchestrated by 14 major banks. This intervention ensured an orderly liquidation of LTCM’s positions, preventing widespread disruptions across global markets.
There is no sense in making stellar returns for three years, only to lose everything in the fourth year. That is not intelligent investing.
This fundamental principle is evident in the natural world, particularly in the animal kingdom. Predators like lions often target the weak and vulnerable rather than hunting the strongest and largest prey. This strategy may not yield the most substantial meal, but it significantly reduces the risk of being injured or killed during the hunt, ensuring that the lion survives to hunt another day. This strategy reflects the concept of survivorship bias, where the value of avoiding significant losses outweighs the potential benefit of a major gain. Similarly, as investors, we should prioritize avoiding mistakes that could lead to heavy losses, even if it means forgoing opportunities for outsized returns.
The key takeaway is that successful investing lies not in chasing big winners - doing so is more likely to blind an investor to risk, which is incredibly dangerous. Instead it is about being cognizant of risk, making the preservation of capital paramount.
High uncertainty, which is distinct from risk, creates opportunities to discover investments with a ‘heads I win big, tails I don’t lose much’ dynamic. In cases such as a sharp drawdown in the valuation of a quality company, which may be caused by entirely exogenous factors, the risk is reduced while the potential upside increases, allowing investors to capitalize on a favourable entry price.
This approach demands patience, keen insight, and the courage to act decisively when others are held back by uncertainty. The intelligent investor will learn from the likes of Pabrai, Marks and Buffett while avoiding the folly of LTCM.
