Financial History 145 Spring 2023 | Page 15

ago . They have survived millions of years amid ferocious predators by being very sensitive to making type I errors — errors of not being too careful . Obviously , some individual deer do end up making the fatal error of commission by drinking at watering holes when predators are present , but the species as a whole has done remarkably well .
If you have seen African wildlife videos or gone on a safari , you will have noticed how vigilant wildebeests , antelopes , zebras and other herbivores are . They seem to see danger where there is none . But it is this alertness that has allowed them to survive and thrive for millions of years . A type I error of underestimating a threat could be the last error one of these animals makes .
But there is a significant trade-off to the approach of minimizing the risk of type I errors : the deer make many more type II errors . A type II error , or the error of omission , means avoiding a watering hole where no predator is waiting . In some cases , a type II error may turn out to be a fatal mistake . A thirsty deer may not be able to run quickly enough to escape a predator , but on average , making this trade-off in favor of reducing the number of errors of self-harm has worked quite well for the species .
Let ’ s now turn our attention to the predator . The predator , too , can make two types of error : It can commit itself to killing prey that turns out to be too dangerous or too large or too fast ( type I error ), or it can refrain from attacking prey that it could easily have killed ( type II error ). Which error do you think a predator makes more often ?
A cheetah is the fastest mammal on Earth and routinely achieves speeds of 80 to 100 kilometers per hour while chasing prey . It usually preys on smaller animals like birds , rabbits and small antelopes , and will never attempt to kill an adult water buffalo , a favorite prey of lions . The cheetah is simply trying to avoid getting hurt . Committing a type I error will lead either to death — water buffalos can turn on their hunters aggressively — or wasted energy , when a cheetah chases an antelope that was too far away to begin with .
These mistakes , in turn , will lead to hunger and poorer hunting performance . The fact the species has been successful for eons demonstrates that cheetahs , as a species , have not committed too many type I errors . A type II error for a cheetah would mean not chasing prey it should have . This would leave the cheetah and maybe even her babies hungry , but they would all live to see another day .
Natural selection among animals is incessant and merciless and has produced millions of species , all of whom adhere to this simple principle : Minimize the risk of committing type I errors to curtail the risk of injury or death , and learn to live with type II errors or foregone benefits .
Buffett ’ s Two Rules of Investing
As one should expect , Warren Buffett figured out these lessons from evolutionary theory before almost everyone else . He famously coined his two rules of investing as follows : Rule number one : Never lose money . Rule number two : Never forget rule number one .
But wait a minute . What does he mean by commanding us to “ never lose money ?” How can one choose not to lose money ? Isn ’ t that what every investor wants ? Why would any investor deliberately wish to lose money ?
In fact , Buffett seems to have violated his own two rules on many occasions . For example , in 1993 , Berkshire bought Dexter Shoe for $ 433 million in Berkshire stock . As he detailed in his 2007 annual letter , “ What I had assessed as a durable competitive advantage vanished within a few years … I gave away 1.6 % of a wonderful business — one now valued at $ 220 billion — to buy a worthless business .” In his 2014 annual letter , he admitted his mistake in Berkshire ’ s Tesco investment .
Despite losing money occasionally , what is he asking us to do when he orders us not to lose any ? Buffett has never explicitly explained this ( at least I have never found an explanation ), but this is what I think he means : Avoid big risks . Don ’ t make type I errors . Don ’ t commit to an investment in which the probability of losing money is higher than the probability of making money . Think about risk first , not return .
The definition of “ risk ” used here is not the same as the one defined by corporate finance theorists . Finance theory claims that risk is the chance that the actual investment return will differ from the expected investment return . Thus , if an asset is highly volatile , it will be classified as riskier than an asset that is not as volatile . If you think about this , you will conclude that this is nonsensical . For any investor , risk should simply be the probability of incurring a capital loss .
As Buffett ’ s diktat shows , he is focused on minimizing risk and , in doing so , has become the envy of the entire investment world , which seems obsessed with running after every half-baked business idea . Buffett is the best investor in the world because he is the best rejector in the world .
It ’ s all well and good to assert that we should learn from the evolutionary success of animals and investing success of Buffett to avoid big risks to become better investors . But how ? What is a big risk ? It is not clear that a definition is possible or even desirable for a practitioner . Instead of defining “ big risk ,” below are the kinds of situations that should be avoided .
Be Wary of Criminals , Crooks and Cheats
People don ’ t change . Especially criminals , crooks and cheats . An investor should have no interest in a business owned or run by someone who defrauds customers , suppliers , employees or shareholders . When presented with such a person or business , don ’ t ask if the business is cheap enough for the risk to be mitigated ; don ’ t ask if the individual could be persuaded to change ; don ’ t ask if the crimes are too trivial . Simply walk away .
Avoid Turnarounds
Imagine a tennis match where Roger Federer is playing John , who is ranked 500 in the world , and you are asked to bet 5 % of your wealth on John winning the match . Before the match starts , in a face-to-face meeting , John makes an impassioned plea asking you to ignore his ranking and recognize his innate talent . He speaks very eloquently and makes a slick PowerPoint presentation on his plan to defeat Federer . Would you bet 5 % of your wealth on John ? Hopefully not .
But this is exactly what happens in the world of investing . Managements that have underperformed for long periods are able to convince investors to bet on their business with nothing but fancy promises and McKinsey reports . I blame neither management nor McKinsey because optimism is not a crime . But I do get baffled at investors who , despite having access to
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