Some Risk Management Lessons From Guru Warren

The blindness to risk in the buoyant environment of 2003-07 and the subsequent fall in 2008 (67% down for the year) taught me a lot of useful lessons. Some of those were captured in my earlier blog on Risk Management here. Those lessons still serve as guiding principles to me. From time to time, reading books like "Black Swan" and "Fooled by Randomness" also helps in emphasizing the importance of risk management in investing. But, there is a continuous need for improvement, esp. in an environment where stocks are becoming costlier by the day. Reading the latest letter from Warren Buffet to Berkshire's shareholders gives some good insights into the risk management strategies practiced at BH. Interestingly, whatever is applicable to one of the biggest corporations in the world is also applicable to small investors. Here is what Guru has to say.

Financial staying power requires a company to maintain three strengths under all circumstances: 
(1) a large and reliable stream of earnings; 
(2) massive liquid assets and 
(3) no significant near-term cash requirements. 

If one pays attention, it is not difficult to understand that individual investors must practice these mantras as well.

A large and reliable stream of earnings -  This statement simply means that we should own many sources of earnings(diversify) and the companies that we own should have reliable earnings(Consistent). At some other place in the letter, he mentions the criteria that Berkshire applies before purchasing a company.  One of the important ones is as follows.

Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations).

Above mentioned criteria clearly tells us what kind of companies we should own and what kinds we should avoid.

As far as diversification goes, everyone has their own criteria and comfort level. Too much diversification leads to leniency in stock selection, while too less diversification exposes one to black swans. One needs to find his comfortable mean and stick to his principles. But definitely owning one or two stocks is ruled out.

(Massive) liquid assets - Many individual investors utilize leverage. It really works well in early stages of a bull market. I myself used 10% leverage for generating higher returns in 2014. But, as the market matures, we should definitely move towards liquid assets. Remaining invested only to the level of 75-80% and keeping 20-25% as cash in a matured bull market should be considered by every serious investor. In challenging times like 2008, it helps us in keeping nerves calm and allows us to invest in some really good businesses at reasonable prices. After all, longevity in investing is far more important than a great performance in the short run. In Guru's words:

At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.

No significant near-term cash requirements - This is directly related to the liquid assets. If you are debt laden elsewhere and you have obligations to pay, then your liquid assets will be of no use in bad times. All the lenders will want you to pay in the bad times. And, liquid assets are useful only when the times are really bad. So, if you have an obligation to pay in near term, please don't count on your liquid assets as they might get utilized for near-term cash requirements. Actually, to reduce risk, we should try to remain debt/obligation free at all the times.

There are many important nuggets of wisdom in the letter and I would recommend all of us to read it. But, if one could only take this risk management part and practice it, his investing life would be much more satisfying and fruitful.