When I was growing up, I always enjoyed playing board games, with Monopoly being my favorite.

Go figure.

Site selection, rent collection, and capital allocation: Those were the names of the game. And, as I found out years later, they’re the keys to unlocking enormous wealth in real life as well.

I also loved playing Risk, another property-oriented competition. It used to come with the subtitle, “the game of global domination,” though today it’s “the game of strategic conquest.”

The point, regardless, is to take over every continent by playing offense and attacking your opponent while simultaneously defending your own territories. Like Monopoly, it requires a significant amount of risk analysis.

Hence its name.

Now, a board game centered around becoming a worldwide dictator – especially one filled with calvary, infantry, and cannon – might not seem like the most practical practice for a successful adult life. But it taught me to analyze the full range of possibilities my decisions could lead to positive and negative alike.

That’s not just a big deal. It’s enormous.

To quote legendary investor Howard Marks, co-founder and co-chair of Oaktree Capital Management, risk analysis is the “most interesting, challenging and essential aspect of investing.” Even as a younger man, it helped me navigate some challenging markets like the:

  • 1994 spike in interest rates (from 3% to 6%)

  • 1998 Russian default, or ruble crisis

  • 2000 tech-stock bubble

  • 2001 accounting scandals of Enron and WorldCom

And while the 2008 global financial crisis dealt me a painful lesson on the full extent of risk analysis I was able to put that new awareness to work over the next decade. So, when the 2020 shutdowns happened, I was very well prepared.

I’m not predicting a similar crisis now, for the record. Just a garden-style recession.

Even so, it usually pays to be prepared for whatever may come.

You Can Win the Investing Game of Risk

Thanks to all the economic downturns I’ve lived through, I’ve developed an “extreme conservatism” that has given me a definitive advantage as a stock picker.

For instance, I was always careful about assessing each property I bought and tenant I signed. But now that I more fully understand the importance of risk analysis, I utilize a defensive approach so much more.

Just like in the game of Risk, you need to have that bigger goal you’re shooting for. After assessing where you are, who you are, and where you want to be, you choose a financial figure you want to reach by a certain time.

The best way to achieve it – whatever it is – is by spending and losing as little money as possible while you look for growth opportunities. To quote Marks again:

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is the essential element in investing.

It’s not hard to find investments that might go up. If you can find enough of these, you’ll have moved in the right direction. But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk.

The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.

Today on our new YouTube channel, fellow Wide Moat Research analyst Nick Ward and I discussed the likelihood of a potential recession and ways to navigate it. It’s a topic we’ve been addressing a lot lately.

Click the image below to watch the show.

 

And it’s one we’ll continue to cover as we navigate the first few months of Donald Trump’s presidency – complete with all the economic consequences they bring. Nick recently wrote how Trump “may be willing to face short-term pain for the good of the country’s balance sheet long term.”

I have to agree. In which case, as we discussed on The Wide Moat Show, there are rules you need to know about.

Risk Analysis Rule No. 1: Understand Your Investments

I wrote on the importance of understanding your investments earlier this month, explaining how, “You shouldn’t buy up a business you don’t know a thing about.” In that article, I pointed to a real-life example in which I once owned multiple Papa Johns pizza stores.

I had no business getting into the pizza business. Not when I had no idea what I was doing.

I just assumed that since I knew the basics of making a pizza and owned a successful business – that wasn’t related to making pizza – I’d be fine. Shockingly enough, I ended up being wrong in that risk analysis.

As I often tell folks, “The best way to get a million dollars is to start out with $2 million and buy a pizza franchise.” That was my story, anyway.

This same concept applies to investing. One of the best ways to lose money is to sink it into something you don’t understand.

It doesn’t matter if it’s the “latest and greatest” or the stock that “everybody’s buying.” If you can’t wrap your head around it, don’t bother.

Otherwise, it’ll probably end up bothering you before long.

Risk Analysis Rule No. 2: Don’t Forget About Diversification

Always diversify.

Always. Always. Always.

That’s the painful lesson I had to learn in the 2008 crash. Back then, I had built my entire world of wealth around a single concept: real estate.

Worse yet, most of my net worth was tied up with one company with one business partner. We owned around 30 properties, so we at least had that level of diversification going for us.

But investment wealth needs to be spread across more than just one category for truly successful results.

I saw that in the years leading up to the Great Recession, where my business partner began investing in properties he didn’t understand. (See Rule No. 1.) When they started going bad, he compensated by using our collective assets as an ATM machine.

And then we lost everything.

There was little I could do to stop that fire once it started. I could only focus on rebuilding out of the ashes.

Unfortunately, I rebuilt on real estate alone. So the housing market debacle wiped me out all over again.

Had I practiced responsible diversification, I wouldn’t have had to go through that painful process once, much less twice.

Risk Analysis Rule No. 3: Employ the Margin of Safety

Margin of safety is the best risk-mitigation tool on the planet, though one that took me decades to grasp.

Back when I was buying land and overseeing construction, I always looked at cost. My goal was to buy the best products at the best prices.

It’s Business 101.

It’s Investment 101 too. When you buy quality assets at a discount, they’re more likely to increase in value. The greater the discount, the greater your potential for gain.

This isn’t rocket science. But it can be difficult to practice when you really, really want to own a particular stock.

Fight the urge anyway. Because even the best businesses can lose you money if you buy their stock when it’s overvalued.

I also need to point out how much money you can lose if you’re buying non-quality companies. In those cases, even a fire-sale stock price isn’t a guarantee of success.

Warren Buffett – who said “you really can’t go wrong” if the margin of safety becomes “part of your DNA” – is very well aware of this. When he first invested in Berkshire Hathaway in 1962, it was a struggling textile business he was hoping to turn around.

Instead, Buffett estimates he lost around $200 billion on it over 20 years.

That’s why Howard Marks said, “Great investing requires both generating returns and controlling risk. And recognizing risk is an absolute prerequisite for controlling it.”

Here at Wide Moat Research, our No. 1 goal is to help members navigate risk. We do that by utilizing sound investment principles focused on fundamental analysis.

And we do it well.

Maybe our risk-acknowledging preservation principles won’t lead to global domination. But they’re a proven way to help you achieve your financial goals and sleep well at night along the way.

Happy SWAN (sleep well at night) investing!

Regards,

Brad Thomas
Editor, Wide Moat Daily

MAILBAG

What other ways do you navigate risk? Write us at [email protected].