Excerpted from the Geometry of Wealth by Brian Portnoy, Published by Harriman House. Available Wherever Books Are Sold.
We constantly navigate a delicate balance between taking enough risk to get ahead, but not so much as to court danger. In that balancing act, we first seek to avoid mistakes, if possible, and to mitigate the consequences of those that inevitably occur. Not losing is the first step toward winning.
Being wrong is an unavoidable part of the human experience. Not that we aim to screw up. We are always striving to succeed, to do better, to be right. In the domain of money as much as any other, we want to be more right than others—to leverage our edge. Trying to be more right is daily bread for most of us: choosing the right pre-school for our toddlers, making accurate sales projections, choosing the fastest route home, picking the best stock, anticipating the next storm.
The challenge is that as we push to be more right, we leave ourselves open to loss. The more risk we take, the wider the range of outcomes, both good and bad. So, at least at the start, we don’t want to be more right, we want to be less wrong. This is winning by not losing.
Legendary investor Howard Marks makes a critical distinction between “risk avoidance” and “risk control.” By avoiding risk, we can’t progress. Instead, the aim should be to control risk—taking enough, but not too much.
Pascal tried to be less wrong. He didn’t know what the future held, so he made a ballpark guess and took his chances. Contrary to what appears to be the scientific rigor and mathematical precision of finance, most of what we care about is incalculable. Risk is usually hard to define and almost always impossible to measure precisely. We need not look much further than severe market crashes that a statistics Ph.D. would claim are once-in-a-lifetime events but that happen every decade or two. Black swans are more common than we think, and not just in the stock market.
The philosophy of less wrong—the heart of the “protect” stage of our triangle—courses through key elements of our money lives: Insurance, investing, and debt.
Insurance. This is the most obvious example of how most of us intuitively try to be less wrong. We don’t know if our house will catch on fire. We suspect it won’t. We don’t act carelessly around flames, we purchase smoke detectors, and have an extinguisher handy. But you never know. So we buy fire protection on our homes and don’t give it a second thought. Most of the insurance premiums we pay for our homes, cars, and lives will forever be “lost.” But we don’t see them as money squandered. For small sums, we buy peace of mind. Who doesn’t sleep a little bit better knowing that if such a catastrophe happened, they’d still be able to put their life back together? Pascal bought insurance on his soul and was, I’m sure, happy to pay the premiums.
Investing. In one of the most important investing articles ever written, “Winning the Loser’s Game,” money sage Charley Ellis argued that most investors should win by not losing. He used the game of tennis to illustrate his point. For novice tennis players (which is nearly everyone) victory usually stems from avoiding errant shots and keeping the ball in play. We patiently capitalize on a competitor’s mistakes; we let the game come to us. Professional tennis players do something entirely different. They hit the ball with power and pinpoint accuracy. In tennis, like investing, professionals strive to be more right, while most others should focus on being less wrong.
Great investors naturally think about being less wrong. Legends like Warren Buffett, Charlie Munger, Howard Marks, Paul Tudor Jones, George Soros, and Seth Klarman never flip coins. They patiently wait until the odds are so stacked in their favor it would be foolish not to bet. They make plenty of mistakes along the way, but focus on minimizing the damage. Summarizing the point nicely, George Soros said: “My approach works not by making valid predictions but by allowing me to correct false ones.” Truly skilled investors value flexibility, adaptability, and the ability to withstand losses in order to fight the next day.
Debt. The less wrong mentality reveals a fresh view on why debt or excessive borrowing is a problem. Yes, rule number one in most personal finance checklists is: Don’t spend more than you make. We know that. Nonetheless, many do not heed that advice. That’s a problem in the obvious sense that we’ll have to find some way to come up with the money to pay back our lenders. But indebtedness also has a ripple effect through our lives in that it limits our flexibility. Much of our need to calibrate happiness with our financial wherewithal requires us to adapt to changing or unforeseen circumstances. By curtailing our ability to adapt, debt makes that dynamic even harder than it already is. Debt not only puts us in the hole financially, it also limits our choices and inhibits our ability to be less wrong. Especially when debt compounds, it forces us to make decisions we wouldn’t have made otherwise.
In setting our main priorities for growing and staying wealthy, controlling risk comes first. This isn’t the sexy part of money. That comes later. This is the hard part because it involves a great deal of thought about how we should conduct our affairs, how we want to risk what we have in order to get ahead.
It’s hard because the rewards for doing this right are almost never visible. At the protect stage, the rewards are largely non-events, things that don’t happen. There are no awards or accolades for controlling risk, no shiny new car in the driveway for exercising prudence. Nonetheless, failure at this stage, failure to plan for life’s inevitable accidents and mistakes, ensures that we will not be wealthy, or at best consigns our fate to life’s randomness, where things arbitrarily work out or they don’t.
About the Author:
Brian Portnoy, PhD, CFA, is an expert at simplifying the complex world of money. In his two books, The Geometry of Wealth and The Investor’s Paradox, he tackles the challenge of not only making better investment decisions but also how money figures into a joyful life.