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Like baseball, investing is more about safe hits that’ll get you on base rather than hitting home runs. The importance of calculating down-side risk rather than upside gains is one of the most overlooked concepts in stock market investing.

Of course Warren Buffett is often quoted as saying, “Rule No.1 is never lose money. Rule No.2 is never forget rule number one.”

One of the best pieces on the subject comes from one of my favorite investors, Joel Greenblatt.

Greenblatt is an Adjunct Professor at Columbia University Graduate School of Business. He’s Managing Partner of Gotham Capital, a hedge fund that he founded in 1985, and a Managing Principal of Gotham Asset Management. He’s also written three books.

If you’re serious about investing. Do yourself a favor and grab a copy of Greenblatt’s book, You Can Be A Stock Market Genius, from the library. While most investing books can be dry and dense, this book is very easy to read.

Let’s hear what he has to say on minimizing down-side risk and getting on base…

In Chapter 2 – Some Basics – Don’t Leave Home Without Them, he discusses a number of basic investing rules, one of which includes managing your down-side risk:

“One cherished and immutable law of investing is that there is a trade-off between risk and reward.”

“The more risk you assume in your portfolio, academics and most professionals agree, the more reward you receive in the form of higher returns. The less risk assumed, the lower the return. In short, you can’t get something (high returns) for nothing (taking low risks). This concept is so fundamental that it provides the underpinning for the investment strategies of both academies and professionals.”

“Of course, if the discussion ended there, you could just dial up your desired level of risk and receive the targeted return you deserve. In a perfectly efficient world, this relationship between risk and reward should hold true. Obviously, since you will be looking for pockets of opportunity where there are inefficiently priced investments (i.e., stocks or investment situations so far off the beaten path that analysts and investors have not priced them correctly), this immutable relationship between risk and reward should not apply.”

“That, however, does not make the concept of risk/reward irrelevant to you. Far from it. It is perhaps the most important investment concept of all. That’s why it’s so amazing that, at least when it comes to analyzing the risks of individual stocks, most professionals and academics get it wrong. They get it wrong because they measure the ‘risk’ portion of risk/reward in an erroneous and truly puzzling way.”

“Risk, according to generally accepted wisdom, is defined as the risk of receiving volatile returns. In the academic world, risk is measured by a stock’s “beta”— the price volatility of a particular stock relative to the market as a whole.”

“Usually the calculation of “beta” is based on an extrapolation of a stock’s past price volatility. In this topsy-turvy world, the distinction between upside volatility and downside volatility is greatly confused: a stock that moves up significantly over the course of a year is labelled riskier than a stock that moves down slightly during the same period.”

“Also, using past price movements (or volatility) as the basis for determining the riskiness of a particular stock can often lead to faulty conclusions. A stock that has fallen from 30 to 10 is considered riskier than a stock that has fallen from 12 to 10 in the same period. Although both stocks can now be purchased for $10, the stock which has fallen the farthest, and the one that is now priced at the biggest discount to its recent high price, is still considered the “riskier” of the two. It might be.”

“But it could be that most of the stock’s downside risk has been eliminated by the huge price drop. The truth is you can’t really tell much of anything just from measuring a stock’s past price movements.”

“In fact, not only doesn’t a stock’s past price volatility serve as a good indicator of future profitability, it doesn’t tell you something much more important—how much you can lose. lets repeat that: It doesn’t tell you how much you can lose.”

“Isn’t risk of loss what most people care about when they think of risk? Comparing the risk of loss in an investment to the potential gain is what investing is all about. Perhaps, since the measurement of potential gain and loss from a particular stock is so subjective, it is easier, if you are a professional or academic, to use a concept like volatility as a substitute or a replacement for risk than to use some other measure.”

“Whatever the reason for everyone else’s general abdication of common sense, your job remains to quantify, by some measure, a stock’s upside and downside. This is such an imprecise and difficult task, though, that a proxy of your own may well be in order.”

“One way to take on this challenge is to think, once again, in terms of the in—laws. As you recall, if they find a painting selling for $5,000 when a comparable painting by the same artist has recently sold at auction for $10,000, they buy it.”

“The perceived cushion of $5,000 between auction value and purchase price is what Benjamin Graham, the acknowledged father of security analysis, referred to as their “margin of safety.” If the in-laws’ perceptions are correct, their margin is so large that it is extremely unlikely they will lose money on their new purchase.”

“On the other hand, if their perceptions are somewhat off – the quality of their painting is not quite up to standard of the one recently auctioned, the $10,000 price was a one-time aberration, or the art market collapses between the time of purchase and the time they get to the auction house—their losses should be minimized by this initial built—in cushion, their margin of safety.”

“So one way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself. In other words, look down, not up, when making your initial investment decision.”

“If you don’t lose money, most of the remaining alternatives are good ones. While this basic concept is simple enough, it would be very difficult to devise a complicated mathematical formula to illustrate the point. Then again, not much down side to that. . .”

Thanks Joel!

Joel Greenblatt used Magic Formula Investing as his preferred investment strategy. This has been written about extensively by Tobias Carlisle, founder of this site, in his book, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations.

I personally prefer to use the screens and the implementation strategy here at The Acquirer’s Multiple, because I find it the easiest. But that’s just me!

A concentrated portfolio of value stocks, like the ones provided here at The Acquirer’s Multiple, have historically proven to be one of the most successful methods of achieving long term out-performance in the stock market.

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