Risk is manageable; Soros achieves investment certainty in a completely different way. Like Buffett and all other successful investors, Soros evaluates his investments, but he employs a completely different set of criteria. Soros's key to success lies in actively managing risk, which is one of the four risk-avoidance strategies used by investment masters. These four strategies are:
1. Not investing.
2. Reducing risk (Warren Buffett's primary method).
3. Active risk management (a strategy Soros is highly skilled in).
4. Actuarial risk management.
Most investment advisors heavily recommend another risk-avoidance strategy: diversification. But for investment masters, diversification is laughably absurd. No successful investor limits himself to just one strategy. Some, like Soros, use all four strategies.
1. Not investing;
This has always been an optional strategy: put all your money into treasury bills (risk-free investment) and then forget about it. Surprisingly, every successful investor employs this strategy: if they cannot find investment opportunities that meet their criteria, they simply do not invest. Many professional fund managers even violate this simple rule. For instance, during a bear market, they turn their investment targets towards "safe" stocks like utilities or bonds, reasoning that their declines are less than those of general stocks. After all, you can appear on "Wall Street Week" and tell the eager audience that you too are unsure what to do in the current circumstances.
2. Reducing risk
This is the core of Warren Buffett's entire investment strategy. Like all investment masters, Buffett only invests in areas he understands, where he has both conscious and unconscious competence. But this isn't his only rule: his risk-avoidance method is tightly integrated with his investment standards. He only invests in companies he believes are priced well below their intrinsic value. He calls this his "margin of safety." Under this principle, almost all the work is done before the investment is made. (As Buffett says, "You profit when you buy.") The result of this selection process is what Buffett calls "high-probability events": returns with near-certainty, approaching (though not exceeding) the risk-free rate of treasury bills.
3. Active risk management;
This is primarily a trader's strategy and also the key to Soros's success. Managing risk is very different from reducing risk. If you've reduced risk enough, you can go home and sleep soundly or take a long vacation. Active risk management, on the other hand, requires constant vigilance over the market (sometimes minute by minute), and acting calmly and swiftly when it's necessary to change strategy (for instance, when a mistake is discovered or the current strategy has run its course). Soros honed his risk-management skills during the Nazi occupation of Budapest, when he faced the risk of death daily. As a survival master, his father taught him three survival rules that still guide him today:
1. Taking risks is nothing special.
2. When taking risks, don't bet everything you have.
3. Be prepared to retreat promptly. In 1987, Soros estimated that the Japanese stock market was about to collapse, so he shorted stocks in Tokyo with the Quantum Fund and bought S&P futures contracts in New York, ready to make a big profit. But on Black Monday, October 19, 1987, his dream evaporated. The Dow Jones dropped a record amount, the largest single-day drop in history. At the same time, the Japanese government propped up the Tokyo market. Soros suffered defeats on both fronts. "He was doing leveraged trades, and the survival of the fund was at risk," Stanley Druckenmiller, who took over the Quantum Fund two years later, recalled. Soros didn't hesitate. Following his third risk management rule, he began a full-scale retreat. He offered his 5,000 futures contracts at 230 points but found no buyers. The same happened at 220 points, 215 points, 205 points, and 200 points. Finally, he offloaded them between 195 and 210 points. Ironically, the selling pressure eased as he left the position, and the futures closed the day higher—canceling out the entire year's profits. But Soros didn't fret. He had acknowledged his mistake, admitted he had misunderstood the situation, and, as he does with any error (whether minor or life-threatening), he adhered to his risk control principles. The only difference this time was the scale of the position and the market's low liquidity. Survival comes first. Nothing else is important. He wasn't paralyzed, didn't hesitate, didn't stop to analyze, reflect, or consider whether he should hold on to the position hoping for a reversal. He swiftly exited without hesitation. Soros's investment method is to first hypothesize about the market and then "listen" to the market, assessing whether his hypothesis is correct. In October 1987, the market told him he had made a fatal mistake. When the market overturned his hypothesis, he had no reason to hold his position. Since he was losing money, his only option was a rapid retreat. The 1987 crash cast a pall over Wall Street for months. "Afterward, every manager I knew who got hurt in the crash was almost numb," Druckenmiller said. "They didn't know what to do. I'm talking about legendary figures in the industry. For instance, renowned hedge fund manager Michael Steinhardt said: 'That fall left me despondent. I almost didn't want to continue. The losses hurt more because earlier that year, I had advised cautious moves. Maybe I lost my judgment, maybe I wasn't as sharp as before. My confidence waned. I felt lonely.' But Soros wasn't like that. He was one of the biggest losers, but he wasn’t affected. Two weeks later, he returned to the market, aggressively shorting the dollar. Knowing how to handle risk and sticking to his principles, he quickly put the disaster behind him, making it history. Overall, the Quantum Fund still achieved a return rate for that year. Emotional detachment; the mindset of the investment masters has something unique: they can completely detach from their emotions. No matter what happens in the market, their emotions remain unaffected. Sure, they might be happy or sad, angry or excited, but they can quickly set these feelings aside, clearing their minds. If you let personal feelings govern you, you are extremely vulnerable in the face of risk. An investor ruled by emotions (even if they theoretically know what to do when things go wrong) often hesitates and endlessly agonizes over what to do, eventually retreating to alleviate the pressure (often at a loss). Buffett achieves necessary emotional detachment through his investment method. He focuses on the quality of businesses. His only concern is whether his investments always meet his standards. If they do, he is content, regardless of the market’s judgment. If a stock he holds no longer meets his standards, he will sell it, regardless of its market price. Warren Buffett doesn’t care about market trends. It’s no wonder he often says he wouldn’t mind if the stock market closed for ten years. "I also make mistakes"; like Buffett, Soros’s investment method helps him detach emotionally from the market. Besides the confidence he and Buffett both possess, his ultimate safeguard is to "roam about telling anyone patient enough to listen that he also makes mistakes." He hypothesizes about how a specific market will change and why, and then invests based on this hypothesis. The word "hypothesis" itself implies a high degree of experimental stance, making it unlikely for someone to "marry" their position. However, as he publicly predicted "the 1987 crash” would start in Japan, not the U.S., he sometimes feels certain about what "Mr. Market" will do next. When reality doesn't align with his expectations, he is still alarmed. Soros’s belief that he is also fallible overrides all other beliefs, forming the foundation of his investment philosophy. Therefore, when the market proves him wrong, he immediately acknowledges it. Unlike many investors, he never holds a position on the grounds that "the market is wrong." He exits promptly. Thus, he can extricate himself from troublesome situations without emotional entanglements, appearing almost emotionless and ascetic to others. 4. Actuarial risk management; in reality, the fourth risk management method is to operate like an insurance company. When an insurance company underwrites a life policy, it has no idea if it will need to pay out to the insured. Maybe it will need to pay out the next day; maybe it will be 100 years later. It doesn’t matter to the company. An insurance company doesn’t predict when you might die, when your neighbor’s house might burn down or be robbed, or when any other event it has insured might occur. The company's risk control method is to underwrite numerous policies, enabling it to predict its annual payout amount with reasonable accuracy. By considering the general scenario rather than special cases, an insurance company can set premiums based on the expected average value of events. Hence, your life insurance premium is calculated based on the average life expectancy of people of the same gender and your health condition when you apply for insurance. Insurance companies don’t judge your life expectancy. Actuaries calculate premiums and risk levels, which is why I call this risk control strategy "actuarial risk management." This method is based on an average value called the "expected value of risk." Although investment masters might use the same terminology widely accepted by people, what they truly care about is expected average profits. For example, if you bet $1 on a coin flip, your chances of winning or losing are 50%. Your expected average profit is 0. If you flip the coin 1,000 times, betting $1 each time, your funds at the end of the gambling session should be about the same as at the beginning (unless an unusual series of tails leaves you bankrupt midway). A 50% chance isn’t very attractive, especially after accounting for transaction fees. But if your chances of winning and losing are 55% and 45% respectively, things are different. Your total winnings in successive events will exceed your total losses because your expected average profit has risen; every dollar you invest is expected to return $.
Gambling, investment, and risk
Gambling: noun—a risky action; any event or thing involving risk. Verb (transitive)—to take a great risk, hoping for a great reward. Verb (intransitive)—to bet or stake something on an event with a particular probability. People often equate investment with gambling, and with good reason: in essence, actuarial work is "playing the odds." Another reason (although a bad reason) is that too many investors enter the market with a gambler’s mindset—"hoping for a great reward." This mindset is especially common among novice commodity traders. To illustrate the similarities, let's consider the difference between a gambler and a professional gambler. A gambler plays games of chance for money—hoping for a big reward. Because he rarely wins, his primary return is the thrill of playing. Such gamblers sustain the gambling industries of Las Vegas, Monte Carlo, Macau, and lottery institutions worldwide. Gamblers put themselves at the mercy of the "gods of luck"; no matter how kind these "gods" may be, their earthly representatives live by the motto "never be gentle with naive customers." The result, as Buffett says: “when people engage in money transactions that seem to have little downside, wealth transfer happens, and that’s how Las Vegas thrives.” In contrast, a professional gambler knows the odds of winning and losing in the game he plays and only bets when the odds are in his favor. Unlike weekend gamblers, he doesn’t rely on dice rolls. He has calculated the odds of winning and losing and therefore, in the long run, his gains will outweigh his losses. He participates in the game with the mindset of an insurance company underwriting policies. He values the expected average profit. He has his system, just like investment masters. And part of this system, enough to make him invincible, is choosing games that statistically offer long-term profitability. You can’t change the odds of winning or losing in card games, blackjack, or roulette, but you can calculate the odds and determine whether you can play games with favorable expected average profits (odds).
If you can’t, don’t play. Simple! The professional gambler's knack isn’t just calculating odds: they look for gambling opportunities where the balance of chances must tilt in their favor. I have a friend who is a member of the Alcoholics Anonymous. Once, he took a 60-minute ferry ride to take care of some business and returned in the evening. He noticed a group of drunks sitting around a table at the back, enjoying beers they had bought from the bar. He pulled up a chair, took a deck of cards from his bag, and said, "Anyone up for a couple of rounds?" Professional gamblers rarely buy lottery tickets. They don’t genuinely gamble. They don’t "risk a great deal hoping for a great reward." They repeatedly make small wagers, knowing mathematically, their investment will pay off in the long run. Investing is not gambling. But the actions of professional gamblers at a poker table and the actions of investment masters in the market share similarities: both understand the mathematics of risk and only place their money on the table when the odds are in their favor.
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