Every investor should be able to define their risk profile. There’s no real right answer to what the correct balance should be - only your personal preferences and life situation. If you’re younger and have no debt or dependents, then you might skew toward more aggressive strategies. If you are saving to send your children to college, you might err on the side of caution.
Regardless of your situation, however, you need to decide whether you want to play offense or defense. In his book "The Most Important Thing," value investor Howard Marks (Trades, Portfolio) uses sports as an analogy to investing to make this point.
What does it mean?
Marks begins by defining the difference between offense and defense:
“What is offense in investing, and what is defense? Offense is easy to define. It’s the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains. But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.
Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mindset needed for one and the mindset needed for the other, and a big difference in the tactics to which the two lead.”
In sports terms, this is like the difference between trying to win and trying to not lose. Anyone who has played amateur tennis knows this feeling: “If I can just avoid hitting the ball into the net or out of court, sooner or later my opponent will make a mistake.” Some may think this strategy is needlessly restrictive, but Marks disagrees:
“While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or nonaspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance”.
It helps to be a pessimist
The goal of playing good defense is to minimize your losses in the down years, and to not worry about lagging in the good years. You achieve this by applying especially rigorous criteria in your stock screening, excluding securities with the potential for downside even if the upside potential is great.
“There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error and being less willing to bet on continued prosperity, rosy forecasts and developments that may be uncertain.
The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. In addition to the ingredients described previously that help keep individual losing investments from the portfolio, this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.”
The core idea here is to avoid plays that are high risk-reward. We generally think high risks are tolerable if the potential rewards are greater, but a defensive strategy excludes these from your portfolio. Contrast this with an offensive strategy:
“Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work, but prove harmful when they don’t: again, the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.”
As Marks himself said, there is no one correct balance of offense and defense. The only requirement is to understand what these styles of play are, and how they fit into your own investment paradigm.
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