“Watch the downside; the upside will take care of itself.” – Marty Gruss
Marty Gruss was a mentor to hedge fund manager John Paulson.
In speaking with many people regarding their investments, people have a general tendency to ask about what the upside is for their investment. That is rightfully so because they want to know what the potential return is for their investment, but in investing nothing is ever 100% and is risk less. All assets have an inherent risk to them.
What is rather baffling is why investors, both retail and institutional do not ask enough about the downside risk. Which is startling because more people lose in investing than gain because they fail to understand the risks they are investing in.
Questions to ask in deploying capital
- What is the most I would lose and the probability of further losses occurring relative to the upside of the investment?
If the investment is purchased at $92 and has an expected value of $100. Then the upside potential of the investment is $8. The risk on the downside is even more extreme at a potential loss of $92. But say the same investment is instead priced at $50. Your upside is $50 and your downside is $50. You’ve reduced your risk in this second email because you are now risking less of your capital, which is now increasing your upside.
Now let’s say you invest $133, and yet the investment is worth only $100. You laugh, because why would ever anyone do this. Investors do. Think of the people that invest right at the high of any investment bubble. It this example, there is really only way to go and that is down.
Now we use an extreme example here. But we think it was the only way to drive home the point. Consider the downside when you invest, and the upside will take care of itself.
- Is there a herd mentality on the investment, that is only saying there is an upside potential. It could raise red flags that the herd is not aware of the downside risks
- Determine the value of the investment you are investing in before you decide to investment.
- Make sure the downside risk is low.
- Be cognisant that you have down your homework and you are not relying on someone else’s opinion.
Time to sell:
Now that you have a position in the investment, you have figured all the reasons to find out what the potential upside is and thought up the downside risk. Now is the most important time to start questioning why you should not being owning it. Continue to ask yourself if the reason you bought the investment still holds. This will help you determine if any new information goes against the reason you invested in the asset. But we think if you use the example of we discussed above, to see if the asset is nearing is upside potential, that it will help you manage the downside potential of your investment.
Food for thought:
Why is it people are willing to buy a lottery ticket, say $2 with minimal risk and large upside even though the odds of winning are low? The downside is $2 but the upside is potentially tens of millions of dollars. Yet investors buy into investments at or above the investment value with