Seth Klarman on Being Ready for What’s Next

Bull markets can play tricks on investors perception of risk. So much so, that the end result can be costly.

Since the instant people recognized markets move in cycles, it’s been a recurring theme. Each bull market produces a fresh crop of investors — new investors absent experience and experienced, but absent-minded investors — believing it can never get worse.

It leads investors into a false sense of security through optimism and overconfidence, confusing skills with luck, “brains with a bull market,” believing high returns are easily earned and risk is nonexistent.

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The longer a bull market drags on, it gets easier to forget what came before it. The result is investors take chances they normally wouldn’t take but leave themselves dangerously exposed to what inevitably comes next.

It’s one of the easiest mistakes to make. It’s probably one of the most warned about too.

Seth Klarman did exactly that to the MIT Sloan Investment Club in October 2007.

“Warren Buffett often quips that the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance. For 25 years, my firm has strived to not lose money — successfully for 24 of those 25 years — and, by investing cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio — and with risk comes losses. Some investors target specific returns… The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.”