The Indispensability of Risk

🌈 Abstract

The article discusses the importance of risk-taking in investing and draws analogies between investing and other competitive endeavors like chess and sports. It emphasizes that earning high returns often requires bearing meaningful risk, and that the risk of not taking enough risk can be detrimental. The article also highlights the paradoxical nature of risk-taking, where success does not necessarily mean consistent wins, but rather a balance of well-reasoned investments, some of which work out well.

🙋 Q&A

[01] The Indispensability of Risk

1. What is the main analogy the article draws between investing and chess?

• The article draws an analogy between the concept of "sacrifice" in chess and the need to take on risk in investing. Just as chess players sometimes intentionally sacrifice a piece to gain an advantage, investors often have to bear the risk of loss in pursuit of potential gains.

2. What are the two types of sacrifices described in chess, and how do they relate to investing?

• The article describes two types of sacrifices in chess:
  • "Sham" sacrifices, where the piece being given up will bring concrete, calculable benefits
  • "Real" sacrifices, where the gains are neither immediate nor tangible, such as controlling more space or creating weaknesses in the opponent's position
• In investing, the author draws a parallel, stating that buying a 10-year Treasury note is a "sham" sacrifice, while most other investments involve "real" sacrifices where the risk of loss is borne in pursuit of uncertain gains.

3. What is the key lesson the article derives from the concept of sacrifice in chess?

• The key lesson is the "indispensability of risk" - that taking on risk is necessary to achieve substantial gains, as evidenced by the famous saying "no risk, no reward" and the idea that "not being willing to take risks is an extremely risky strategy."

[02] The Risk of Not Taking Risk

1. What are the three main choices investors typically face regarding risk and return?

• The three choices are:
  • Avoiding risk and having little or no return
  • Taking a modest risk and settling for a commensurately modest return
  • Taking on a high degree of uncertainty in pursuit of substantial gain, but accepting the possibility of substantial permanent loss

2. Why does the article say that the "efficiency" of the market usually precludes the possibility of earning big gains with little risk?

• The article states that the "efficiency" of the market, meaning the fact that other market participants are not unintelligent, usually prevents the possibility of earning big gains with little risk. This is because such opportunities would be quickly identified and exploited, eliminating the potential for outsized returns with minimal risk.

3. What are the risks associated with not taking enough risk as an investor?

• For individual investors, not taking enough risk may result in returns that are insufficient to support their cost of living.
• For professional investors, not taking enough risk may cause them to fail to keep up with their clients' expectations or their benchmarks.

[03] How to Think About Risk-Taking

1. What does the article say about the relationship between earning high returns and consistent success?

• The article states that earning a high rate of return over a long time period does not necessarily connote a record of consistent success. Rather, it more often results from making a large number of investments, with a relatively small number of big winners offsetting a larger number of decent or losing investments.

2. What are the three key ingredients the article identifies for Warren Buffett and Charlie Munger's great investment performance at Berkshire Hathaway?

• The three key ingredients are:
  • A lot of investments in which they did decently
  • A relatively small number of big winners that they invested in heavily and held for decades
  • Relatively few big losers

3. What is the key lesson the article derives about the need to take risks in investing?

• The key lesson is that investors must accept that success is likely to stem from making a large number of investments, some of which will not be rewarded with high returns. Refusal to take risk in this process is unlikely to lead to the desired investment outcomes.