In the game of chess, it is impossible to be successful without understanding how to defend against traditional attacks- often called “gambits.” I learned the importance of having a good defense in chess many years ago through a humiliating defeat. While on vacation in New Orleans with my family, we noticed a grandmaster sitting alone with a chess board at a table outside the French Market. Beside him on the table were several newspaper and magazine articles detailing his chess career as a younger man. It was the summertime and over 100 degrees that day by the Mississippi River- not exactly ideal playing conditions. Being a reasonably good player, I welcomed the chance to challenge myself against a real expert. The advertised cost of $10 to sit and play seemed like a good deal. My father sat beside me to watch. The grandmaster was quite an eccentric fellow- he spoke fast and had plenty of unusual opinions about how the world worked. He was a frail older man dressed in a tattered Hawaiian shirt and a U.S. Navy cap. If he wasn’t sitting beside a chess board one might have assumed that he was living on the streets. He certainly did not seem the least bit intimidating. As I soon learned the hard way, appearances can be deceiving.
The grandmaster allowed me to take the first move, and naturally I decided that I would go on the offensive. I moved quickly and decisively, while my opponent sat with a puzzled look while sweating profusely in the heat. After about seven moves, he looked up at me and smiled. With a thick southern drawl he proclaimed confidently: “You are done kid – checkmate in five moves.” I was shocked- I didn’t know whether the grandmaster was joking or being serious. It didn’t appear obvious to me that I had already lost the game from looking at the board. But sure enough, as much as I tried to escape my fate, I wound up losing the game in five moves as the grandmaster predicted. The last time I lost a game that quickly was when I first started learning how to play chess. The grandmaster explained to me that “defense is the best offense” – you can’t just blindly attack when your position is fragile, nor can you mount an effective offense without a solid defensive formation.
I had attempted to beat him by focusing too much on attacking the weaknesses in his player formation while completely ignoring the vulnerability in my own- in his view this was a classic “rookie” mistake. This experience completely changed my opinion about the importance of defense in chess. To confirm the grandmaster’s point, recent analysis shows that 7 out of 10 of the most powerful openings in chess history are designed around building an effective defensive formation. (source: Chess.com )
Investing in the stock market is a lot like the game of chess. Most amateurs are concerned with offense; they are always on the hunt for tips on finding the hottest stocks or fund managers. Everyone loves to talk about what to buy but no one really talks about what or when to sell. When is the last time someone told you a story about their failures rather than their latest and greatest success? Selling is a defensive move that is designed to reduce losses or protect profits rather than make money. Being able to sell when things do not turn out the way you planned or when the environment becomes uncertain takes both humility and discipline. You have to tuck your tail between your legs and admit that you were wrong. As a consequence talking about selling- especially when you realize a loss- makes for much less exciting cocktail conversation. But you can’t win in the long run without accepting losses. The trick is to keep your losses small and ride your winning trades as long as you can. This puts a much smaller burden on having to buy the right investment at the right time.
But that is not what most investors do. Instead, they tend to focus only on what they need to own which we consider to be only half of the “offense” decision (the other half is to buy at the right time). Furthermore, the “defense” decision is completely ignored. It is natural for investors to assume that success in the financial markets is simply a matter of finding the best stocks or asset classes to buy. In our quest to seek better offense, most people seek the advice of “experts” that will presumably provide advice that can make us a lot of money. Unfortunately, it is human nature to pay attention to the “experts” that seem the most confident and have strong opinions. If you spend enough time in the investment advisory world you realize that the pundit’s number one priority is selling a convincing story, whether it is grounded in reality or not. Their entertaining stories are typically constructed by weaving disparate facts and connecting the dots using current events to support their argument in a way that may seem reasonable on the surface. Like religious or cult leaders, these experts never waver in their opinions even when the markets go far in the opposite direction of their predictions. Their unwavering confidence is great for building a loyal following of subscribers or investors, but it is deadly for the unpredictable world of financial markets. These pundits have absolutely no concern for preserving capital or having a good defense. The real experts much like the grandmaster are quiet and unassuming. They focus on making good decisions rather than telling good stories. Most importantly they have a defensive mindset and are willing to change their minds if they are proven wrong by the market:
The few people I’ve known over the years who’ve been unquestionably successful investing in America were decisive individuals without huge egos. The market has a simple way of whittling all excessive pride and overblown egos down to size. After all, the whole idea is to be completely objective and recognize what the marketplace is telling you rather than trying to prove that what you said or did yesterday or six weeks ago was right. The fastest way to take a bath in the stock market is to try to prove that you are right and the stock market is wrong. Humility and common sense provide essential balance.William O’Neil, considered one of the greatest investors
of all-time and owner of Investor’s Business Daily.
One of the key concepts that O’Neil tends to stress is having the discipline to sell when you are wrong- and this is a key component of the “defense” decision. Good defense is essential for survival in the volatile waters of global financial markets. Advisors much like investors spend their time seeking the “holy grail” of strategies that delivers returns consistently with little or no risk. But the best way to achieve a good return profile with low risk is to focus first on avoiding exposure to large corrections or bear markets. This is because positive returns are not worth as much as negative returns for investor portfolios. In other words, every point you make on “offense” is not worth as much as every point you save on “defense.” Consider that a 33% loss requires a 50% return to breakeven. During the 2007-2009 bear market the S&P500 fell 58% which required a 140% rebound to fully recover. While bear markets are devastating for investors, and picking individual stocks is even riskier than owning a portfolio of asset classes. In the 1973-74 bear market, the Dow corrected 50% but the average stock fell more than 70%. During the Depression the average stock lost 90% of its value between 1929-1933. From 2000-2002 many high momentum stocks lost 75-90% of their value, 9/10 investors lost a lot of money (source: O’Neil, How to Make Money in Stocks). There is no amount of money that can be made in a bull market that cannot be lost when things go the wrong way against your positions.
Imagine if every blocked goal in professional soccer or in hockey was worth two points! The stars would no longer be the offensive players, instead the defensive players would be the most important and well-paid. At Blue Sky, we consider defense to be the best form of offense in building our portfolios for investors. While we also strive to provide a good offense, we realize how much more important it is to protect what investors already have. Like other “experts” we may offer our opinions from time to time, but we let our systematic approach to risk management do the talking. In the next post we will discuss how to create an effective defense and how it can lead to superior risk-adjusted returns over time.