Investing is part art and part science and above all is about decision making under uncertainty. In a recent video, I came across some nuggets of wisdom from an unlikely source – Mr. Ajit Doval, India’s National Security Adviser. The video set up as a question and answer session, gives some fascinating insights into decision making under uncertainty – an area in which Mr. Doval is clearly well versed.Worst Case Scenario:
When asked how tough decisions are made under uncertainty, at 3min and 25 sec in the video, Mr. Doval’s says – in decision making, first work out the worst case scenario. Once we know what the worst outcome of a decision can be, we know our maximum downside – which immediately brings clarity to the decision making process. The next step is to apply skills, knowledge and resources to mitigate the worst case scenario and improve upon it. At 9min 25 sec in the video Mr. Doval further qualifies that we must be brutally honest with ourselves regarding the outcome. He says remove all adjectives and adverbs and simply use nouns and verbs !!
This approach has implications in investing. The worst case outcome in ANY investment decision is not only a complete wipe out of the initial investment, but in some cases when leverage is involved with personal guarantees, financial ruin can result. To mitigate the downside, Investment decision making must incorporate four levels of protection :
First - No investing with borrowed money and of-course no personal guarantees. A corollary of this is to avoid Partnership Firms – since they can have unlimited liabilities.
Second - Investing in investee companies that have large debt fuelled balance sheets must be only when
(a) the debt is of long term in nature and
(b) the income streams of the investment are smooth and predictable.
Third – limit exposure per investment such that even if the defences of (i) and (ii) are gate crashed, the maximum exposure is still controlled to the extent of allocation.
Fourth - It is only after the above three safeguards are cleared that we apply our mind and study a specific investment opportunity for its suitability.
At 26min and 5sec of the video, Mr. Doval refers to the motto of his school which was “Play the Game”. He goes onto to say that his teacher chose him for the boxing team not because he was the best boxer, but because he never gave up and always lasted till the last round (even if he finally lost). Mr. Doval was alluding to the simple principle that to win a game, one must first BE IN THE GAME. One must be able to hold in the face of adversity and stay in the ring till the last round. Never should we be in a position that we are wiped out even before the game is finished.
This principle of Playing the Game is also mathematically derived in the Kelly Criteria. The Kelly Criteria gives fascinating mathematical insights into how one should size a bet to generate optimal long term capital growth while avoiding short term ruin. In our greed to earn more and fast, we tend to bet heavy and risk losing all our money very early. Later when and if a suitable investment opportunity is presented, there remains no capital to take part in the opportunity.
Mr. Doval comes from a field far removed from investing. Nevertheless, his vast experience with decision making in the real world (where real lives are at risk) under uncertainty has given him a wisdom that applies to worlds beyond national security.