Avoiding Permanent Impairments of Capital
Investing is an exercise in repeated decision making over time. So, the goal of investing is to maximize the geometric mean of investment outcomes, not the arithmetic mean. As a result, our approach to underwriting and — by extension — risk management is focused on reducing the likelihood that we experience permanent impairments of capital for each investment. We consider our primary risk to be a business materially underperforming our long-term earnings expectations. In other words and in total, we are striving to take “bankruptcy” spaces off the board:
The Kelly Criterion
We use the Kelly Criterion as a framework for position sizing, which specifies that we should consider both expected returns and potential ranges of operational outcomes. The key takeaways as we apply Kelly to portfolio construction:
- The higher the expected return for an investment, the larger the position size should be (and vice versa)
- The narrower the potential range of operational outcomes for a business, the larger the position size should be (and vice versa)
- For an investment where the expected return is high (larger numerator) and the underlying business is high quality (smaller denominator), Kelly recommends an investor concentrate capital in this superior idea
- “Zeroes,” which represent permanent capital loss, are important and should be carefully avoided