I recently had a chance to ask Steven Sears who writes The Striking Price column at Barron’s and is also the author of new book The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails a handful of questions. He was kind enough to provide some really fleshed out answers to my questions, so I am going to run one each day this week. I hope you enjoy the format. Without any further ado here is part one:

AR: You talk in the book about having a “risk first” approach to investing. It makes a great deal of sense, so why do so few individuals/institutions use this approach?

SS: Ignorance and perversity. Those traits exist alone, or in combination, in most individual and institutional investors who fail to first identify and manage risk before putting money to work.

For individual investors, I think the difficulty in focusing on risk before reward stems from the simple fact that most people are never told that that is the way to properly invest. This is due to how Wall Street is marketed, covered by news media, and intuitively perceived. It’s like what Willie Sutton said when asked why do you rob banks? Because that’s where the money is. It’s a great line and it is precisely why so many people come to Wall Street, but I think that anyone who enters the market on those grounds is so off that they are rarely able to recover their balance. In all candor, it is a big reason why I decided to write my book. So much of the information needed to effectively navigate the market is scattered about, and sometimes hard to synthesize, which contributes to why so many investors greed in and panic out of the market. They have no discipline, or investment style. They don’t do any real research. They read about something, or they hear about something, and they buy and it is a fascinating cycle.

One fund manager I interviewed in Indomitable said he thought most investors lacked conviction about their investments, which is why they are always so easily rattled. This manager, who has beaten the Standard & Poor’s 500 Index for each of the last 20 or so years, is slavishly devoted to his models. When he buys a stock, he has already committed to sell the stock should the price rise say 50% or 100%. He has noticed that when his stocks hit his performance targets, and he starts selling, that the shares may run up another 20% or so. He thinks this is because the stocks have finally started  appearing on momentum screens, or other trading screens, and so the public, and even hedge funds, bid the stocks up even higher. Rather than trying to extract the final ounce of money out of the stock, the manager stays true to his discipline and sells. He did start a hedge fund to capture the last 20%, but that’s pure trading, and it’s a pretty safe bet that many untrained investors who buy when that manager is selling are so heavily focused on the stock’s past performance – it went up 50% or 100% or more in the past few years and the chart looks great – that they buy high and ride the stock right down the slope of hope and sell somewhere near the bottom. This is what I mean in the book about individual investors who greed in and panic out of stocks.

Now, perversity may seem like a strange word to describe investing, especially institutional investors who are supposedly so clinical in their market approach. But perversity is apt because many strange things can happen when institutional investors cannot meet performance benchmarks. If you are paid to beat benchmarks, or at least match them, and you know that there are only a few times each year you have to disclose fund holdings, many perverse things can occur out of sight of investors and disclosure reports. I was at an investment conference recently and one of the portfolio managers, a guy with an enviable record, essentially said that the industry was filled with people who last three or four years at a particular fund, and then they blow up taking too much risk trying to make a name for themselves, or trying to salvage returns. Because they’re playing with O.P.M. – Other People’s Money – the blow ups aren’t that big of a deal, at least not to the guy blowing up because he still makes money and he doesn’t really have much of his own capital at risk. Besides, if the added risk works, he’s a hero. If it doesn’t work, many of them reinvent themselves someplace else on Wall Street. So this idea of risk first investing is critical for people investing their own money, and those who give money to managers. You have to always ask if your fund manager, or you, is taking on too much risk to achieve investment returns. If you are only focused on how much money you will make, but not how much money you have at risk, something is wrong.

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Part 2 coming up tomorrow.

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