Why a backup system can be a bridge to investment success

Those that have been investing for a while, will know all too well that things can go wrong. It could be that a company hasn’t met its targets, or a key contract gets cancelled. Whatever the reason, it often results in a hefty share price fall.

Though it’s an unpleasant experience, making mistakes is not at all unusual. In fact, famed investor Peter Lynch once said that even the best of analysts are right just six out of ten times.

So how do we mitigate this high failure rate, and how do we prevent these failures from becoming overly consequential to our portfolios?

One way, is by using an important idea from engineering, which is the idea of redundancy and backup systems. This is where there is a duplication of critical components or functions in a system, with the goal of making the system more reliable.

An example of redundancy is in a bridge, where if say a girder is damaged, the bridge continues to carry the load due to the presence of multiple load pathways.

Berkshire Hathaway’s vice-chairman Charlie Munger, who calls backup systems a very powerful idea, said, ‘We try to arrange our affairs, so that no matter what happens, we’ll never have to ‘go back to go’’.

Backup Systems

We see backup systems everywhere in life, and overall, they make our lives both safer and better. Having a spare tyre in a car is an example of a backup system. If we get a flat, we can change the tyre and be on our way.

Home insurance is a backup system. In the highly improbable, but highly consequential event of a house fire, home insurance allows us to rebuild our house with minimal financial impact.

Our hospitals have alternative power sources such as diesel generators, so that in the event of a power failure, the hospital and its critical care systems, can continue to run.

In an aeroplane, a co-pilot is a backup for the pilot. If the pilot has a heart attack mid-flight, the co-pilot is there to take over flying duties, to guide the plane and its passengers to safety.

IT systems must also have backup capabilities, so that if the primary system fails, there is an automatic and seamless switch to a backup, to ensure there is no disruption of service.

Back to bridges

The concept of margin of safety is best illustrated in a bridge. The type of bridge that we want to drive over, is one that can carry loads much greater than the weight of our vehicle. This gives us a margin of safety.

How much margin of safety do we need? It all depends on the consequences of being wrong.

Warren Buffett said, ‘If you’re driving a 9,800-pound truck across a bridge that say holds 10,000 pounds, and the bridge is only six inches above the ground, then you may feel okay. However, if the bridge is over the Grand Canyon, then you may want a little larger margin of safety’.

Hence when there’s a lot at stake, we want a large margin of safety. Having backup systems and redundancy in our investment strategy is very important. Here are four ways we can do this:

1. Diversification. This is spreading your investment risk across numerous stocks, sectors and even geographies. Owning a share portfolio, an actively managed fund, or an ETF, that is well-diversified, means that if a failure occurs in one stock, then the overall portfolio is still protected.
2. Buying stocks with a large margin of safety. This is the difference between the stock’s actual price and its intrinsic value. The greater the margin of safety, the lower the risk. Having a large margin of safety helps to prevent substantial loss if your projections are wrong or too optimistic. This is particularly important for our colleagues at Intelligent Investor. Speaking of, click here to watch the teams speeches from the live conference this week.
3. Hold some cash. In your personal finances, it’s always good to have a backup of cash set aside in case of emergencies. In investing, it also pays to have cash set aside, which can then be used when stocks become cheap.
4. Invest in your own financial education. The more that we know about investing, the fewer blind spots we will have, and the safer we will be. Knowledge also helps us to adapt better to change and avoid common pitfalls. Our InvestSMART Bootcamp is only $49 and a great way to start your investing journey.