Take Calculated Risks
Guest post by Ted Lamade, Managing Director at The Carnegie Institution for Science
Given December 7th marked the 81st anniversary of Pearl Harbor and America’s entrance into World War II, many Americans will think of generals like Douglas MacArthur, Dwight Eisenhower, George Marshall, and George Patton. Few will remember Chester Nimitz. Yet, by commanding the entire Pacific Fleet from the attack on Pearl Harbor to the Japanese surrender in Tokyo Bay, Nimitz played as large a role as anyone in the Allied victory.
Each Allied general was under enormous pressure, but as Craig Simon highlights in his recent book, “Nimitz at War,” the pressures facing Nimitz were unique given the timing and scope of his assignment.
“Following the attack on Pearl Harbor, Nimitz was expected to mount an early offensive, but first had to revive morale of those who served under him. He had to corral independent-minded subordinates and keep them focused on shared objectives. He had to maintain relationships with his difficult counterpart Douglas MacArthur, as well as with his superiors. He carried the expectations of a nation impatient for revenge and eventual victory, while confronting a formidable and implacable enemy in the Japanese Navy.”
Most uniquely, with his fleet operating thousands of miles from the U.S. homeland and given that the Japanese could intercept most communications, Nimitz had to make countless decisions with extremely limited information.
Often times, Nimitz would not hear from his subordinates for several days, or even weeks. This meant that in advance of a battle, he would have to make decisions without knowing exactly how the enemy was positioned. In their wake, he would then have to issue orders without knowing how many ships or soldiers either side had lost. Then, when the numbers were eventually reported, they were consistently under- or over-counted.
So, how did Nimitz navigate these challenging circumstances? How did he make the critical decisions that led to victories at Midway and the Coral Sea in the absence of so much information? By ascribing to the mantra,
“Whenever possible, take calculated risks as may be warranted”
A simple concept on the surface, but one that is vastly underappreciated, especially today.
THE PRESENT DAY
Eight decades removed from Pearl Harbor, we live in a much different world. Instead of being delayed and limited, information is instantaneous and endless. Yet, despite this new reality, why does it seem that decision making is often more flawed than ever?
My sense is that today’s deluge of information is creating a false sense of confidence in people’s belief that they can forecast the future. Therefore, instead of “taking calculated risks when warranted,” many are taking outsized risks when they are not.
Need a few obvious, and recent, examples?
Look no further than the likes of Sequoia, Insight, NEA, and Tiger Global betting and losing hundreds of millions of dollars on FTX after becoming enamored with the company’s future prospects and its founder, Sam Bankman-Fried. Or, the “expert” pollsters who forecasted that Republicans would win the 2022 midterms in a “red tsunami.” Or, those who believed that the energy sector was no longer investable less than two years ago, only to see it outperform the rest of the market by more than 120%.
Nimitz’s philosophy of “taking calculated risks when warranted” is just the start. His approach to leadership and wisdom extends much further.
Nimitz was obsessed with the issue of tradeoffs. In preparation for every military advance, he would weigh the costs of doing so by asking the question,
“If we push further, is the possibility of inflicting more damage on the enemy worth the odds of losing a carrier?”
In this case, Nimitz knew his carriers would determine the fate of the war in the Pacific. Therefore, he was incredibly judicious about putting them at risk.
Warren Buffet has taken a similar stance throughout his career often saying,
“Never risk what you have and need for what we don’t have and don’t need.”
Over the past few years, I have been surprised by how rarely this logic has been applied to decision making.
Look no further than the rapid push into ESG. While the case for saving and preserving the planet is undoubtedly important, many investors disregarded the risks associated with moving too quickly, namely higher prices, energy shortages, and rising geopolitical conflicts.
How about interest rates? For years savers clamored for them to be higher. Yet, since rates have spiked higher, savers have been singing quite a different tune after experiencing principal losses in their bond portfolios, tighter credit conditions, and a frozen mortgage market.
Tradeoffs can stretch back much further as well. Just look at China. The U.S. has increasingly integrated the Chinese into the global economy and brought them into multinational organizations with the hopes of bringing the world closer together and smoothing commerce. While doing so created numerous positive outcomes, namely higher living standards in China and lower prices throughout the world, it also has created the potential for a Cold War 2.0 scenario.
Pushing ahead is often warranted. Other times it is not. Either way though, it is almost always worth asking the question, “If we push ahead, do the potential returns justify the risk of losing in unforeseen ways?” If so, this might serve as a warning to companies looking to scale back their office space footprint to enable employees to work-from-home and save a buck in the near term (putting its culture at risk longer term), employees who feel like they have all the leverage today given unemployment is sub 4% (risking being the first to be out of a job when it rises), and investors who continue to materially favor illiquidity over liquidity (risking forced fire sales or overspending on inflated asset prices if the economy struggles for longer than many expect).
Shortly after Pearl Harbor, FDR put Nimitz in charge of the Pacific fleet. At his first press conference, a reporter asked Nimitz the question,
“What are you going to do now?”
“All we can do is bide our time and take advantage of any opportunity that might come along.”
As Simon writes in his book, “It was quintessentially Nimitz: candid but restrained, and delivered in a calm, unpretentious tone.”
Every investor wants to be active. To spot a new opportunity, source a new deal, or commit capital to a new investment. Given the pace of activity, size of funds raised, and number of companies that have gone public over the past few years (more than 1,000 IPO’d in 2021 alone), a large number of investors have been especially active recently (and often frenetic).
Yet, a small portion of investors have heeded Nimitz’s advice. These investors have bided their time, while waiting for the right opportunities. Today, their time has come with performance dispersion among the S&P 500 sectors the widest in fifty years (currently energy is up ~60%, while communication services is down ~35%), volatility is close to all-time highs, and bonds have experienced their worst selloff in decades.
Why does this matter?
It matters because when overly active investors move to the sidelines and patient investors enter the game, capital flows typically begin to change direction, investment styles shift (e.g., high growth to profitability in this case), young job seekers adjust their career plans (e.g., from tech to other industries as tech hiring contracts), and industries adapt. The herd is culled, and new winners begin to emerge. We saw this in the wake of the dot.com bust, the financial crisis, and nearly every other cycle throughout history. This time should be no different. As a result, keep an eye out for those patient investors as they will lead the way.
WILLINGNESS TO THINK DIFFERENTLY
Against many objections, when Nimitz’s veteran pilots were wearing down after long stints fighting at Midway and the Coral Sea, he decided to send them back to the mainland instead of keeping them in Hawaii or out at sea. The obvious reason was that he knew his pilots needed some rest and relaxation (“R&R”). The less obvious reason was that he thought it would provide an opportunity for them to mentor and instruct younger pilot trainees.
The impact of this decision was profound. Not only did it revive his veteran pilots’ morale and stamina, training these younger pilots created a multiplier effect by more than doubling the number of American pilots able to effectively fly missions in the Pacific.
Meanwhile, Japanese commanders took the opposite approach by keeping most of their trained pilots on active duty. Unlike the Americans, this decision had the deleterious effect of causing an already exhausted group to suffer more losses, while younger Japanese pilots were forced to enter the fray largely untrained and untested.
At the time, several of Nimitz’s critics considered it unconventional at best, and downright imprudent at worst. Yet, it proved to be the absolute right decision, especially in the long run.
Making an unconventional decision can be a very lonely action. Yet, when the person making it has intimate knowledge of a situation and has calculated the risks involved, it often proves to be precisely the right one.
Most recently, this was the case for those who made the decision to invest in energy companies two years ago and tilt portfolios towards profitable value stocks earlier this year. Unsurprisingly, at the time both had been widely disregarded, disdained, and even considered “uninvestable” by many.
Knowing this, I would be taking a hard look at parts of the market that are garnering the least amount of interest and attention today, starting with international equities, U.S. small cap equities, and for the bravest of investors, select parts of the office market.
Nimitz was known for regularly saying,
“I do not want to hear or see such gloom and defeatism. We are not going to do any good sitting here mourning or wailing or wringing our hands. Do the best you can with what you have.”
While Nimitz would openly encourage feedback from his subordinates, he refused to indulge complaints. He believed in optimism and finding solutions, which meant controlling what he could and not worrying about what he could not.
These days, investors are inundated and obsessed with discussing what is wrong. “The Fed is destroying the economy”…“The U.S. government is broken”…“Rates are too high”…“Rates *were *too low”…“There was too much fiscal stimulus”…“There was *not enough *fiscal stimulus”. It is endless.
The fact is, it is what it is. Instead of wasting breath on the macro headline of the day, investors would be better off focusing on understanding their current situation the best they can with the information at hand and investing accordingly.
Said another way, they would be better off focusing on “taking calculated risks when warranted.”