Weekend Reading

Jon writes about this on his blog. When? That’s what everyone wants to know. The answers to why a bull market ends come pouring in the second the when is confirmed. But the explanations why are usually complex. They certainly won’t help anyone predict the next turn. They’re often secondary, or scapegoats, to what really happened.

Peter Bernstein offered a simple answer to what triggers the end of all bull markets: What was the secret ingredient that kept investors buying and buying at higher and higher prices? Was it the myths that this market, like all bull markets, created to justify itself? Although the myths helped keep the pot boiling, the basic explanation for the bull market’s longevity and vitality in the face of so much economic difficulty is simpler, more fundamental, and more easily generalized. The same simple, fundamental explanation applies to the bull market’s sorry end as well.

The common thread that runs through all equity bull markets is confident expectations of higher earnings ahead. The common thread that ties the onset of all bear markets together is the loss of those confident expectations of higher earnings ahead. History shows us, over and over, that bull markets can go well beyond rational valuation levels as long as the outlook for future earnings is positive.

Bull markets require economic slack so that companies can grow, and positive trends in real business activity to take advantage of that slack. Remember, stock prices show no consistent relationship with interest rates, exchange rates, inflation rates, budget policy, monetary policy, or any of the other things professionals love to discuss. These forces matter only when they matter to the future movement of corporate earnings. Those same irrational valuations that seem to defy gravity spur the “myths” that get investors into trouble. The big mistakes — overconfidence, trivializing risk, chasing returns — can leave investors under-protected for what inevitably comes next. Overpaying for (optimistic) future earnings never ends well.

Jon concludes that the important thing is to recognize the role confidence has on market prices and the obvious risk of getting caught up in the excitement.

Jeremy Walter writes that perhaps one of the most confusing word we use in finance – and perhaps in life in general – is risk. We are reminded of the different types of risk that investments are subject to market risk, strategy risk, small company risk, turnover risk, limited market risk, concentration risk, interest rate risk. We have risks in life that we commonly insure against. Our homes burning down. Our vehicles being totalled. Our physical ability to earn income. Us or loved ones dying earlier than expected. Healthcare and medical expenses. We have risks that we don’t think about as frequently. Inflation risk. Longevity risk. Income stability risk. Legal liability risk. And these are just the financial types of risk in our lives.

But what is the risk? Oftentimes people define it as the loss of something – which is true but perhaps doesn’t capture all dimensions of it. Walter thinks the risk is simply the chance that something doesn’t go according to plan. And if we accept that, then we need to accept the fact that our plans – financial and non-financial – need to be flexible and need to be able to adapt. In addition, the more complex the situation, the more different, independent risks and variables are involved.

We just acknowledge that risk is the price of admission to anything worthwhile. There are some types of risk that you can insure against. There are other types that you can diversify against. And there are other types you simply can’t do anything about. It’s virtually impossible to eliminate all risk. And that’s ok. As long as we’re aware of it, and we recognize the importance of flexibility. So again – the risk is three things. Risk is (1) a part of life that (2) accounts for things not going according to plan, but (3) is the price of admission for achieving anything worthwhile.

And once we realize it, maybe the risk isn’t as scary – nor as difficult to define – as we think.

Tadas Viskanta writes on his blog that investing is to a large degree a solved problem. We know, by and large, what works and mostly what doesn’t. But that doesn’t mean that everyone should invest exactly alike. Don’t let anyone tell you otherwise.

Why? Because we all have unique situations, differing histories and wildly varying risk tolerances. Constructing an efficient portfolio today is straightforward. Humans are not. Dialling in a portfolio in sync with our risk tolerance is no small feat.

There are as many solutions as there are people. For some people holding more cash than can be reasonable is a way to sleep better at night. This may not jibe with most models but it works for them. For others, 100% equities are perfectly reasonable. For other people kicking the cash habit is really difficult.  So long as the products are low cost, transparent and risk-appropriate for the end-user. Who are we to judge?

The point is there is no perfect way to invest. Just as there is no perfect way to parent. Everyone parent, child and situation are different. Parenting like investing requires consistency and care, not perfection.

Have you made some mistakes getting to where are you are today? Everyone has. Nobody hits on an investment strategy that works for them right out of the gate. Even if they did it would have to change with them over time. As Kristine Hayes at Humble Dollar writes: As with most things in life, there’s no “one size fits all” solution when it comes to finances. Rather than questioning the decisions I’ve made in the past, I’m beginning to appreciate the things I’ve done right.

Tadas Viskanta reminds us to be grateful for how you got here, because something will change. Soon you will be off in a different direction, figuring things out as you go.

“The best strategy is the strategy you can stick with through thick and thin. That will differ for all investors.” – Wes Gray founder Alpha Architect, an asset management firm 

Ravichand on his blog writes about how winners bet selectively. The Question that investor face – Do you chase many mediocre opportunities in the market and bet frequently or search for a few great opportunities and bet selectively?

In the absence of a crisis, great investing ideas/opportunities are very rare and you generally get one or two of them in a year. Many good ideas can only be a poor substitute for a single great idea. Yet we want some “action” in the market every single day and many times we end up placing bets on even moderately good ideas. Why?

 The possible reasons: Need for “action” or seen doing something;  No one is sure when the next great opportunity will come and/or how big it will be;  Professional fund management compulsions; Sitting on Cash on the sidelines without swinging your bat is nerve-wracking;  Not many have the luxury to sit all day long “reading” (working)

Quoting Buffett is a cliché but many times it’s the most appropriate. If you think that you would need a large number of investing bets because you have a big corpus then spare a minute to have a look at Warren Buffets investments in marketable securities. Around 87% of his USD 173 billion worth investments at the end of 2018 were concentrated in just 15 securities. By betting selectively on a few great ideas, Buffett has made a fortune.

The research study also highlighted this fact that investing only on our high conviction ideas and consciously avoiding mediocre lower conviction ideas will do wonders to our portfolio returns and our investing career.

5 C’s of selective betting

 Competence: The skill required to find great ideas. You cannot become a great Pastry chef if you don’t know how to bake. Similarly, if you are going to bet selectively on great ideas then you should first be competent enough to identify one.

Cash: Adequate Funds to back the great ideas What is the use of a great idea if it cannot be backed by adequate funds. Allocate too little and you cannot really feel the impact. Allocate too much and your portfolio can get wiped off. Always back great ideas with materially significant allocation which is neither too little or too much

Conviction: High confidence in your idea When you bet, place your stakes on an idea on which you have the highest conviction. The one which you believe has the best chance of success backed by research, data and thought. Betting selectively in great ideas only requires a bundle of confidence. Confidence is needed in your investing process, in your investing strategy and most importantly in – YOURSELF

Courage: Courage in times of crisis. Great opportunities come usually when there is a crisis or what you say as “when there is blood on the street”. There could be great opportunities when outstanding companies are going through a temporary problem. Courage to back up your great ideas during a crisis is priceless.

Character: Ability to say “No” Last but certainly the most important “C” is your “character” – your basic nature, trait and mental make-up. Similarly, for an investor, the ability to say “No” is a tremendous advantage. When your friends and colleagues are caught in the market frenzy, maintaining a Zen level of calmness and not biting at every cookie thrown at you requires a great temperament. Sitting on cash without hitting the buy requires character.

This post is part of a series on The Virtuous Investor written by Joachim Klement. Let’s face it, we all make mistakes, both as investors and in our lives. There is no shame in making mistakes, but there is shame in not wanting to get better at whatever you strive to do. If you want to be a great painter, you better paint as many paintings as you can. The first few are likely going to be rubbish, but over time, your skills will develop, and you will get better at it. Does that mean you are going to be the next Leonardo da Vinci or Pablo Picasso? Probably not, because these painters had an exceptional amount of talent that only very few people have. But that talent needed to be exercised and practised before it could come to full fruition.

What is true for artists is true for investors as well. We all have to practice investing in order to get better. And just like most artists never will be as good as Leonardo, so too will most investors never be as good as Warren Buffett. But you can at least strive to become the best investor you can be. There is one crucial difference between artists and investors. While we can choose to become an artist or not, everyone is forced to become an investor, whether they like it or not.

The practice is a necessity for investors, but unfortunately, practice is only half the ticket to better returns. The other half is to learn from past mistakes. And unfortunately, this is where most investors fail miserably. As investors, we tend to forget our past mistakes and remember our past successes.

The virtuous investor is aware of this faulty financial memory and uses techniques to record investment decisions and learn from mistakes. The simplest technique Klement knows of and uses are investment diaries. In an investment diary, you record every investment decision you make with three short bullet points:

1. What decision did I make?
2. Why do I think this investment is going to make money?
3. What could go wrong?

These three bullet points in your investment diary give you a picture of your thinking. After a while (and Klement recommends doing this regularly) you can review past decisions and your thinking at the time. This way, you will start to understand where you made mistakes in your investment decisions and learn to avoid these mistakes over time. Klement admits that it is a long and tedious process that will improve your investment performance only gradually, but as with almost all things in life, there are no shortcuts.

Becoming a good investor not only takes years of practice, it takes years of deliberate practice which means not just doing things, but systematically reviewing past actions to learn from past mistakes and build on past successes.

Ian Cassel writes that an investor learns from hindsight and get paid for foresight. Often times an opportunity exists because the conditions aren’t perfect yet. Investor has to pull the trigger in advance of all the pieces coming together. Investment success is determined by two things: First, How well you assimilate imperfect information and Second, Your ability to identify when you are wrong quicker.  

Jeff Bezos of Amazon said the following about decision making. Cassel thinks that it is the perfect description of investing: “Most decisions should probably be made with somewhere around 70% of the information you wish you had. If you wait for 90%, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.”

The price of certainty is expensive because it slows you down. We want to know everything. If I just knew a little more. A little more. A little more. But knowing more often times breeds confidence but not accuracy. 

Cassel thinks if Bezos would have continued his quote he would have said focus on the 70% that matters and be okay if the 30% you don’t know hurts you. You have to live with the possibility that you could be wrong. You can’t let the fear of the 30% steal your courage to move forward if you believe the odds are in your favor. 

How can you be both quick and accurate?  Cassel applies four filters to every new company he evaluates: An organization with signs of intelligent fanaticism; A business that can grow through a recession; A balance sheet that can weather a storm and act with occasional boldness; A stock that can conservatively double in 3 years.

When Cassel applies these four filters he might miss something, but it cuts to the core of what is important. He can normally size up a new opportunity that he is attracted to in a few hours. Over the years Cassel found being quick has served better than being slow. If it takes a long time to get to a buy decision then it probably isn’t a buy. The great opportunities are normally obvious, at least to an investor.

In addition, Cassel found buying small and averaging up later as you gain additional conviction is a great way to counterbalance being fast and right with the risk of being fast and wrong. You aren’t going to be right all the time, but try to be wrong as fast as you can and move on. 

“Be willing to make decisions. That’s the most important quality of a good leader. Don’t fall victim to what I call the “ready-aim-aim-aim-aim” syndrome. You must be willing to fire.” – T. Boone Pickens

Jon writes about this on his blog https://novelinvestor.com/. He quotes Stan Druckenmiller “Every great money manager I’ve ever met, all they want to talk about is their mistakes. There’s great humility there.”

Investing is just a long series of decisions where some end in gains and others end in losses. If you’re doing it right, the gains outweigh the losses in the end, hopefully, by a large enough margin that your goals are reasonably satisfied. In other words, every investor makes mistakes. Those that don’t are lying. That’s the uncomfortable truth. Those that go on to be great investors, learn this through experience…and apparently love to talk about it. So what’s the benefit of constantly talking about their mistakes? For one, they embrace the inevitable.

Peter Bernstein writes about the importance of this realization and why it matters: The trick is not to be the hottest stock-picker, the winningest forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive! Performing that trick requires a strong stomach for being wrong because we are all going to be wrong more often then we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future. The nature of uncertainty in the process makes being wrong inevitable because not only will you make mistakes, you can make the right decision and still lose money. So are you prepared for it? Survival is about planning for the inevitable losses in advance.

Following a few basic investing principles help with this.

Ben Graham introduced the idea of margin of safety decades ago as a way to embrace mistakes from the start. It’s as simple as leave room for error. He believed the possibility of being wrong should be factored into the price you pay for an investment. The idea is to pay a low enough price, so even if you’re wrong, you only lose a little. In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches… The riskiest moment is when you’re right. That’s when you’re in the most trouble because you tend to overstay the good decisions.

When you combine it with diversification — spreading your money across multiple investments — if one turns out bad, it won’t be devastating.  That’s what diversification is for. It’s an explicit recognition of ignorance. And I view diversification not only as a survival strategy but as an aggressive strategy because the next windfall might come from a surprising place. You reap further benefits when you diversify. If some investments inevitably turn out worse than expected, the opposite could happen to others — some turn out better. In other words, you get unexpected opportunities. Not a bad consolation prize for survival.

Dan Mikulskis asks us on his blog realreturn.blog what really matters most in the volatile, uncertain and ambiguous environment of investing. Is it Better earnings models? More research? Using skilled managers? Access to deals? These things can and do matter, and fortunes have sure been made promoting these ideas. But for the majority of end investors, it’s often more fundamental (and basic) wisdom that has a bigger impact. There aren’t any secrets, some of the best advice is simple, but not easy.

Direct Attention: The world is noisy and our attention easily distracted to the wrong things, this can be bad. There’s always another macro forecast, a piece of economic data, a political event or an under-performing manager to take our attention. Most of this doesn’t matter in the big picture. Be intentional.

Measure what Matters: Returns, risk, and progress toward your objectives. Don’t get drawn into all the rest of the weeds too often. Be wary of measures turning into targets that aren’t fully aligned with your outcomes.

Accept Responsibility: The decisions you take will have an important impact on outcomes, but it takes a lot of work to rid decision of bias. Avoid the table-pounding guru with sweeping powers. Reward dissent, be accountable, divide & conquer, be truth-seeking, deploy diversity well. Warren Buffet says “The people who know the edge of their own competency are safe, those who don’t, aren’t”

Prepare for Uncertainty: The future will not evolve in nice straight lines as much as we might wish it to. You will lose money at some point and you will be unsure of what to do. Prepare in advance for these moments and manage your own future expectations. Pre-commit. Set yourself up to react confidently to both good and bad news. Peter Bernstein reminds us that the most important thing about risk is the ability to make decisions under uncertainty.