The Most Important Thing
These are personal notes (some copy/pasted), so please don't judge any grammar! If you see something interesting here, let's discuss it!
Second Level Thinking
- Investing is as much of an art as it is a science.
- Successful investing means beating the market. However if the market falls 50% and your portfolio falls 40% did you really succeed?
- Successful investing requires superior insight, intuition, sense of value and awareness of psychology (second level thinking)
- In order to beat the market you must think differently than the market
- Questions to ask oneself when considering a new investment: what is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does the consensus think? How does my expectation differ than the consensus? How does the current price of this asset comport with the consensus view of the future and with mine? Is the consensus psychology that’s incorporated in the prices too bullish or bearish? What will happen to the assets price is the consensus turns out to be right, and what if I’m right?
- Ask yourself how and why you should succeed at investing and also why others fail
- If your behavior is conventional you’re likely to get conventional results, only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average
Understanding Market Efficiency (and its Limitations)
- Market is efficient in the way that it is “speedy, quick to incorporate information,” but not “right”
- Although the “efficient” market often misvalues assets, it’s not easy for any one person – working with the same information as everyone else and subject to the same psychological influences – to consistently hold views that are different from the consensus and closer to being correct
- Some asset classes appear to be more efficient than others however this is not permanent
- Second level thinkers know that they need to have an edge in their information, analysis, or both
- A market characterized by mistakes and mispricings can be beaten by people with rare insight. The existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it.
Value
- Buying below intrinsic value and selling when the price of security is above intrinsic value is the fundamental point of value investing
- Technical analysis and momentum investing are not successful methods of investment
- Net-net investing is when the market value of a business is less than the current assets minus the liabilities of the business. You could theoretically buy all the stock, liquidate the current assets to pay off the liabilities, and be left with the business and some cash
- With growth investing there’s less emphasis on a business’s current attributes and more emphasis on its potential
- Some value investors incorporate growth into the intrinsic value of the business (Buffet)
- Hold your intrinsic value firmly as being correct about an investment isn’t synonymous with being correct right away
- An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse
- Two essential ingredients for profiting in a declining market: have to have an idea of intrinsic value, hold that view strongly enough to hang in and buy even when prices declines suggest you’re wrong
The Relationship Between Price and Value
- Establishing a healthy relationship between fundamentals – value – and price is at the core of successful investing
- There’s no such thing as a good or bad idea regardless of price
- Knowing when to buy cures many of the mistakes from selling too early
- The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up
- Fundamental value will be only one of the factors determining a security’s price on the day that you buy it. Try to have psychology and technical on your side as well.
- Things that are overpriced can stay overpriced for a long time. Eventually, though, valuation has to matter
Understanding Risk
- Risk is a bad thing. An investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk
- Investors must consider the risk entailed versus the potential return. Equilibration is suppose to render prospective returns proportional to risk
- In order to attract capital riskier investments have to offer the prospect of higher but there’s no guarantee that these have to materialize
- There is a positive relationship between risk and expected return and uncertainty about the return and possibility of loss increase as risk increases
- Value investors rarely perform exceptionally in a heated bull market but display consistent profitability in any market condition
- There is no mathematical formula to measure risk, it is only a matter of opinion
- The Sharpe ratio (ratio of excess returns over treasuries divided by the standard deviation of the return) has some relevance when considering that fundamentally riskier securities fluctuate more than those of safer ones
- Sortino ratio looks at only downside volatility, however neither Sortino nor Sharpe do a good job of measuring future loss
- Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world
- Underestimating uncertainty and its consequences is a big contributor to investor difficulty
Recognizing Risk
- Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do
- High risk comes primarily with high prices
- Awareness of the relationship between price and value is a essential component of dealing successfully with risk
- When people aren’t afraid of risk they’ll accept risk without being compensated for doing so
- The degree of risk present in a market derives from the participants in that market, not from securities, strategies, or institutions.
- The reward for taking incremental risk shrinks as more people move to take it “pervasiveness of risk”
Controlling Risk
- Great investors are those who take risks that are less than commensurate with the returns they earn
- Achieving high returns with high risk means very little – unless you can do it for many years, in which case the perceived “high risk” either wasn’t really high or was exceptionally well managed
- Risk is not observable but loss is. Loss generally happens only when risk collides with negative events
- Risk control is invisible in good times but still essential, since good time can so easily turn into bad times
- Many believe good investments beat the market (alpha) while taking on the same amount of risk. However other good portfolios match the returns of the market while taking on less risk.
- Invest only when the you’re convinced the likely return far more than compensates for the risk
- Risk control is the best route to loss avoidance. Risk avoidance is likely to result in return avoidance as well
- Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners
Being Attentive to Cycles
- Most things will prove to be cyclical and the greatest opportunities for gain and loss come when people forget this rule
- The reason things is life are cyclical is because people are emotional and inconsistent, not steady and clinical
- Easy credit leads to capital destruction, where the cost of capital in projects exceeds the return on capital and eventually to cases where there is no return of capital
Awareness of the Pendulum
- When investors are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-adverse, prices can offer more return than risk
- The main two risks of investing: the risk of losing money and the risk of missing opportunity
Combating Negative Influences
- The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological
- The combination of greed and optimism causes people to pay elevated prices for securities that are in vogue and hold things that are high priced in the hope there’s still some appreciation left
- The counterpart of greed is fear which is overdone concern that prevents investors from taking constructive action when they should
- The process of investing requires a strong dose of disbelief. Inadequate skepticism contributes to investment losses
- Investors are always looking for a “silver bullet” or a ticket to riches without risk. Skeptical belief that the silver bullet is at hand eventually leads to capital punishment.
- In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.
- The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing- are factors that are near universal. These have a collective impact on investors and result in frequent investment mistakes.
- Bubbles are capable of arising on their own and need not be preceded by crashes, whereas crashes are invariably preceded by bubbles
Contrarianism
- Attempting to build a career around market extremes, extreme high and low times, should be an important component of any investor’s approach
- Knowing when and how to act during these extremes can only come through experience
- For a contrarian you must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong
- A highly profitable investment t
Finding Bargains
- Investment is the discipline of relative selection
- The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble
- Unlike assets that become the subject of manias, potential bargains usually display some objective defect – weak asset classes, company laggards, over-levered balance sheets, and inadequate structural protection are some examples of this
- The necessary condition for the existence of bargains is that perception has to be considerably worse than reality
- Given the way investors behave, whatever asset is considered the worst at a given point in time has a good likelihood of being the cheapest
Patient Opportunism
- Patient opportunism – waiting for bargains – is often your best strategy
- The only real penalty in investing is making losing investments. There’s no penalty for omitting losing investments, just rewards. And even for missing a few winners, the penalty is bearable.
- Many organizations fail because they choose to pursue high returns in a low return environment. When prices are high it’s inescapable that prospective returns are low (and risks are high).
- The key during a crisis is to be insulated from the forces that require selling and positioned to be a buyer instead
- Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during melt downs
Knowing What You Don’t Know
- It’s hard to know what the macro future holds focus on smaller picture things where an investor can gain a knowledge advantage “know the knowable”
- Make an effort to figure out where a business or market stands in terms of cycles and pendulums
- Forecasts are of very little value. During “normal” times the future is much like the past and forecasts are mostly correct but of little value. When the future turns out to be very different than the past very few forecasts are correct although they would be of significant value
- No one likes having to invest for the future under the assumption that the future is largely unknowable
- Some of the biggest losses occur when overconfidence regarding predictive ability cause investors to underestimate the range of possibilities, the difficulty of predicting which one will materialize, and the consequences of a surprise
Having a Sense for Where We Stand
- The only thing we can predict about cycles is there inevitability
- Investors should try to figure out where they stand in terms of each cycle and what that implies for their actions
- Investors should try to gauge the present position which is knowable in order to understand the psyches of market participants, the investment climate, and thus how investor should respond (take the markets temperature)
Appreciating the Role of Luck
- A great deal of success of everything we do as investors will be heavily influenced by the roll of the dice
- Investors much learn to decide which outcomes came about because of luck and which because of skill. Until one learns to identify the true source of success, one will be fooled by randomness
- Every record should be considered in light of the other outcomes – Taleb calls them “alternative histories” – that could have occurred just as easily as the “visible histories” did
- It is important not to look at investor’s track records but what they are doing to achieve those records. Does it make sense? Does it appear replicable? Why haven’t competitive forces priced away any apparent market inefficiencies that enables this investment success?
- A correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people asses it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown.
- In the long run there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t.
- We need to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones
Investing Defensively
- Defense – significant emphasis on keeping things from going wrong – is an important part of every great investor’s game
- Investors should strive to keep up in good times and outperform in bad times. This way they can achieve above-average results over full cycles with below-average volatility
- Defense can be achieved by extensive due diligence, applying high standards, demanding a low price and generous margin for error, being less willing to bet on continued prosperity, rosy forecasts and developments that may be uncertain.
- In fixed income distinguishing yourself isn’t a matter of selecting the paying bonds you hold but rather excluding the bonds that don’t pay. This is what Graham and Dodd considered a “Negative Art”
- Most investment managers careers end not because they fail to hit homeruns but because they strike out too often
- At Oaktree the motto is “if we avoid the losers, the winners will take care of themselves”
- Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t know and can’t control are hallmarks of the best investors
Avoiding Pitfalls
- The sources of errors are primarily analytical/intellectual or psychological/emotional.
- “Failure of imagination” unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences
- The success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers
- The assumption that something can’t happen had the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment
- The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error
- A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, nonfundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, affecting everything similarly
- During a crisis the loss of confidence prevents many from doing the right thing at the right time
- When there is nothing particular clever to do, the potential pitfall lies in insisting on being clever
Adding Value
- Passive index investing epitomizes investing without value added
- According to theory the formula for e
- xplaining market performance (y) is y=a+Bx where a is equal to alpha, B is equal to beta, and x is the return of the market
- Risk adjusted return hold the key, even though – since risk other than volatility can’t be quantified – it is best assessed judgementally, not calculated scientifically
- The performance of investors who add value is asymmetrical – they capture more market gain than the loss they suffer.
Reasonable Expectations
- Investors must ask themselves: What their return goal is, how much risk you can tolerate, and how much liquidity you’re likely to require in the interim
- It’s essential to understand that “cheap” is far from synonymous with “not going to fall further”
- We should be glad to buy on the way down. If something is cheap buy and if it gets cheaper, buy more. It’s not realistic to expect to buy at the bottom
Pulling it all together
- Buying below value is the most dependable route to profit. Paying above value rarely works out as well.
- When other investors are unworried, we should be cautious; when investors are panicked, we should turn aggressive.
- It can require patience and fortitude to hold positions long enough to be proved right
- Only investors with unusual insight can regularly define the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail