Inflation Protection for Long-Term Investors

How to Become a Better Investor: 4 Principles Behind Exceptional Investment Decisions

Instead of searching for the next hot investment idea, we should strive to make sustainable, above average investment decisions. Successful investing isn’t based on home-run type bets. It’s based on sound decision making over many years. To do this, we need to develop principles to guide our decisions regardless of the market environment. Since the future is unknown and will not be exactly like the past, we can’t rely on rigid rules to guide us in every situation. Principles, however, can be adapted and applied to all environments.

To become a better investment decision maker, we should focus on process, not outcome. Many investors judge their decisions by how well their choice worked out. If the stock they picked went up, they conclude it was a good decision. If it went down, it was a bad decision. This analysis is misguided. In the short run, luck and randomness dictate many outcomes. We can be right for the wrong reason. For example, winning money at a casino may be viewed as a good decision, but it was actually a bad decision bailed out because luck was in your favor. If you continue to play at the casino, I can guarantee you will end up with a bad outcome. Luck isn’t a sustainable process. Because the process behind this decision is stacked against you (the odds favor the casino), judging your success by one outcome masked the flawed process underneath.

We encounter the same thing as investors. We buy a stock for the wrong reason, and when it goes up, we take credit for the great decision. Except that it wasn’t a great decision. It was just lucky. We constantly confuse luck and randomness with the quality of the underlying decision-making process. We need to focus on the process to make correct decisions. Any one decision may not go the way we want it – that’s just reality. But what we can’t do is judge ourselves based on one-time examples. We need to judge our decisions making by examining the reliability and accuracy of our underlying process.

Investors, like superforecasters, need to build a consistent and rational approach to decision making. Let’s examine how we can apply some of the principles behind Phillip Tetlock’s book, Superforecasting: The Art and Science of Prediction, to the investment world.  

Principle #1: Unpack the question into components. Distinguish as sharply as you can between the known and unknown and leave no assumptions unscrutinized. 1

Investors should also break down any decision into smaller components. By segmenting the decision into manageable parts, we can better understand the underlying fundamentals without being overwhelmed. We can pass judgement on each individual item and build up our understanding. Otherwise, we overcomplicate the situation by trying to comprehend too much at once.

We should separate the critical underlying assumptions for every decision. These are often buried deep and are usually neglected, unless each assumption is identified. Without examining these drivers, we don’t understand our investments. We also need to uncover the unknowns and the resulting risks. By doing this, we can prepare and plan accordingly.

We often fool ourselves into thinking we know more about our stocks then we really do. We focus on headline-type issues – earning per share, top-line growth, news flow, etc. While these play a role in analysis, we need a deep understanding of the company. For example, when thinking about growth, we need to look at what’s driving the growth. What is the incremental ROIC on that growth? Is it profitable growth above the cost of capital? Is it organic or acquisition driven? Funded by operating cash flow or debt/equity issuance? Is it sustainable? Is the growth protected from competition, or will competition compete away the value of that growth?

Principle #2: Adopt the outside view and put the problem into a comparative perspective that downplays its uniqueness and treats it as a special case of a wider class of phenomena. Then adopt the inside view that plays up the uniqueness of the problem.2

Investors should incorporate an outside view when making any decision. Renowned investor Michael Mauboussin states, “The outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.”

“An inside view considers a problem by focusing on the specific task and by using information that is close at hand and makes predictions based on that narrow and unique set of inputs. These inputs may include anecdotal evidence and fallacious perceptions. This is the approach that most people use in building models of the future and is indeed common for all forms of planning.”3

We regularly fail to take the outside view and normally focus on the inside view. We just care about the current decision in isolation and neglect all the other previous decisions that share common characteristics. These previous decisions provide valuable information. As Michael mentioned, the inside view traps us by viewing every decision as unique, instead of trying to learn from similar past decisions. Because the inside view is often complicated with bias, anecdotes, and noise, it provides a terrible basis for investment decisions. The more we can take an outside view and learn from other similar decisions, the better we can calibrate the true probability of making a correct decision.

For example, when buying a stock, investors often gravitate to salient but anecdotal evidence. How fast is the company growing? What has the stock price done? What does the market think of this stock? We latch onto these headlines as a foundation for making decisions. The better approach is to go back in history and look at other stocks with the same characteristics and see how those worked out. By doing that, we have a larger sample size to base a decision. The evidence is better supported because there are more examples that cancel out the idiosyncratic, “inside view” effects.

Instead of looking at our investments in isolation, compare them to similar investments in the past. How have they performed over time? Did those investments work out like expected, or were there unexpected changes that negated the fundamental premise of the investment? For example, if we invest in commodity investments, don’t just look at the current investment fundamentals in isolation. Look back and examine how other commodity investments worked out. We will be surprised how few commodity investments, with the same underlying premises, actually worked out as expected for the investor. By comparing our investment to a reference class, we bring in long-term experience and real case studies to help solidify our investment thesis. If we find more disconfirming evidence than we expected, we may not have such a great investment opportunity after all.

Principle #3: Also explore the similarities and differences between your views and those of others—and pay special attention to prediction markets and other methods of extracting wisdom from crowds.4

We should always be looking to challenge our assumptions and beliefs. We can’t know everything, and we often make mental mistakes. By honestly trying to figure out where we go wrong, we can improve our decision making and build better decision-making habits. Ask yourself, “Why am I seeing this as an opportunity when the rest of the market thinks different?” Am I wrong and the market has it correct? How can I find out? What additional research can I do to tilt the odds in my favor?

Markets usually get to the right decision, although there are moments where they spectacularly fail. We need to understand when the conditions exist for each of these scenarios. If we don’t, we will assume we have an informational edge when we are really just overconfident.

We need to seek other investors who disagree with us. This provides us with necessary counterbalance to our own mistakes and flawed reasoning. We can’t do this ourselves. We are too biased to be 100% independent when reviewing our own work and assumptions. We need someone who can provide an educated and independent assessment of our decision. It’s not easy to hear, but criticism is crucial to our success. We need discomfirming evidence. It doesn’t do us any good to talk to someone who already agrees with us. Chances are that both people are making the same reasoning errors or exhibiting the same mental biases.

The solution is simple. Instead of finding people that agree with us, we should seek people that disagree with us. Examine their arguments and try to understand the differences. It’s not easy. There is never definitive proof on either side. The goal of the exercise is to force us to uncover your own mistakes, biases, and misjudgments. Our ego is the biggest impediment to this process. It’s not fun thinking about how we are wrong. Instead of trying to prove how smart we are, we should go into these situations just trying to learn. We will be amazed how much we can grow as an investor when we stop trying to look smart and instead focus on learning.

Principle #4: Express your judgment as precisely as you can, using a finely grained scale of probability.5

All investment decisions are a matter of probability. Investors who think in terms of certainty or act with 100% confidence fail to understand reality. The world is too complex to have perfect information. It’s painful to acknowledge the limits of our understanding, but we can’t fool ourselves into thinking we know more than we really do. Great investors view all decisions along a probability spectrum. Since they know nothing is for certain, they wait until the odds are in their favor to make big investments. If the odds aren’t there, they wait. And wait. And wait. It might take years for compelling investment opportunities to appear. Investors must be exceptionally patient until the markets provide the right opportunities.

We need to frame our decisions as a series of probabilities. For example, we might assign different odds to how fast a company might grow and how profitable they will become. By doing this, it forces us to examine scenarios that we otherwise might neglect. Many investors just concentrate on the scenario they think is the most likely.

The probabilities are never exact and we will never know how close we got on any one particular decision. Applying higher level mathematics or complex algorithms doesn’t help either, as it will just deliver false precision. The critical idea is to force us to go through the thought process of challenging our own beliefs and examining scenarios that we normally would neglect. It will never be a perfect science, because in the short run reality is full of randomness, complexity, and uncertainty. In the long run, principles-based decision making delivers above average investment returns.

Probability based thinking can lead to counter-intuitive investments. For example, investors often view a highly volatile investment as “risky”. If they instead view that investment in terms of different scenarios of risk and reward, they may find an attractive investment. Even if the base scenario implies a high likelihood of a loss, an upside scenario may deliver a gain many multiples of that loss, leading to an asymmetric risk/reward payoff. Even though most investors neglect the opportunity because of the headline “risk”, astute investors can uncover opportunities in their favor by thinking with probabilities.

Notes:

1,2: From Superforecasting: The Art and Science of Prediction by Philip Tetlock and Dan Gardner

3: http://michaelmauboussin.com/excerpts/TTexcerpt.pdf

4,5: From Superforecasting: The Art and Science of Prediction by Philip Tetlock and Dan Gardner 

Become a Better Investor - 5 Principles from Warren Buffett's 2017 Annual Letter

A few weeks ago, Warren Buffett released his annual shareholder’s letter and again delivered some compelling insights for investors. Buffett’s timeless and simple investment principles are great lessons for all investors to revisit. Even if you don’t agree with Buffett on all of his political/personal views, his investing advice remains the gold standard for investors who want long-term, actionable wisdom. He honestly speaks his mind and backs up his words with action – often billions of dollars of action behind his investments. He has what most market pundits lack – skin in the game. When Buffett talks about investing when others are fearful, he backs that up by investing large amounts of money. This is a striking difference to most market advisors and strategists who recommend ideas, but rarely commit any of their own money. If there is real money, it’s the clients, and not theirs, at risk.

Buffett’s words are so powerful because he 1) has the track record to back up his claims and 2) he commits Berkshire capital when he says he will. Given these reasons, Buffett’s annual letter should be recommended reading for all investors. After digesting his latest annual letter, I’ve summarized 5 key principles investors should incorporate into their own process. Most of these are not new, but unfortunately investors have a bad habit of forgetting obvious lessons. It pays to revisit these and the annual Buffett letter is a great way to do it.

Note: I highly recommend reading the letter in its entirety. Here’s a direct link to the letter. All italicized passages in this article are directly from the 2017 letter.

Principle #1: Investment success depends on the price paid, not just the inherent fundamentals of the underlying asset.

Here’s Buffett from the 2017 Annual Letter:

In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price. [my emphasis added]

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.

Buffett mentions many of the same things other investors emphasize – great companies, wide business moats, attractive reinvestment opportunities, superior management, etc. Hard to disagree with those. But when investors screw up, it’s often because they get the price wrong. Even though they find attractive companies, they pay too high of a multiple, leading to investment underperformance or negative returns, even though the underlying business is performing well.

Think about it – if price didn’t matter, Buffett wouldn’t be sitting on cash today. Surely he has identified great businesses he would like to own today. Why doesn’t he just buy these great businesses and watch them grow and grow and deliver great results for Berkshire shareholders? It’s simple - it wouldn’t work. As the price rises, returns on any investment migrate from great to good to mediocre to poor to disastrous. What you pay determines where on that scale you will fall.

 It’s tough work to figure out what you should pay. It’s a complex mix of discount rates, growth, return on investment, business/credit cycle, competition, and on and on. There’s never an easy answer and it will never be easy. That’s why investing is hard and there are so few Buffett’s. It’s not supposed to be easy.

Most investments across asset classes have simple and consistent valuation benchmarks to determine a reasonable price. It’s not an exact science. The point is to buy when there is a clear margin of safety. In today’s markets, most equities and fixed income assets are priced in the upper valuation ranges, some at extreme levels.

As Buffett mentions, investors need to exercise caution when allocating to risk assets. There is a growing sense of comfort and complacency in the market, given the recent tax cuts and continued economic growth. However, valuations already take this into account. It’s a fatal error to pick out arbitrary events (like the tax cuts) to justify higher and higher valuations. And there’s even debate on whether tax cuts will deliver any long term, net economic growth at all. Many investors who justify paying top decile valuations are doing so on a very shaky foundation. Historically (and mathematically), paying top valuations leads to subpar future returns.

It won’t turn out well for these investors. The sins of poor decision making today won’t be apparent until the future. It takes significant independent and long-term thinking to make wise investments in today’s markets. Buffett is clear about where he stands on valuations, and you as an investor should ensure you fully understand the price you are paying and the implications it will have on future returns. If you think valuations are reasonable today, prove to yourself you understand what has to go right to make sure the future turns out the way you need it to.

Principle #2: Beware of leverage as it often hides fatal flaws in many investments. Leverage takes a mediocre return and creates the illusion of an exceptional return. Unfortunately, investors don’t realize this into it's too late.

Here’s Buffett from the 2017 Annual Letter:

The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities). We also never factor in, nor do we often find, synergies.

It’s obvious that a bad business, loaded up with debt, is a disaster waiting to happen. However, it’s less obvious that good businesses with too much debt often suffer the same fate. Leverage is seductive. Leverage enhances returns, growth, and EPS. For a while at least. Even the worst business can show earnings growth by either buying another company or investing internally, if it’s fueled with cheap debt. It works in the short-term and will continue as long as the current environment doesn’t change. But economies, markets, and businesses are subject to a shockingly high degree of unforeseen change and disruption, all of which will destroy leveraged investments and transactions.

Business executives and investors fall victim to this curse. It’s hard to resist borrowing cheap money when there appears to be arbitrage like opportunities to put that money to work in higher returning investments. The fatal flaw in this process is the simple: the future will not remain like the present. Investors often deal with an unknown future by extrapolating current trends and assuming the environment will stay the same.

Investors who have studied their history understand that the past is filled with unexpected shocks and regime changes in the markets. Growing economies go into deep recession. Great businesses face new competition that destroy their current business model. Free flowing credit markets seize up, causing solid businesses to face a liquidity squeeze when their debts mature. Accommodating markets can quickly become unaccommodating, so leverage will swiftly impair investments when the cycle turns.

It’s not an easy thing to do, but at some point investors need to decide whether they are on the offensive or defensive. As Howard Marks has stated, you can’t have both. You can’t get all the return you want and be super defensive. It’s one or the other.

Buffett chooses defense. As he mentions in the letter, he evaluates deals on an all equity basis, even though adding leverage would enhance the return. He doesn’t count on synergies, even though they would make the acquisition more attractive. Investments based on leverage and synergies rarely deliver the promised returns to investors. Investors would be wise to remember this lesson as they evaluate new investments. Separate the speculation (leverage, synergies, high growth forecasts) for the likely reality (little synergies and modest growth).

Principle #3: While holding “safe” investments remains unpopular with many investors, it provides the necessary dry powder to withstand market shocks and take advantage of market opportunities.

Here’s Buffett from the 2017 Annual Letter:

Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers – or even that of friends who may be facing liquidity problems of their own. During the 2008-2009 crisis, we liked having Treasury Bills – loads of Treasury Bills – that protected us from having to rely on funding sources such as bank lines or commercial paper. We have intentionally constructed Berkshire in a manner that will allow it to comfortably withstand economic discontinuities, including such extremes as extended market closures.

Buffett is content sitting with billions of short-term Treasury Bills, a rare thought for most investors. Why does he do it? It goes back to the first principle – he can’t find attractive investments at today’s valuations. He’s patiently waiting for the next opportunity.

Should investors copy Buffett and sit in cash as well? It’s a tougher call for most investors. Obviously, most investors can’t match Buffett’s investment capability, temperament, and business analysis ability. It pays for investors to remain towards a fully invested portfolio. While investors don’t have to make a drastic move to safer assets, they should move enough to remain comfortable during the next downturn. A higher allocation to “safe” assets makes sense when valuations and expected returns are subpar or even negative.

Unfortunately, many investors neglect this and it’s not because they necessarily disagree with the logic. They don’t deny you should buy more assets when prices are low and sell assets when prices are high. Buy low, sell high. The problem sits with their emotions – as risk assets like stocks continue to run up, investors can’t handle the thought of missing out on future gains if the markets continue to rise. In short, they become momentum traders and hope the market continues to rise. But all economic, business, and credit cycles come to an end. If investors are top heavy in risk assets at the peak, they will suffer excessive losses on the way down. The solution is not to dump all the risk assets and sit in cash. It doesn’t have to be an extreme move. But investors should tilt away and rebalance to safer assets when valuations call for it. That’s why its imperative to have a fundamental gauge to judge the attractiveness of asset classes. It doesn’t have to be complicated – a moving average P/E for stocks, a long-term average spread level for bonds, etc.

The biggest problem comes back to investor’s emotional biases – they can’t stand re-allocating away from assets that have recently done well. The “buy low, sell high” logic is thrown out as they are seduced by the easy money being made today. But it will end, as it always does. Remember, the lesson is not to completely dump stocks and go to cash. The idea is to remember that all good markets come to and end, and investors need to consider their ability to handle a down market, and structure their portfolio accordingly.

Principle #4: In the short-term, prices disengage from fundamentals, often in a violent and unpredictable manner. Investors who are prepared for them will succeed, those who are unprepared will fail.

Here’s Buffett from the 2017 Annual Letter:

Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:

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This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.

Buffett emphasizes the lesson on the inherent dangers of adding leverage to an equity portfolio. As Buffett states, even a portfolio with high quality Berkshire shares would have been decimated if leverage had been added.

There is a bigger lesson here than just the dangers of leverage. It’s the idea that in the short-term prices can drop to wildly unexpected levels. Many investors aren’t ready when this happens, resulting in knee-jerk reactions and emotionally charged investment blunders. If quality investments like Berkshire fall over 50% in these time periods, imagine what happens to lower quality companies! There are two lessons here. First, these events, while unexpected, happen regularly in the markets. Second, the goal is not to predict these events, but the prepare for these events. Investors who are mentally ready and have dry powder to deploy will use these opportunities to make exceptional investments at absolute bargain prices. Investors who are not ready will often panic, sell out at the bottom, and lock in huge losses and forego any participation when the market recovers. Same market event, but two completely different outcomes, all based on the preparation of investors before these events occur.

Principle #5: Many active managers have failed to deliver their promise to investors. Hedge funds, fund of funds, and other active managers continue to lag their respective benchmarks, often by a large amount. Investors need to challenge their own conviction when allocating to active managers, making sure they really understand the unique capabilities of their managers.

In 2007, Warren Buffett made a simple bet with Protégé Partners. Buffett bet that the S&P 500 would outperform a group of five fund of funds over a ten-year period. Protégé, an advisory firm, selected a group of fund of funds and bet they as a group would outperform the S&P 500, after all fees and expenses. Buffett was making a bet based on something he has believed for a long time – the performance of most Wall Street products and strategies, after including the layers of fees and expenses, end up delivering staggeringly low returns to investors while enriching the managers. Buffett and Protégé each put up money that would be donated to the winner’s charity of choice at the end of the 10 years. Below is Buffett’s recap of the bet that just ended this year.

Here’s Buffett from the 2017 Annual Letter:

 “The Bet” is Over and Has Delivered an Unforeseen Investment Lesson

I made the bet for two reasons: (1) to leverage my outlay of $318,250 into a disproportionately larger sum that – if things turned out as I expected – would be distributed in early 2018 to Girls Inc. of Omaha; and (2) to publicize my conviction that m

The 90% Rule: Making Better Investments with Less Anxiety

A Nonessentialist approaches every trade-off by asking, “How can I do both?” Essentialists ask the tougher but ultimately more liberating question, “Which problem do I want?” An Essentialist makes trade-offs deliberately. She acts for herself rather than waiting to be acted upon. As economist Thomas Sowell wrote: “There are no solutions. There are only trade-offs.”

You can think of this as the 90 Percent Rule, and it’s one you can apply to just about every decision or dilemma. As you evaluate an option, think about the single most important criterion for that decision, and then simply give the option a score between 0 and 100. If you rate it any lower than 90 percent, then automatically change the rating to 0 and simply reject it. This way you avoid getting caught up in indecision, or worse, getting stuck with the 60s or 70s. – Essentialism, George McKeown

In his book, Essentialism, George McKeown illustrates the benefits of deliberately making trade-offs to build a better and more “essential” life. His 90% rule consciously directs our focus and energy by eliminating decisions that fall below 90%. Logically, this means eliminating many good ideas that we would normally pursue. Why would we do that?

We rarely consider the negative effects of chasing all the good/average/mediocre decisions because we don’t consciously track the unintended consequences. It seems worthwhile until we consider the full cost of our actions. We pursue too many good decisions instead of focusing on a few great ideas. Chasing too many decisions leads to never-ending distractions and an overwhelming sense of “busyness”.

In today’s environment, investors have the same problem. By chasing hundreds of news stories, ideas, and recommendations, we end up distracted, overwhelmed, and ultimately ignorant. We don’t invest the energy in mastering the important principles. Consequently, we unknowingly make poor investments without realizing it until it’s too late. We feel like we should always be doing something – making a trade, firing a manager, or reading a headline. There is a perpetual action bias as patience is viewed with scorn. In an upward market, investors don’t have the patience to sit in safer assets. One of the worst things an investor can do is lose patience and settle for poor opportunities.

The 90% rule makes us slow down and consciously consider our ideas. Great investors aren’t trading every day. They have a few big ideas per year. That’s it. The notion that we need come up with exceptional ideas every week is unrealistic and leads to mindless activity. Investing is a game of quality, not quantity. We only need a few great investments over the course of many years to deliver exceptional results. We need to raise our standards when we take on risk to ensure we are adequately compensated for doing so. When we abandon that principle, we have little margin of safety when things don’t work out as we expected. The 90% rule isn’t perfect, but it avoids the marginal ideas that often get us in trouble. The 90% rule would stop a lot of bad investments. Because of our bias to settle for good ideas, our portfolios end up stuffed with marginal investments, instead of a high conviction, best ideas portfolio.

“Hell Yeah or No”

Entrepreneur Derek Sivers created the same rule to decide his commitments and areas of focus. He calls it the “Hell Yeah or No” rule.

Derek explains -

Use this rule if you’re often over-committed or too scattered. If you’re not saying “HELL YEAH!” about something, say “no”. When deciding whether to do something, if you feel anything less than “Wow! That would be amazing! Absolutely! Hell yeah!” — then say “no.” When you say no to most things, you leave room in your life to really throw yourself completely into that rare thing that makes you say “HELL YEAH!”. Every event you get invited to. Every request to start a new project. If you’re not saying “HELL YEAH!” about it, say “no”. We’re all busy. We’ve all taken on too much. Saying yes to less is the way out. - https://sivers.org/hellyeah

Derek emphasizes that anything less than a “Hell Yeah”, is a “No”. Does that mean rejecting perfectly good ideas? Absolutely. We need give up the good opportunity today to capture the exceptional opportunity in the future. Adopting this rule makes life easy and delivers better results. The more we agonize over a good idea, the more time and energy we waste. It seems painful in the moment to reject a good idea. Remember, exceptional investments, just like ideas, are not evenly distributed – they come in bunches, waves, and clusters. Just because we don’t see a compelling investment today, we shouldn’t force the issue and trap ourselves in an average idea. If we’ve invested everything we have in good ideas, there is nothing left for the great ideas.

Buffett’s 90% Rule

Warren Buffett says it best. He talks about waiting for the fat pitch – waiting for the odds to be heavily tilted in our favor before investing. Here’s an excerpt from his 1997 Annual Letter -

Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business "pitches" we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun.

When we can't find our favorite commitment -- a well-run and sensibly-priced business with fine economics -- we usually opt to put new money into very short-term instruments of the highest quality. Sometimes, however, we venture elsewhere. Obviously we believe that the alternative commitments we make are more likely to result in profit than loss. But we also realize that they do not offer the certainty of profit that exists in a wonderful business secured at an attractive price. Finding that kind of opportunity, we know that we are going to make money -- the only question being when. With alternative investments, we think that we are going to make money. But we also recognize that we will sometimes realize losses, occasionally of substantial size.- http://www.berkshirehathaway.com/letters/1997.html

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot,” Buffett has said. “And if people are yelling, ‘Swing, you bum!’ ignore them.”- http://www.omaha.com/money/buffett/warren-buffett-waits-for-a-fat-pitch-before-taking-a/article_40026e55-60c2-54b6-95c5-bbee134d1696.html

Because of institutional mandates, competitive pressures, and ingrained bad habits, investors swing at bad pitches. Investors must keep up with other investors because if they lag behind, they are fired. Investment committees, boards of directors, and clients want their money managers to “do something”, especially if other investors are making money. After all, why pay them to sit around and do nothing? It doesn’t take managers too long to understand they better start swinging at pitches, even if they are constantly striking out.

How can we overcome this? It’s not easy. We need to embed patience in our process. Get comfortable waiting, and waiting, and waiting. The ability to invest independently and at the right time/price is critical. Investors can’t be evaluated like a factory worker. You can’t measure investment productivity by looking at activity, action, or output. Superior investing is about capturing rare opportunities, not about how many trades we make. In fact, the more decisions we force ourselves to make, the worse the outcome. Fewer decisions done better.

In expensive markets, it’s challenging to find homerun ideas. It’s a natural consequence of high-priced markets. It doesn’t mean that investors stop looking for ideas. There are always mispriced assets, no matter the level of the general markets. They are just harder to find. More importantly, preparation today equips investors to make homerun investments when those opportunities arise.

The worst thing an investor can do is give up on the 90% rule and settle for mediocre ideas. It’s tough to remain patient when the markets continue to hit all-time highs. The fear of missing out is real.

Charlie Munger’s Advice

Charlie Munger, Warren Buffett’s business partner, explains another variation of the 90% rule - Buffett’s 20 punch rule.

Here’s Charlie from his USC Commencement Speech -  

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple. [emphasis mine]

When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all.”

He says, “Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better.”

Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn't the conventional wisdom. - https://old.ycombinator.com/munger.html

Treat your investments as sacred – more money is lost by getting into bad ideas than it is by missing out on good ideas. It’s easy to take a good idea and fool ourselves into thinking it’s a great idea. The 90% rule demands complete self-honesty. Remember, investments that meet the 90% rule are rare. It’s not easy to find exceptional opportunities. If we constantly find a lot of 90% ideas, we need to stop and think about how realistic and honest we are with ourselves. The higher the honesty, the more likely we will make wise investments. By following the 90% rule, we raise our investing standards, build a greater margin of safety, and can swiftly navigate an unpredictable future.

6 Investment Principles That Transform Fear & Uncertainty into Opportunity

Investing is all about the future. We invest cash today with an expected but ultimately uncertain amount of cash to be received in the future. The problem with the future is it’s largely unpredictable. Sure, we do our best to estimate and forecast what will happen, but ultimately, we invest in unknown and uncertain environments.

In a 2006 paper, Investing in the Unknown and Unknowable, Richard Zeckhauser described the challenges and opportunities of investing in unknown and unknowable environments. It’s a powerful article that explains why:

1.       Investors are overconfident in their ability to predict the future.

2.       Investors are reactionary and respond poorly to uncertainty and ambiguity.

3.       Investors should view the unknown as an opportunity, not a threat.

An uncertain future isn’t predictable, but we can prepare. Major investing mistakes occur at the extremes – whether a deep financial crisis or unconstrained market highs. Ambiguous and uncertain environments magnify poor decisions. These environments cause us to lose our rational, logical thoughts and rely on our primal, reactionary mental instincts. They goal is to understand how our mind reacts to unknown situations and design ways to turn these situations into opportunity. In essence, we should focus on preparing for uncertainty, not predicting uncertainty.

Investors should consider the following six lessons to help reframe unknown environments from fear to opportunity. As Richard stated, “Though investments are the ultimate interest, the focus of the analysis is how to deal with the unknown and unknowable.” Understanding the basics of the unknown allows us to make better decisions with less mental anguish. This can apply beyond investing to everyday life.

Principle #1: Understand When Traditional Financial Theory Fails

The essence of effective investment is to select assets that will fare well when future states of the world become known. When the probabilities of future states of assets are known, as the efficient markets hypothesis posits, wise investing involves solving a sophisticated optimization problem. Of course, such probabilities are often unknown, banishing us from the world of the capital asset pricing model (CAPM), and thrusting us into the world of uncertainty.

The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance. -Zeckhauser’s Investing in the Unknown and Unknowable.

Traditional financial theories work well in normal environments, but break down at the extremes. It’s our preparation for extremes that enables us to navigate uncertain waters. Proper investing at extremes has more to do with emotional intelligence than financial expertise. It’s about making gut-wrenching decisions during financial chaos or irrational optimism. In theory, you should be following the same basic prudent investing rules regardless of the environment: rebalancing to your target portfolio, managing your liquidity and cash flows, and examining your risk profile. In a crisis, prudent behavior disappears as typical financial relationships break down. Our decision making becomes a random assortment of knee-jerk reactions and emotionally-fueled urges.

The practical solution is to first accept these situations will occur. Don’t stick your head in the sand. We can’t predict the causes or magnitudes of extreme events. But while prediction fails, preparation advances. We can prepare by understanding the investments we own so we can overcome our emotions and regain long-term, logical thinking. We can run through scenarios and stress our portfolio to extremes to figure out how much pain we can handle.

Finally, we can study historical events and learn lessons from other great investors who went through similar situations. There are two benefits. First, it’s comforting to know the best investors have gone through the same pain and faced the same impossible decisions that we will face. Second, we can actually borrow these investor’s techniques and tools for our own use. Many great investors lay out exactly how they approach unique situations. We can build a library of principles to help guide us during uncertain environments.

The second dreary conclusion is that most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear, often to protect themselves from sniping by others. But for all but the simplest investments, entanglement is inevitable – and when investors do get entangled they tend to make significant errors. -Zeckhauser’s Investing in the Unknown and Unknowable.

Ignoring the unknown is not an acceptable strategy. Delaying the recognition magnifies future errors. These errors can eliminate years of sound investing during normal times.

Remember the 2009 financial crisis. Investors who had done everything right up until then were caught off guard with the severity of the crisis. Many investors had excessive amounts of risk going into the crisis, and then compounded the problem by going to cash at the bottom. It’s not that investors forgot the basics of investing. It’s that they didn’t prepare for the “entanglements” in advance, so investors weren’t ready to make better choices.

Principle #2: To Capture Excess Investment Returns, Study The Unknown/Unknowable

Such idiosyncratic UU [unknown and unknowable] situations, I argue below, present the greatest potential for significant excess investment returns.

The first positive conclusion is that unknowable situations have been and will be associated with remarkably powerful investment returns. The second positive conclusion is that there are systematic ways to think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment returns. To be sure, some substantial losses are inevitable, and some will be blameworthy after the fact. But the net expected results, even after allowing for risk aversion, will be strongly positive. -Zeckhauser’s Investing in the Unknown and Unknowable.

Exceptional opportunities occur in volatile environments. These unknown and unknowable (Zeckhauser refers to them as “UU”) situations, can deliver significant opportunities. Investors scared of big price moves won’t have the fortitude to handle the occasional misses. Remember, the goal is to grow the total portfolio value over time. How many misses you have isn’t the important variable; it’s the totality and magnitude of your wins and losses that matter. Those who prefer no losses at all, often sacrifice significant total return growth verses investors who can handle some losses but allow their successful investments to more than compensate for those losses.

There is nothing wrong with a conservative, diversified portfolio that avoids higher return/higher risk investment situations. It’s important to understand where you have an advantage and where you don’t.

However, investors who excessively try to avoid volatility and uncertainty often buy and sell at the worst possible times, locking in losses to avoid mental pain.

Do not read on, however, if blame aversion is a prime concern: The world of UU is not for you. Consider this analogy. If in an unknowable world none of your bridges fall down, you are building them too strong. Similarly, if in an unknowable world none of your investment looks foolish after the fact, you are staying too far away from the unknowable. -Zeckhauser’s Investing in the Unknown and Unknowable.

Investors’ excessive desire to avoid looking foolish punishes their future returns. For example, it’s always hard to buy near the bottom since the trend looks so bad and the news flow is negative. And because investors tend buy early, they will certainly look foolish in the short term. This apparent foolishness compounds the already challenge of capturing exceptional opportunities. The ego’s desire to avoid looking wrong in the short term causes huge long-term pain. Short-term, “foolish” decisions can often be the most profitable, because a little early pain is necessary to capture the biggest opportunities.

But it would be surprising not to see significant expected excess returns to investments that have three characteristics addressed in this essay: (1) UU underlying features, (2) complementary capabilities are required to undertake them, so the investments are not available to the general market, and (3) it is unlikely that a party on the other side of the transaction is better informed. That is, UU may well work for you, if you can identify general characteristics of when such investments are desirable, and when not. -Zeckhauser’s Investing in the Unknown and Unknowable.

Let’s examine the 3 characteristics –

1.       UU Underlying features – Most UU (again, shorthand for unknown and unknowable) situations are a result of previous excesses being unwound in a rapid fashion. This can be an erosion of asset value at financial institutions (2009 crisis) or a shift in commodity supply & demand causing rapid price declines (2015 oil collapse). There are constant factors leading up to these crises. Easy money in the form of cheap debt or plentiful capital for investment. Excessive enthusiasm. Embracing new valuation paradigms with no substance. These environments begin with reasonableness but end up at extremes due to extrapolation, momentum, inadequate risk consideration, and a disregard for mean reversion and competition. There is usually a claim that this time is different.

2.       Complementary Capabilities – These capabilities refer to an investor’s ability to correctly analyze a UU situation. Although there is no guarantee of success, great investors have a few key attributes that convert a UU situation into a wise investment. First, they have the correct mental makeup and behavior regulation that enables logical and emotion-free analysis. Nothing is harder than trying to keep your head when a market is collapsing. Great investors acknowledge the uncertainty and emotion, but quickly engage their higher cognitive powers to establish agency over the situation. Highly complex investments don’t lend themselves to casual analysis by unprepared investors.

Second, they are subject matter experts on the specific market or security. Successful investing is not about blind investing into UU situations. Mean reversion works on average, but there is enough variation around the average which allows investors to blow up their portfolio. You don’t have to become the most knowledgeable and obtain a Ph.D, but you must know enough the tilt the odds in your favor. Not all investments that price at bargain levels will make it, and a few zeros can destroy your portfolio or cause you to lose faith in your process at the moment you need it most.

Finally, successful UU investors focus on risk control. Risk control is not about avoiding risk. Risk control is about thoughtfully approaching your portfolio with a sense of humility that offsets the natural tendency to overinvest or overconcentrate. Humility checks your ego and spreads your risk among several very attractive investments, rather than focus on one or two high conviction names. Well-known investors have been burned by overconfidence in their top ideas. When these go bad, they lose more than they can ever recover. Investing is always uncertain and unpredictable, and overconfidence will trap even the best investors.

3.       Information Asymmetry

Investors should pay close attention to the other investors in the market. If the situation favors the other side of the trade because they have an informational advantage, investors will likely lose. In some markets, such as IPOs, M&A transactions, art investing, etc, sophisticated/specialized investors will have a significant advantage. These markets are highly competitive and leave most investors as the sucker. However, UU situations are different. They are avoided because of the psychological pain and uncertain environment. All investors generally have the same informational level.

Principle #3: Judgment, Not Intelligence, Distinguishes Great Investors

Alas, few of us possess the skills to be a real estate developer, venture capitalist or high tech pioneer. But how about becoming a star of ordinary stock investment? For such efforts an ideal complementary skill is unusual judgment. Those who can sensibly determine when to plunge into and when to refrain from UUU investments gain a substantial edge, since mispricing is likely to be severe. -Zeckhauser’s Investing in the Unknown and Unknowable.

Judgement determines whether our investing intelligence is converted into money-making investments. Intelligence needs to be applied to the correct asset, at the correct price, at the correct time. Lots of smart, sophisticated investors execute poorly. For example, they buy good assets at the wrong price. They let emotions and hubris interfere with great thinking and end up buying or selling at the wrong time or in the wrong markets.

Note, by the way, the generosity with which great investors with complementary skills explain their successes – Buffett in his annual reports, Miller at Harvard, and any number of venture capitalists who come to lecture to MBAs. These master investors need not worry about the competition, since few others possess the complementary skills for their types of investments. -Zeckhauser’s Investing in the Unknown and Unknowable.

It’s an interesting thought – does Warren Buffet or other great investors fear giving away their secrets? No. They know the right combination of intelligence, temperance, humility, sound judgment, and courage may take decades to develop. Investors can’t turn on this ability when they want. It’s a mindset that needs deep cultivation and a lifetime of practice.

Principle #4: Overcoming Investor Biases Requires Thoughtful & Deliberate Training

Behavioral decision has important implications for investing in UU situations. When considering our own behavior, we must be extremely careful not to fall prey to the biases and decision traps it chronicles. Almost by definition, UU situations are those where our experience is likely to be limited, where we will not encounter situations similar to other situations that have helped us hone our intuition. -Zeckhauser’s Investing in the Unknown and Unknowable.

UU situations are not won by accumulating more facts or having a bigger spreadsheet. In these environments, there is an irreducible amount of uncertainty, no matter how much work and effort is applied. Clearly, you need to do your homework before investing. But many investors have the false idea that they can get rid of all uncertainty. They fool themselves with blind overconfidence. Our mind’s natural tendency is to eliminate any apparent uncertainty, through the stories we tell ourselves or our selective analytical approaches. UU situations require analysis and work, but ultimately success comes down to making a tough decision when the probability is deeply in your favor.

There are too many investor biases and mistakes to list here, but the important takeaway is to get comfortable with uncertainty. It’s a natural condition of successful investing. The goal is not uncertainty elimination, but uncertainty acceptance and management. If you accept uncertainty, you transform your outlook on uncertainty from a situation to fear to a situation to exploit.

Principal #5: Invest Where Others Neglect

The major fortunes in finance, I would speculate, have been made by people who are effective in dealing with the unknown and unknowable. This will probably be truer still in the future. Given the influx of educated professionals into finance, those who make their living speculating and trading in traditional markets are increasingly up against others who are tremendously bright and tremendously well-informed. -Zeckhauser’s Investing in the Unknown and Unknowable.

Just as in business, it often pays to invest in assets neglected by the competition. Fast growing ideas attract significant capital, reducing the expected returns and raising the risk profile. Investors who are late to the party will end up with higher risk and lower returns. For most investors, they are unlikely to be the first movers or early followers. They will arrive late, invest at the peak, and suffer significant losses.

The antidote is to go where there is less competition, little excitement, and significant uncertainty. These factors drive most investors away and create mispricings as prices significantly deviate from fundamentals.

Even sophisticated investors are likely to shy away from these areas.

First, their clients expect and prefer lower volatility and consistent returns, rather than volatile but higher returns. Clients want a smooth ride, and don’t tolerate excessive volatility from even the best managers.

Second, manager themselves feel pressure to gravitate towards opportunities that have a compelling narrative. Narrative-based investments are an easier sell to internal management and the public because they sound so good and have often performed well. But these attributes don’t correlate with future success, as competition and mean reversion often reverse any positive momentum and derail the narrative.

Finally, investments that appear certain today will often become uncertain, and vice versa. Uncertainty isn’t a permanent characteristic of any particular asset class. Uncertainty ebbs and flows based on investor emotions and economic conditions. Today’s uncertain areas may become more predictable as industries and companies adjust and adapt to new environments.

Because these environments are fluid and dynamic, they are always working toward an equilibrium condition. For example, when companies go bankrupt, those bankruptcies often give the remaining companies a stronger competitive position, higher market share, and a bigger share of the profits. So the conditions that cause uncertainty will usually correct itself as the markets and competitive economies adjust to new realities.

If you understand this process, you can be forward thinking and have a reasonable idea how these industries will evolve, even when it seems that the pain or uncertainty is unmanageable.

By contrast, those who undertake prudent speculations in the unknown will be amply rewarded. Such speculations may include ventures into uncharted areas, where the finance professionals have yet to run their regressions, or may take completely new paths into already well-traveled regions.

Similarly, the more difficult a field is to investigate, the greater will be the unknown and unknowables associated with it, and the greater the expected profits to those who deal sensibly with them. Unknownables can’t be transmuted into sensible guesses -- but one can take one’s positions and array one’s claims so that unknowns and unknowables are mostly allies, not nemeses. And one can train to avoid one’s own behavioral decision tendencies, and to capitalize on those of others. -Zeckhauser’s Investing in the Unknown and Unknowable.

Avoid depending on ultra-precise analysis as an attempt to remove uncertainty. The goal is to get close enough in your understanding of the situation to make an educated guess and position accordingly. Investors comforted by false precision are usually wasting time or fooling themselves.

Principle #6: Bet According To Your Advantage; But First Be Honest About Whether You Really Have An Advantage

…The greater is your expected return on an investment, that is the larger is your advantage, the greater the percentage of your capital you should put at risk…Most investors understand this criterion intuitively, at least once it is pointed out. But they follow it insufficiently if at all. The investment on which they expect a 30% return gets little more funding than the one where they expect to earn 10%. Investment advantage should be as important as diversification concerns in determining how one distributes one’s portfolio. -Zeckhauser’s Investing in the Unknown and Unknowable.

There should be some obvious intuition that higher conviction ideas with less risk and higher expected returns should have bigger positions in your portfolio.

In principle, I agree with that assessment. But there is a major assumption underlying this idea that must be true for this to work:

Do you actually have an advantage?

How do you know?

How do you know if you have correctly analyzed, vetted, and arrived at the correct conclusion?

What if you are just overconfident and mistaken?

How would you know until it’s too late?  

Anecdotally, I have heard several investors proclaim an investment as their #1 idea, only to see it actually end up as one of the worst ideas. I don’t believe an investor’s conviction level translates into above average returns. In fact, there may be an inverse correlation between the two. Anyone can pitch a compelling idea that promises all upside and no downside. It doesn’t mean it will happen.

If the difference between two ideas is significant enough, they should have different portfolio weights. But again, this all rests on the ability of the investor to be well calibrated to know when these differences really exist and when they are false.

Summary

Two rays of light creep into this gloomy situation: First, only rarely will his information put you at severe disadvantage. Second, it is extremely unlikely that your counterpart is playing anything close to an optimal strategy. After all, if it is so hard for you to analyze, it can hardly be easy for him. -Zeckhauser’s Investing in the Unknown and Unknowable.

As a final reminder, most investors you compete with are not playing an optimal strategy. Most are struggling, trying to figure out the best move in a complicated and uncertain world. Especially in periods of extreme stress, investors are likely to be on edge, forgetting the basic investing tenants and relying on emotion and gut feeling. By contemplating these principles, you have taken the initial steps to properly execute in the right investment situations. To be sure, you won’t get every decision correct. And yes, you may end up trading across from Warren Buffet or some elite hedge fund. But those situations will be the minority, especially if you adhere to these principles when thinking about the unknown and unknowable.

If you acknowledge and embrace the unknowable, you are better equipped to handle reality as it is – uncertain and unpredictable. By using wise judgement and training to overcome your inherent misconceptions, you outperform competing investors by leveraging your circle of competence and understanding when to make appropriate bets.

The 6 Principles in Review:

Principle #1: Understand When Traditional Financial Theory Fails

Principle #2: To Capture Excess Investment Returns, Study The Unknown/Unknowable

Principle #3: Judgment, Not Intelligence, Distinguishes Great Investors

Principle #4: Overcoming Investor Biases Requires Thoughtful & Deliberate Training

Principal #5: Invest Where Others Neglect

Principle #6: Bet According To Your Advantage; But First Be Honest About Whether You Really Have An Advantage

The Influence of Crowd Psychology on the Investor

In 1895, Gustave Le Bon published his best-known work, The Crowd: A Study of the Popular Mind. At the time, Le Bon enhanced the understanding of crowd psychology by researching and proposing several theories of how our beliefs and actions are altered in a “crowd” state.

How can a book from 1895 be useful to investors today? The basic idea is that our minds have not changed over the last 100 years. We still respond to the same emotions and biases as our ancestors. We repeat the same mistakes, generation after generation.

The influence of the crowd has never been more relevant. We must protect our mind from the opinions and ideas we accept. The information deluge is constant. It’s a fuzzy, almost imperceptible line to separate our own opinions from the opinions of the masses. That battle is consistently lost by unprepared investors who let their guard down when making investment decisions. 

Because we, as humans, are susceptible to overconfidence, we assume the crowds have no influence on our mind. We are too confident - it’s always other people’s problem, not ours. We are way too smart to be influenced by crowds.  I wish that were true, but studies clearly indicate otherwise.

How do we fight against becoming the “crowd” and learn to combat the frivolous and dangerous ideas?

Based on Le Bon’s work, I have created 8 lessons to prepare your mind against crowd behavior. (Note: all quotes attributable to Le Bon’s work, The Crowd)

It’s not an easy or painless endeavor. As Le Bon stated, “Science promised us truth, or at least a knowledge of such relations as our intelligence can seize: it never promised us peace or happiness.”

Understanding crowd psychology is not comfortable. We might not like the journey, but ignoring science dooms us to forever remaining in the crowd.

1.       The Struggle to Maintain Independence

It is only by obtaining some sort of insight into the psychology of crowd that can be understood how slight is the action upon them of laws and institutions, how powerless they are to hold any opinions other than those which are imposed upon them, and that it is not with rules based on theories to pure equity that they are to be led, but by seeking what produces an impression on them and what seduces them.

The goal is to understand how a crowd imposes its will on our minds. The first step is always understanding the process. The second step is creating a habit or framework to counter crowd effects.

We see that the disappearance of the conscious personality, the predominance of the unconscious personality, the turning of feelings and ideas in an identical direction by means of suggestion and contagion, the tendency to immediately transform the congested ideas into acts. These receive the principal characteristics of the individual forming part of a crowd. He is no longer himself, but has become an automaton who has ceased to be guided by his will.

Whenever we self-identify with a crowd, whether consciously or unconsciously, we strip away our ability to remain objective and rational. It’s evident in politics and religion. Ever try to have a logical political or religious debate? How quickly did it devolve into an anecdotal argument full of personal attacks and red herrings? Most people quickly move into defensive positions and start to defend their identities, rather than the argument. Once that happens, all reason disappears and no progress is made.

The crowd is at the mercy of all external exciting causes, and reflects their incessant variations. It is the slave of the impulses which it receives. Isolated individuals may be submitted to the same exciting causes as a man in a crowd, but as his brain shows him the in advisability of yielding to them, he refrains from yielding. The truth may be physiologically expressed by saying the isolated individual possesses the capacity of dominating his reflex action, while crowd is devoid of this capacity.

Remember, the crowd doesn’t seek the truth; it’s in constant search of excitement, novelty, and reward. If you understand that, you are prepared to understand events with a free mind. By remaining outside the crowd, you retain your capacity to evaluate the situation independently.

It’s never a problem to agree with the crowd, as long as you come to that decision through independent means. And doing that is never easy.

2.       Excitement and Novelty Drive Belief

The exciting causes that may act on crowds been so buried, and crowds always opening them, crowds are in consequence extremely mobile. This explains how it is that we see them pass in a moment from the most bloodthirsty ferocity the most extreme generosity and heroism.

When financial crowds operate in extreme directions, the market moves defy logic. What excited a crowd one day is erased with a terrifying reversal in sentiment the next day. These actions are unpredictable and wild. Although we try in vain to understand what is happening, it’s sufficient to attribute these moves to crowd behavior. Don’t waste time and energy trying to dissect the “meaning” of what these moves mean. There is no meaning, other than investors are all behaving under the spell of crowd psychology. While other factors, like leverage, enhance these effects, the root cause is always the crowd on one side of the trade.

They may be animated in succession by the most contrary sentiments, but they will always be under the influence of the exciting causes of the moment…Still, though the wishes of crowds are frenzied they are not durable. Crowds are as incapable of willing as of thinking for any length of time.

On the positive side, the extreme swings don’t last. Fundamentals eventually matter, and the crowds that operate irrationally eventually run out of assets to sell or run out of money to buy. The best course of action is remaining patient and vigilant. These are the opportunities to take advantage of the crowd, by using their instability against them.

3.       Crowd Beliefs Shut Down Thinking

A crowd is not merely impulsive and mobile. Like a savage, it is not prepared to admit that anything can come between its desire and the realization of its desire. It is less capable of understanding such an intervention, a consequence of the feeling of irresistible power given it by its numerical strength. The notion of impossibility disappears from the individual in a crowd.

Investors during the 2000 tech bubble and the 2006 housing bubble understand why the notion of impossibility disappears from the investment crowd. During those bubbles, tech and housing assets were viewed as can’t miss opportunities, and no amount of rational thinking could prevent investors from believing it was different this time. These assets couldn’t fail because of new paradigms, due to the Internet emergence in 2000 or the unending real estate boom in 2006. Owning these assets and watching them rise reinforced the belief that these assets couldn’t go wrong. But they did, and in a big way.

The improbable does not exist for crowd, it is necessary to bear the circumstance well in my to understand the facility with which are created and propagated the most improbable legends and stories…The simplicity and exaggeration of the sentiments of crowds have for result that a throng knows neither doubt nor uncertainty.

Legends and stories, not facts and data, drive investment booms and busts from healthy to extreme. It’s the stories that convince us of the invincibility and permanence of new ideas. During a bull market, our minds run wild with the possibilities of fantastic gains and newfound wealth. During a crisis, we believe everything is going to zero and assume permanent financial destruction.

The commonality behind both situations is our reliance on stories, rather than relying on factual research and historical lessons. We quickly dismiss any logical approach, because we’ve attached our opinions to the movement of the crowd.  

Whether the feelings exhibited by a crowd be good or bad, they present the double character being very simple and very exaggerated. On this point, as on so many others, and individual in a crowd resembles primitive beings.

We become primitive, in the sense we abandon our developed cognitive processes and let our reptilian brain direct our actions. Our primitive brain was well-designed for living 2,000 years ago, but has not adapted to the modern financial world. Because fear and greed operate on our basic, primitive minds, we must deliberately engage our higher cognitive mind to think clearly.

4.       Emotion Dominates Facts and Evidence

An individual may accept contradiction and discussion; a crowd will never do so.

The chain of logical argumentation is totally incomprehensible to crowds and for this reason is permissible to say that they do not reason or that they reason falsely and are not to be influenced by reasoning.

Crowds dismiss all alternative explanations and contradictory evidence. There are excuses for everything, and no amount of facts or reason will persuade a crowd.

Evidence may be accepted by an educated person, but the convert will be quickly brought back by his unconscious self to his original conceptions. See him again after the lapse of a few days and he will put forward a fresh his old arguments and exactly the same terms.

We can educate, train, and then educate some more, but still never escape the grasp of the crowd. It takes persistent training to re-wire our brains to instinctively recognize and fight the influence of the crowd. It doesn’t happen overnight.

I’ve personally experienced and seen others attempt to change behavior by just adding more information and assuming that will change behavior. Because our behavior is based on cognitive processes evolved over millennia, it’s going to take more than new info to make the change. It’s about using new info to transform habits into permanent behavior change.

That’s why you see investors make the same, repeated mistakes. We can spend all day convincing people of one thing, only to have them revert back a day later. The reason is two-fold. It’s the brain’s way of resisting change and reflects our ill-designed attempts to convert behavior. Permanent, long-term behavior modification requires repeated exposure to live training. Anything else is futile.

A longtime is necessary for ideas to establish themselves in the minds of crowd, but just as long a time is needed for them to be eradicated. This reason crowds, as far as ideas are concerned, are always several generations behind learned men and philosophers.

When we think of “learned men and philosophers” within investing or business, we gravitate toward the those who have proven their investing acumen over decades. JP Morgan, John Rockefeller, Andrew Carnegie, Ben Graham, Warren Buffet. All exceeded their generation by operating outside of the normal crowd state. The goal is to incorporate the lessons of the historic greats and operate with different principles than the crowd. It’s not enough to know different information. We must operate with a different set of principles than the crowd: independence, grit, intelligence, foresight, contrarianism, and persistence.

It is not than the facts and themselves that strike the popular imagination, but the way in which they take place in our brought under notice. The epidemic of influenza may very little impression on the population because they happened a little at a time, as opposed to one giant event that would’ve caused an uproar among the population.

The hardest beliefs to challenge can be the most non-obvious. Incorrect beliefs that have been learned gradually often lack the vividness that would normally cause us to re-examine those beliefs.

5.       Strong Beliefs are Fine, But be Open to Change

A person is not religious solely when he worships a divinity, but when he puts all the resources of his mind, the complete submission of his will, and the whole sold ardor of fanaticism at the service of a cause or an individual becomes the goal and guide of his thoughts and actions.

It’s fine to have beliefs, and strong beliefs at that. But all beliefs need at least 3 qualities:

1.       Evidenced based – valid, fundamental data should support your beliefs. Data is not always perfect and is never guaranteed, especially when thinking about the future. But there is no room for mythical or untested beliefs to drive investing decisions.

2.       Open to modification or reversal – strongly held beliefs should be changed when the weight of the evidence tips to the side of change. Beliefs should be held tentatively, ready to be changed when sufficient data/evidence is presented. Some beliefs may change daily (for example, because prices move daily, what is a terrible deal at one price is a great deal at another price) or may be rarely change (the idea that investing and saving for the future is a good thing). There’s no easy answer to this, other than to evaluate each belief on its own when new evidence is presented.

3.       Separate beliefs from your identity – if you attach beliefs to your identity, personality, or other personal trait, you run the risk of keeping beliefs not because they are correct, but because you become more interested in defending your ego and reputation. For example, if you always self-identify as bullish and optimistic on the stock market, it’s challenging to change your mind when the market is overvalued, because you have created a reputation and identity as someone who is perpetually bullish. It’s hard to have the guts to change your mind when your identity is something else.

You’ve created cognitive dissonance when your identity is telling you one thing (buy stocks) and the evidence is telling you another (sell stocks). The identity almost always wins, because our minds have a bigger interest in protecting our identity than searching for the truth. This is deadly for investors. Don’t take permanent stances in investing. Don’t create reputations or identities that make it painful to change your mind.

The masses have never thirsted after truth. They turn aside from evidence that is not to their taste, preferring to deify error, if error seduced them. Whoever can supply them with delusions is easily their master, whoever attempts to destroy their illusions is always their victim.

Many investors are eternally searching for the magic formula or guaranteed path to riches. They spend thousands of dollars on programs and systems that supposedly “reveal” the inside secrets of investment success. When viewed through a logical, rational lens, these claims are ludicrous and insane. But when viewed through the “crowd” lens, these programs make perfect sense. They appeal to investor’s desire for a can’t miss system, no matter how incredulous.

Investors must recognize when they fall under the spell of delusional, yet seductive systems that promise riches. It’s an inherent bias we all need to fight, and the minute we let our guard down, we succumb to our primal, crowd-based motives.

The experiences undergone by one generation are useless, as a rule, for the generation that follows, which is the reason why historical facts, cited with a view to demonstration, serve no purpose.

There are several reasons why investors forget the lessons of the past.

1.       We assume the people in the past were unsophisticated/unintelligent. We will never make those same mistakes. Wrong. While we have certainly advanced as a society, poor investing decisions in the past were usually never the result of a relative disadvantage in IQ or decision making. While we may know more today, we are also making decisions in a world that is more complicated and uncertain than it was in the past. In absolute terms, we may have an edge, but we are playing a more complex investing game. We are in a tougher environment, so we are relatively no better off.

2.       Hindsight is 20/20 – With the benefit of hindsight, we create all sorts of reasons why we wouldn’t have made those same mistakes. But it’s always obvious in retrospect, never in real-time. If you think it’s so easy, write down some can’t miss ideas today, and track those over a course of 3-5 years. Chances are you will have as many misses and wins, if not more misses. It’s a simple experiment to prove how hard it is to move hindsight into foresight.

3.       We assume the environment today is more predictable because we have access to more immediate information. Yes, we do have more information, and some of it is extremely valuable. However, that information comes with a lot of noise (data or information that has no predictive use or functional utility). And the catch is, it’s difficult to separate those two groups. We often get a mess of data and try to figure out what is news and what is noise. There’s never a clear answer, because what is useful in one environment is useless in another. You must be very clear about what edge you have and understand your circle of competence. Once you start to drift outside your core competence, you make all sorts of mistakes, including mistaking noise for news.

 6.       Understand the Psychological Tricks Preying on Your Mind

We’ve already discussed the problems dealing with unpredictable and complex investment situations. But there is even more trouble for us.

The financial industry promises to help investors navigate the complex investment world. Of course, they don’t expect to do that for free. It’s a lucrative industry that spawns many charlatans, con men, and promotors who want a slice of our wealth in exchange for bogus market-beating systems and hot stock tips.

These are both people and corporations full of bad advice and misdirection. To defeat them, you need know the tricks they play. Le Bon suggests several situations and triggers to watch for to understand when you are being pulled in the wrong direction.

We have already shown the crowd or not to be influenced by reasoning, and can only comprehend rough and ready associations of ideas. The orators who know how to make an impression upon them always appealing consequence to their sentiments and never to the reason. The laws of logic have no action on crowds.

The first idea: understand they always appeal to emotion, not reason. They sell with stories and dreams, not verified facts and evidence. If they based their approach on raw evidence, 1) their performance/client results look terrible, and 2) it does little to inspire wealth and riches when looking at cold numbers. They need to get you excited to get rich, or at least distract you from the flaws and risks in their argument. So always separate fact from story.

Given to exaggeration and its feelings, a crowd is only impressed by excessive sentiments. An orator wishing to move a crowd must make an abusive use of violent affirmations. To exaggerate, to affirm, to resort to repetitions, and never to attempt to prove anything by reasoning or methods of argument well known to speakers at public meetings.

It is terrible at times to think of the power that strong conviction combined with extreme narrowness of mine gives a man possessing prestige. It is nonetheless necessary that these conditions should be satisfied for man to ignore obstacles and display strength the will and a high measure. Crowds instinctively recognize and men of energy and conviction the Masters they are always in need of.

Two elements persuade a crowd. Strong conviction and extreme narrowness. Strong conviction delivers an overwhelming aura of superiority and challenges your ability to think independently, even if the conviction is baseless. Extreme narrowness reinforces that there is only one solution and path forward. It leaves no room for alternative explanations or doubt.

7.       How False Beliefs Spread

The first is that as the old beliefs are losing their influence to a greater and greater extent, they are ceasing to shape the ephemeral opinions of the moment as they did in the past. The weakening of general beliefs clears the ground for crop of haphazard opinions without a past or future.

As economic and investment cycles progress, investors abandon common-sense, fundamental principles and gravitate towards riskier, crowd-like behavior. There is always a rationale why the old beliefs don’t matter and the new ideas must be the new answer.

A second reason is that the power of crowds being on the increase, and this power being less and less counterbalance, the extreme ability of ideas, which we have seen to be a peculiarity of crowds, can manifest itself without let or hindrance.

As ideas spread, they build momentum and a cult-like power that begins to defy reason and logic. Unfortunately, these ideas don’t need any extra push when they start to spread. They build their own momentum through the explosive exponential power of networks.

8.       Why We are Doomed to Repeat Our Mistakes

Judging by the lessons of the past, and by the symptoms that strike the attention on every side, several of her modern civilizations have reached that phase of extreme old age which precedes decadence. It seems inevitable that all peoples should pass through identical phases of existence, since history is so often seem to repeat its course.

One of Le Bon’s final lessons is the idea that humans continue to repeat the same mistakes of the past. No matter how much we improve our understanding, intelligence, or technology, we have ingrained biases and tendencies that we can never permanently overcome. Due to laziness and ignorance, we assume these lessons don’t apply to us, because it’s so hard to create an outside, objective filter to view our own actions. Even though we can’t remove them, we can circumvent and avoid the consequences by deliberately understanding the underlying causes. The key word is deliberate, because just adding more information will not work. We need a conscious effort to understand the historical lessons and design ways of countering the effects of crowd-like behavior.

4 Secrets to Improve Your Workday: How to Build Career Success

#1 Routine, Not Willpower, is the Key to a Successful Workday

It was as if the first few times a rat explored the maze, its brain had to work at full power to make sense of all the new information. But after a few days of running the same route, the rat didn’t need to scratch the walls or smell the air anymore, and so the brain activity associated with scratching and smelling ceased. It didn’t need to choose which direction to turn, and so decision-making centers of the brain went quiet. All it had to do was recall the quickest path to the chocolate. Within a week, even the brain structures related to memory had quieted. The rat had internalized how to sprint through the maze to such a degree that it hardly needed to think at all. The key to a successful workday is to replace manual effort with habits and routines. Habits allow us to process more work without using extra energy that drains us by mid-afternoon. The attitude of hard work is great, but hard work has a downside because it depletes our energy levels when focused on low-value activities. We can’t produce quality work. -The Power of Habit, Duhigg

In his book, Power of Habit, Charles Duhigg explains how to channel habits into powerful assets to improve our lives.

How can we use these lessons to improve our workday?

The key to a productive workday is to substitute much of our “conscious” hard work into subconscious or automated habits that are less taxing on our energy systems.

Habits, scientists say, emerge because the brain is constantly looking for ways to save effort. -The Power of Habit, Duhigg

What type of work should become an automatic routine? Any repetitive and predictable activity. Emails. Office organization. Regular reports. Mundane transactions. Anything that has low variability is a good candidate for a habit.

What should not become habit? Any task that has high unpredictability or complexity. Because of the inherent variation in these tasks, automation will often lead to incomplete action and the wrong outcome. For example, hiring is a complex process that takes significant deliberate thought. It should not be automatic given the consequences of a bad hire and the variation of prospective employees.

Conserving mental effort is tricky, because if our brains power down at the wrong moment, we might fail to notice something important, such as a predator hiding in the bushes or a speeding car as we pull onto the street. -The Power of Habit, Duhigg

As mentioned above, we can’t power down our brains in high impact situations. It’s up to us to separate our day into routine habits and deliberate action, and not mix the two.

#2 Take a Step Back Before Judging Other’s Behavior

How do you react when a colleague makes a mistake that seems indefensible? Do you assume the person is just plain stupid? Do you assume they don’t care? Do you blame their work ethic or attention to detail?

Executives determined that, in some ways, they had been thinking about willpower all wrong. Employees with willpower lapses, it turned out, had no difficulty doing their jobs most of the time. On the average day, a willpower-challenged worker was no different from anyone else. But sometimes, particularly when faced with unexpected stresses or uncertainties, those employees would snap and their self-control would evaporate. A customer might begin yelling, for instance, and a normally calm employee would lose her composure. An impatient crowd might overwhelm a barista, and suddenly he was on the edge of tears. -The Power of Habit, Duhigg

There is constant tension between the effects of our environment and our ability to influence and control those effects. When we see other’s behavior, we often attribute 100% of that behavior to the person and completely neglect the role of environment. Seldom do we let the person off the hook and blame the environment. It *seems* to make intuitive sense that we are in 100% in control of our actions. Numerous studies have rebuked that belief, but it still persists in managerial behavior.

When we make a mistake, we are likely to blame outside factors instead of looking inward at ourselves. And when something goes right, we often take all the credit and assume the environment had nothing to do with it. We accept all praise and deflect all blame. It’s hard to overcome.

But when dealing with colleagues, hold your initial impression since you likely underestimate the power of the situation.

#3 Use a Crisis to Shake Things Up

After Barack Obama’s election, Rahm Emanuel said, “You never want a serious crisis to go to waste.”

You may not agree with his politics, but he had a powerful point.

All those leaders seized the possibilities created by a crisis. During turmoil, organizational habits become malleable enough to both assign responsibility and create a more equitable balance of power. Crises are so valuable, in fact, that sometimes it’s worth stirring up a sense of looming catastrophe rather than letting it die down. -The Power of Habit, Duhigg

Although a crisis is not a pleasant thing, many organizations waste the opportunity to improve their habits by learning from the crisis. The initial reaction is often hysteria and an ultra-short-term focus on the immediacy of the crisis, rather than improving long-term behavior.

Employees often follow the cues of their leaders. If leaders can’t separate the crisis from the learning, why should they expect employees to do the same? It takes a certain stoic mindset to compartmentalize the urgent crisis from the long-term lessons.

One a crisis has occurred, it’s a sunk cost and no amount of ruminating and stressing will undue the past. The best we can do is learn to modify our routines to ensure the same crisis doesn’t happen again.

#4 Corporate and Employee Behavior is Shaped by Social Convention

Your behavior mimics those around you.

Have you considered your behavior is significantly influenced by those around you? Do you believe you are 100% in control of your actions and habits?

…firms are guided by long-held organizational habits, patterns that often emerge from thousands of employees’ independent decisions. And these habits have more profound impacts than anyone previously understood. -The Power of Habit, Duhigg

It’s likely you have less control than you think. Unless you deliberately engage and understand your habits, you are bound to repeat the same patterns and actions. Your day to day activities are a consequence of the cues and expectations of those around you.

Many behaviors are not a result of deliberate thought but rather an evolving collection of haphazard and unexamined beliefs.

For example, companies often want employees to engage in deep thinking on breakthrough or revolutionary projects. However, they also expect constant and immediate email responses. Studies have shown that by interrupting deliberate effort, it takes 20-40 minutes to re-engage in deep learning.

While the company is hoping for one thing (deep thinking) they are getting something else (distracted workers handicapped by email). The actions of the company must match the words spoken by management. When there is conflict, the actions always win. 

If you want to change behavior, don’t expect more information to alter deep-seated organization behavior. It’s not an information problem. It’s a habit and expectations problem.

A movement starts because of the social habits of friendship and the strong ties between close acquaintances. It grows because of the habits of a community, and the weak ties that hold neighborhoods and clans together. And it endures because a movement’s leaders give participants new habits that create a fresh sense of identity and a feeling of ownership. Usually, only when all three parts of this process are fulfilled can a movement become self-propelling and reach a critical mass. -The Power of Habit, Duhigg

Your focus should first start with company-wide behavior, then re-train organization behavior with systematic training, and finally reinforce with social proof.

A movement starts because of the social habits of friendship and the strong ties between close acquaintances. It grows because of the habits of a community, and the weak ties that hold neighborhoods and clans together. And it endures because a movement’s leaders give participants new habits that create a fresh sense of identity and a feeling of ownership. Usually, only when all three parts of this process are fulfilled can a movement become self-propelling and reach a critical mass. There are other recipes for successful social change and hundreds of details that differ between eras and struggles. -The Power of Habit, Duhigg

To Summarize:

#1 Routine, not willpower, is the key to a successful workday – Quit trying to force your way through bad habits. Re-train and eliminate them instead.

#2 Take a step back before judging other’s behavior – Before rushing to judgment, step back and reflect on situational factors that have shaped people’s behavior.

#3 Use a crisis to shake things up – Rise above the day-to-day challenges of a crisis and learn to modify behaviors instead of ruminating on past mistakes.

#4 Corporate and employee behavior is shaped by social convention – Employee behavior is often shaped by social factors, not rules and logic. If you want to change behavior, alter social expectations.

Dangerous Protest Threatens Harvard's Endowment

Just when the pressures on university endowments seem to abate, another misguided attempt to use endowments as a political weapon falls on Harvard. According to The Harvard Crimson and an article by Bloomberg’s John Lauerman, Hollywood stars, current students, and other activists are demanding Harvard’s endowment divest its holdings of fossil fuel investments. Protesters assert divesting will cut the use of fossil fuels and increase the use of alternative energy. How that would actually work is where the logic gets fuzzy. It’s a shame such a highly regarded institution can produce graduates who support such a misguided stunt. The protest lacks any coherent reasoning, threatens the objectivity of the endowment's staff, and paralyzes the investment decision making necessary for long-term success. Divestments are endemic of a trend to use headline-grabbing exploits instead of engaging in real constructive change.

No real effects...

Divestment of energy related investments have no negative effects on the companies. Managements are not going to change their corporate strategy and mission. Energy companies have dealt with critics for decades! Divesting simply sells the stakes to some other buyer. In the end, there is no real change in any of these transactions. The companies don’t lose any funding! Buyers and sellers trade all day without the company caring. It’s simply a smokescreen to persuade the unsuspecting Harvard community that something is being done. If protestors want to change something, how about producing some real innovation in the energy space that can help shift away from fossil fuels? Divestment tactics are a distracting and meaningless attempt to convince the public that change is occurring.

Invert, always invert...

In fact, protestors actually have it backwards! If they want to induce change, they should advocate increasing the stakes in fossil fuel companies! Higher ownership stakes enables shareholders to voice their opinions through proxy voting in favor of better environmental policies. It allows shareholders to confront company management and engage in real, substantive dialogue. Divestment accomplishes the opposite. It removes any chance to enable change by passing that responsibility onto someone else. Of course, I doubt protesters actually want to put that much work into this; it’s much easier to organize a sit-in!

Dangerous precedent...

Endowments are already under tremendous pressure from university leadership, faculty, and students to deliver above average investment returns to fund the facilities, professors, and students that make Harvard so great. What endowments don’t need are another set of backhanded and dubious mandates that distract investment staff from their real jobs. Harvard’s investment staff has one goal: to ensure the continued growth of the endowment, not to become a pawn in a political and environmental campaign.

As a former portfolio manager at a pension fund, I can felt the challenges of navigating the financial markets before dealing with interference by outside protesters. Pet projects like divestments undermine the investment process that Harvard has successfully built over the previous decades. Investment staff now have to consider if investments made today will someday be examined under a microscope, leading to second guessing the real mission of the endowment. The real victim in this divestment push is not the actual companies; it’s the students and alumni of Harvard who will realize fewer benefits and be asked to shoulder a higher burden for the university.

If protesters want curb the use of fossil fuels, they should start supporting alternative energy projects or fund their own energy startup. Unfortunately, they might find that real change requires hard work and deep commitment, not occupying a university building.

3 Ideas to Implement Today from Buffet's Annual Letter

Warren Buffet’s annual letters are usually packed with interesting insights, but for the past couple years I had been a little underwhelmed by his thoughts. This year’s letter was the exception. As I read the letter for the second time, I realized Buffet laid out exactly how an investor should construct an investment portfolio and evaluate businesses. Although investors won’t find actual recommendations, he delivers something more valuable: a framework for selecting and analyzing businesses that any serious investor can follow. If these lessons make sense to you, you will want to read the entire letter here.

It’s ironic that the lessons seem logical and obvious as he describes them, yet 90% of investors (both individual and institutional) will completely fail at following half of his advice. We can attribute that to attention spans of zero and the general get rich quick mentality. If investors can avoid those handicaps, this year’s letter was a real goldmine for investors who are looking for a sensible way to think about investing.

Although he gives his secrets away for free every year, implementation is always the hard part! I picked out a few of the best and most practical insights that you, the investor, need to follow. By shamelessly stealing Warren’s investment principles, you will be 95% of the way to an effective investment portfolio. Now, the lessons…

One: Businesses > Treasuries

Warren wasted no time describing the tremendous outperformance of U.S. businesses over US dollar denominated bonds over the past half century. As most investors flock to “safe” U.S. treasuries, Warren’s extols the impressive track record of owning American businesses over long time periods. The common perception that stocks are risky and bonds safe is completely discredited by the long term data. Of course, this is no absolute guarantee this will repeat in the future. But consider what you would rather own for the next 30 years: a sensibly priced business that can compound value at 10-15% per year or a 30 year treasury delivering 2.7%?

Investing should be thought of as buying businesses, not trading stocks. Buffet has slowly and methodically built his portfolio of great businesses without the manic-depressive emotions that occupy most investors. Your portfolio should be structured the same way. If you have the time and aptitude to evaluate businesses, wait until they go on sale, and then start building your portfolio.

Two: What Matters Most: Durable, Competitive Advantages

Buffet highlights one the best but most forgotten elements of investing. Warren and Charlie own businesses with durable competitive advantages that can compound value over time without needing excessive capital investment. Notice how he didn’t mention fast growth, growing market share, exciting technology, or world-changing products. He distills a great business into one line.

But how quickly do most investors forget what really matters! 99% of investing conversations revolve around superficial topics that are heavy in excitement but rarely touch on the elements of investment success. Do your investments satisfy this simple test? This idea is powerful because 1) it's free and 2) most investors won’t use it! Resist the urge to fool yourself into thinking you can ignore this advice and “beat the market”. Your portfolio will thank you.

Three: Price Matters

Although Buffet expounds on the promise of great businesses, he doesn’t pay any price for them. Even Buffet admits that at close to 2x book value, Berkshire may likely see price declines in the near future. How refreshing to have a CEO give an honest assessment of the stock price! Not many CEO’s admit their companies are priced to perfection; in fact today most CEO’s are paying egregious prices for their own stock!

Great businesses still need to be bought at sensible prices! What is sensible is debatable, but if your business evaluation skills are sufficient it’s generally achievable to be roughly right on the price. Great businesses are not on sale very often, but it certainly happens. The key is buying with deployable cash to pounce on opportunities (The 2008-2010 timeframe being the last great opportunity).

Price is an area where most investors screw up. We are hardwired to buy high and sell low, and even the best businesses make poor investments when bought at the wrong times. Activity will be skewed toward inaction 90% of the time, but the other 10% will provide incredible opportunities to pick up wonderful businesses at bargain prices.

Bonus: Charlie Munger’s Thoughts

Followers of Berkshire know the wisdom of Charlie Munger. Charlie didn’t disappoint as he gave us a few pages of insight in this year’s letter. I’ll leave you with one piece of advice that applies to both investing and life. Here Charlie describes one of the many aspects of how Warren set up his system for Berkshire Hathaway:

“His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became…”

What great advice for investors and people in general! Notice he didn’t mention checking stock prices, scheduling meetings, or email. Great investors and great ideas are not built from at frantic pace at which the market operates. The compounding of knowledge over time will pay some large dividends if you don’t interrupt the process!

There is a treasure trove of great advice from Warren and Charlie on the Internet. Let me know and I can directly point you to the best material out there.

How a Famed Mathematician Can Make You a Better Investor

In the pursuit of building an investment education, I have found most insightful investment principles are often discovered in other disciplines. Investment books can be great, but most just rehash the same superficial material. True investment insight flows from deep principles that originated from other academic and professional fields.

Richard Hamming was a world renowned mathematician who pioneered research in computing and physics. He worked at the famed Bell Labs, helped design atomic bombs at Los Alamos, and advocated the redesign of mathematics education. Not only were his ideas valuable in computer science and physics, they clearly crossover into the investment world.

So what insights can Hamming share with investors that will enable a successful investment strategy?

Two foundational articles provide great insights for both beginning and sophisticated investors: “You and Your Research” and “A Stroke of Genius in Striving for Greatness in All You Do”. These articles provide a solid blueprint for constructing an investment education. Here are four ideas that readers can implement today.

“Great scientists have independent thoughts…and have the courage to pursue them.”

Hamming talked about the courage young scientists had to pursue new thoughts, instead of sticking with traditional methods. Great investors follow the same path. Independent thought is the linchpin for successful investing. Unaware to most investors, the outside influences we subconsciously entertain degrade the rational and logical mind necessary for investment success.

Great investing ideas often involve courage. The best opportunities are likely out of favor and take significant diligence to understand. Independence provides the clarity to see ideas in an unbiased light.

Investors are constantly being told what to buy, what to sell, and what to worry about. Sophisticated investors are extremely selective in what ideas and opinions they let through their filter. Investing doesn’t have to be a solo act, but each investor needs to build their own foundation.

Solution: My preferred method is to learn from other experts who have exhibited independence throughout their careers. Borrow ideas to fit your situation and mindset, rather than reinventing everything yourself. Some of my favorite examples are Richard Feynman, Teddy Roosevelt, and John Boyd.

“Knowledge and productivity are like compound interest. The more you know, the more you learn; the more you learn, the more you can do; the more you can do, the more the opportunity - it is very much like compound interest…One person who manages day in and day out to get in one more hour of thinking will be tremendously more productive over a lifetime.”

Investing requires diligent and consistent effort to build the competence to judge ideas and have the courage to stick with investments when times get tough. Investors have a nasty habit of interrupting compound growth to pursue hot ideas with a catchy story. Investor’s self-sabotage causes more problems than any geopolitical crisis or recession ever will.

Solution: Leverage great investors. My top 3 are Howard Marks, Warren Buffett, and James Montier. Build off their successes by reading one of their letters daily. Consistent effort in just a short time will yield tremendous results.

“You have to neglect things if you intend to get what you want done. There is no question about this.”

Not only is this quote practical for everyday life, it is also necessary for investors. There is too much information and distractions that bombard investors. To gain the necessary investment expertise and analytical edge, all superficial noise and wasted activity must be filtered away from investor’s attention. Whether it’s endless market commentary or concerns coming out of Europe, most of what investors read and hear has no useful purpose.

Solution: Make a conscious choice to go on an information/activity diet. Free up time that can be committed to building a particular investment skill. Abandon the thought of trying to conquer everything at once. Read a 10-K/Annual Report in your favorite industry each day and watch how a singular focus can deliver rapid investment growth.

“The people who do great work with less ability but who are committed to it, get more done that those who have great skill and dabble in it, who work during the day and go home and do other things and come back and work the next day. They don’t have the deep commitment that is apparently necessary for really first class work.”

Hamming’s insight is a great reminder to investors that investing is long term commitment. Just as great authors commit to their craft, great investors need to apply consistent effort in building their mental toolkit.

Solution: Decide how passionate and committed you are to improving your investment ability. The real test will occur when boredom & repetition sets in and you face a choice: keep building your skill or give up and see your progress unwind.

Actionable Investor Wisdom: Berkshire Hathaway 2015

As a dedicated attendee of the Berkshire Hathaway meeting, I believe the best part of the Berkshire Hathaway meeting is the numerous ideas and principles that carryover to everyday investors. This year, there were a number of valuable lessons and insightful, under the radar comments that will help investors make more money with much less stress. Below is my summary of the can’t-miss lessons investors should take away from the meeting.

No Single Model to Evaluate Businesses

Warren and Charlie forcefully dispelled the myth that there is a secret formula for buying great companies. Investors try to hunt for shortcuts, but were disappointed to hear that there is no easy solution. Charlie and Warren look for businesses that they can reasonably assess over the next 5 years with honest management teams.

The best comments described how they accept/reject opportunities. Their approach was not to look for positive attributes but to look for negative attributes and eliminate those companies. This path leaves only a small number of investable options. Don’t begin the search by focusing on great attributes, but first look for red flags that can eliminate and narrow down choices.

On Investment Success

One of Charlie’s best one-liners: “If people weren’t so often wrong, we wouldn’t be so rich.” It’s a blunt reminder about what drives success and failure in investing. There is nothing arbitrary about losing money. Warren and Charlie highlighted the unintuitive fact that their success is more about removing mistakes from their decisions than trying to know everything.

Investor’s decisions would be much improved by focusing on avoiding the same mistakes that Berkshire avoids: buying story stocks, trading too much, avoiding leveraged companies, etc. It’s simply easier and more profitable to avoid bad decisions, than it is to make good decisions.

Macro Worries

Charlie mentioned they have almost never turned down a deal due to macro factors. They discussed that what they pay adjusts based on the environment, but they don’t let macro factors override the ability to buy a great business at a fair price. As Charlie said, “When you start making predictions you start thinking you know something.”

Investors need to avoid the habit of fooling themselves. In addition, investors spend an inordinate amount of time thinking and worrying about macro conditions. They are much better served by focusing on dependable companies at attractive prices. I’ve seen an exceptional amount of investor money lost by macro-influenced mistakes.

Ego

Charlie: “Ego makes people do dumb things.” Ego causes several problems to investors, including not admitting mistakes and overconfidence. Warren and Charlie admitted several times on stage that they “don’t know” and had no trouble avoiding this trap. Investors need to stop chasing ego-induced decisions that dominate much of the professional and retail investment markets.

Multitasking

Charlie: “I have to think hard about one thing and the concept of multitasking doesn’t appeal to me.” He described how he doesn’t get how people can manage three things at once. This lesson certainly applies to everyday life, and it’s reassuring that the best investors still focus on one task at a time.

There is a complete misconception that successful investing is based on the hyperactive overloading of your brain. Tune out distractions and focus on the long-term fundamentals underlying opportunities.

Leverage

Both Warren and Charlie were asked about adding financial leverage to the business. They responded that they could have, but they “prefer not to sweat at night.” Berkshire Hathaway has done exceptionally well without additional leverage. Both prefer to sleep well rather than maximize potential returns.

A critical concept to investors who are always trying to juice investment returns. It works for a while, but comes at a significant future cost. The cost is not apparent today but will arise when an inevitable crisis hits. Leverage is often added near market peaks since emotions and confidence are high, leading to catastrophic investment losses when prices fall. Investors can easily build great portfolios without the burden of leverage.

I encourage all investors to attend the Berkshire Hathaway meeting at least once in their lifetime. Written notes can’t describe the clarity, simplicity, and humor in how they communicate their lessons. The meetings have tended to get better each year, as Warren and Charlie seemed to have let their guard down and enjoy delivering blunt and honest responses. Contact me for additional notes and advice from the meeting or other Berkshire-related questions.

Are You One of Jamie Dimon’s Lazy Shareholders?

JP Morgan’s CEO Jamie Dimon was spot on after pointing out the laziness of shareholders who blindly followed consultants Glass Lewis and ISS by voting against Dimon’s pay package.

Here’s Dimon via USA Today:          

“God knows how any of you can place your vote based on ISS or Glass Lewis, If you do that, you are just irresponsible, I'm sorry. And you probably aren't a very good investor, either. And you do. Believe me. I know some of you here do it because you’re lazy."

Now a few of ISS and Glass Lewis’s claims have some merit. JPM’s compensation disclosure is far from perfect, which unfortunately is par for the course in the proxy world.

The general level of disclosure in public company proxies is lacking. Bonuses are often based on vague goals, unverifiable metrics, or “adjusted” figures that usually skew to the benefit of management. It’s impossible for any diligent shareholder to have a complete picture of exactly how a board of directors rewards management.

However, the really appalling issue, as Dimon highlighted, is the widespread laziness of investors who are unable or unwilling to read a proxy and decide for themselves.

It’s a concerning trend that investors (the actual business owners) outsource the responsibility of proxy evaluation. Understanding the motivations and incentives of management and board behavior is a critical driver of investment success. Even a ballpark analysis of comp/bonus trends reveals egregious actions and disturbing board behavior. Missing these red flags has destroyed massive amounts of shareholder value.

Proxies are not a tough read for sophisticated investors. Yet some of the biggest (and supposedly sophisticated) investors can’t manage the ability to spend time reading the proxy. It boils down to an abdication of responsibility. It’s now the norm for investors outsource their thinking, creating a population of helpless investors who can’t form an independent opinion.

By deflecting responsibility towards sell-side research, ratings agencies, and corporate guidance, investors fall for the temptation of intellectual shortcuts rather than commit to hard thinking.

The overwhelming propensity of investors is to follow the herd and abandon any ability to think for themselves. The constant reliance on outside help lures investors into confusing information gathering with genuine analysis. The proxy issue is a symptom of a much larger problem: investors who have bigger and more confident opinions on investments they know less and less about. Institutional investors need to commit to full, independent, and thorough due diligence that is respectfully due to their clients.

A Guide To Profit From Market Panics

3 practical steps to profit from market volatility

Most investors hate volatile markets. The best investors exploit volatile markets. Where do you fall? If you witnessed the markets on Aug 24th, you saw extreme price swings not seen since the financial crisis. How is it possible to see huge, high-quality companies trade down 20% and then finish up on the day? The culprits are the massive amount of algorithmic trading and momentum driven investors who try to “get out” before other investors and exacerbate price pressure by adding to the selling. So how can an investor, with little knowledge of the market, end up on the profitable side of market volatility?

Have cash ready to deploy

Nothing is better for capitalizing on volatility than cash reserves ready to be put to work. Not only does cash hold its value during the turmoil, investors don’t have to contemplate what to sell. What’s a good cash level to hold? The best cash amount is a residual level based on the valuations of the equity and fixed income securities in your portfolio and opportunities in the market. 5-20% of your portfolio is a good guide, with more cash as markets get more expensive. Although investors hate getting paid nothing on cash, capturing excess returns during market distress more than compensates for the non-existent yields.

Have a list of quality securities ready to buy 

In times of panic, investors don’t have time to thoroughly research potential investments. The news flow and market movements causes focus to disappear. The solution is to have a portfolio of companies or securities ready to purchase at the right price. All that is missing is a better price, which will occur when volatility strikes. By having this list ready, investors can quickly decide and execute orders without any doubts about the companies they are buying. Best of all, high quality companies get pulled down with the rest of the market. No need to chase highly leveraged, near bankrupt companies. As seen on Aug 24th, companies like GE and Pepsi were pushed down over 20%.

Patience

The biggest problem for investors is the desire to be fully invested at all times because the pain of “doing nothing” is too great. Add in the fact that cash pays nothing today, and you get investors chasing yield all over the market-often in sectors and companies they don’t understand. Great investors have an inordinate amount of patience and conviction in their methodology and knowledge of financial markets. They know crises are hard to predict, but happen in a somewhat regular pattern. Of all three ideas, patience is the most importance. Without it, great ideas and concepts will never be put to work at the right time.

I’ve consistently heard clients talk about market volatility and extreme price moves as if it’s a huge negative. It is if you are unprepared. Great investors see dislocations as an opportunity. Investors have been indoctrinated to worry and pay close attention to short-term volatility, instead of focusing on long-term business returns. Smart investors hope for days like Aug 24th, when unintelligent computer trading and irrational investors rush for the market exit. Those who view volatility as a huge risk instead of opportunity have seriously handicapped their investment portfolio.

Investing By Subtraction

"What does you in is not failure to apply some high level, intricate, complicated technique. It’s overlooking the basics. Not keeping your eye on the ball.”1 - Eliezer Yudkowsky

When investors must confront unexpected problems, their first reaction is to consider new investments, strategies, or funds to deal with the pressing issues. The typical assumption is that something must be missing and by finding that magical investment addition, the new portfolio will be once again be fortified against future problems.

This thought process leads to big problems. Portfolio performance is often handicapped by adding new investments. It’s a human flaw to think that every problem is solved by adding something. It’s often found in medicine (if you are sick add medication), regulation (if there is a problem, add more laws), education (if student outcomes are poor add more testing and requirements).

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”       - Charlie Munger

People fail to consider that problem removal should be the first solution. Investment failures often originate from within! Portfolios often improve by subtractinginvestments, funds, or strategies, not by adding them. Investor allocations have become so heavy with funds layered upon funds, even a sophisticated investor is powerless to make intelligent decisions. Complexity is not sophisticated, simplification is sophisticated.

Less is more: paradox of choice. Large selection leads to inner paralysis. The more choice you have, the more unsure and therefore dissatisfied you are afterward. In this age of unlimited variety, good enough is the new optimum. Learn to love a good choice. – Rolf Dobelli, The Art of Thinking Clearly

The Art of Investing is Knowing What to Remove

Because investors have been taught that it’s useless to think about investment fundamentals and price vs. value, they resort to a shotgun approach of funds and strategies. They succumb to the myth that owning a cluster of random products is diversified and that alone will protect themselves against bad outcomes. Unfortunately, this assumption fails in most instances.

“Sophisticated or complex methods do not necessarily provide more accurate forecasts than simpler ones.”2 – Robin Hogarth

High Correlations

Investors fail to realize their exposure to tight correlations. Most portfolios have tremendous overlap in crowded trades because investors choose to be willfully ignorant of the investments they own.

Labels and Categories are Misleading

Investors rely on superficial categories that fail to explain true exposures. A European company may have 80% of its sales and profits from outside the Eurozone, yet it would be considered 100% European exposure. It’s a common shortcut among investors and advisors because they are too lazy to examine the underlying investments. Labels such as low-risk, liquid, and stable are widely used but often fail to reflect the underlying risks.

Lack of Insight and Understanding

Finally, when a crisis or financial panic ensues, investors have no idea what kind of quality they own. Or know good managers vs. bad managers. Or what investments are undervalued vs. going to zero. And so on…

“In this age of information abundance and overload, those who get ahead will be the folks who figure out what to leave out, so they can concentrate on what’sreally important to them. Nothing is more paralyzing than the idea of limitless possibilities. The idea that you can do anything is absolutely terrifying.”- Austin Kleon, Steal Like an Artist

Investors fool themselves into a false sense of comfort during calm times, only to be exposed and their confidence decimated when the markets get ugly. By reducing investment complexity down to a manageable level, investors will actually understand their true risk exposures. In a world of multi-tasking and unnecessary complexity, simplification is often the antidote to excessive choice and complications. Investors have been taught that diversification works, while making no distinction between the triumph of intelligent diversification and the failure of mindless diversification.

5 Ways Bruce Lee Can Make You A Better Investor

A number of worldly subjects enhance investing wisdom, but the lessons and histories of martial arts provide exceptional value for investors. One of the most famous martial artists, Bruce Lee, was an accomplished author and teacher in addition to his devastating martial art skills. His book, the Tao of Jeet Kune Do, is necessary reading for martial artists and investors. The foundation of the martial arts share many attributes with investing. By taking time to study Lee, you will find an intriguing and effective way to protect your investment portfolio.

I have realized that most important lessons come from outside the “core” disciplines of investing or finance. In fact, I can’t think of many great ideas that originate from the core fields. Instead, subjects such as philosophy, psychology, war/military, and the hard sciences provide real investing lessons. However, only those investors who look introspectively at their mindset and the nature of investing will apply these principles at the right moments.

There are many lessons from Bruce Lee, but the following five ideas will give you an introduction to the parallels between martial arts and investing.

Insight #1

While being trained, the student is to be active and dynamic in every way. But in actual combat, his mind must be calm and not disturbed at all. He must feel as if nothing critical is happening. When he advances, his steps should be light and secure, his eyes fixed and glaring insanely at the enemy. His behavior should not be in any way different from his everyday behavior; no change taking place in his expression, nothing betraying the fact that he engaged in mortal combat. –Bruce Lee

During calm times, you should run through worst-case scenarios, alternate options, and build plans to deal with the uncertain future. Complacent markets provide the time to be “active and dynamic” when running through all the possible ways things can go wrong. It’s a perfect time to simulate all the possible “what if” scenarios that could occur. Rigorous investment preparation starts when things are peaceful, not during crises.

When a crisis actually occurs, you must heed Bruce Lee’s advice and act as if nothing critical is happening. Use these moments to execute the preconceived plan, without manic-depressive behaviors that occupy most investors. If you find yourself desperate to create a plan during a panic, you are not only late but likely to make emotionally charged and disastrous decisions.

For example, if an outside observer saw you during a market panic, would they be able to tell if there is a crisis occurring? Over-reacting and dramatizing market downturns is not a badge of honor – it’s a sign of poor preparation and lack of emotional control. Prepare for downturns when times are calm and the outlook is positive, because you need to keep your head for the rough times that are likely to follow.

Insight #2

Instead of facing combat in its suchness, then, most systems of martial art accumulate a “fancy mess” that distorts and cramps their practitioners and distracts them from the actual reality of combat, which is simple and direct. Instead of going immediately to the heart of things, flowery forms (organized despair) and artificial techniques are ritualistically practiced to simulate actual combat. Thus, instead of “being” in combat, these practitioners are “doing” something “about” combat. –Bruce Lee

In investing’s simplest form, you give up cash today with some uncertain but expected return of cash in the future. That’s it. For some investments, the cash flows my occur regularly and perhaps somewhat predictably; for others it may be a decade before the cash flow received exceeds the cash invested. Neither option is necessarily good or bad – it all depends on what you pay for those cash flows and the riskiness of the cash flows.

Problems begin with investor’s unstable attitudes and poor understanding of the market. Investing has become so complicated and convoluted – constant monitoring of the U.S. and foreign news flow, Federal Reserve actions, Greece problems, short-term volatility, market volume analysis, trend following, technical analysis, earnings estimates, and so on. None of these factors provide any real help for the investor.

What Bruce Lee called a “fancy mess” – distortions that distracts practitioners from the actual reality of combat, is the same problem facing investors: distractions and illusions about what really drives the actual reality of investing.

Successful investing strips away the noise and distractions of the financial industry and redirects focus toward the core principles of what are you paying for a set of cash flows and the riskiness of those cash flows. Everything else is largely a distraction – built in some way to make you act contrary to your nature.

As Bruce Lee stated, “Jeet Kune Do [Lee’s Martial Art] does not beat around the bush. It does not take winding detours. It follows a straight line to the objective. Simplicity is the shortest distance between two points.”

Avoid investing’s “winding detours” - excessive trading, emotional turmoil, fruitless agonizing over noise, pointless ruminations, etc.

To paraphrase Bruce Lee, most investors are not investing, they are “doing” something “about” investing. As Lee mentioned, they have “a blind devotion to the systematic uselessness of practicing routines or stunts that lead nowhere.” So replace superficial activity with real work on the fundamentals of the investment. Make this clear in your mind– are you really investing, or are you dancing around the edges of investing?

Insight #3

Stylists, instead of looking directly into the fact, cling to forms (theories) and go on entangling themselves further and further, finally putting themselves into an inextricable snare. – Bruce Lee

Investors’ greatest problems arise when they are convinced they “know” what’s going on and fail to adjust beliefs when presented with new facts. No one is immune to this problem. Ironically, sophisticated and intelligent investors have a greater chance of falling for these biases.

Investors have a hard time accepting the failure of their prior beliefs and theories, especially those held for a long time or those that were developed internally. Ego protection is a problem in martial arts and it’s a problem in investing - it’s a problem for life in general. The unwillingness to kill your sacred beliefs leads to disaster.

Bruce Lee stated, “As martial artists continue to pursue a path of blind acceptance and unwavering confidence, they trap themselves in an ‘inextricable snare’.”

Investors often have the same mindset. I regularly witness bad beliefs. Some investors fall in love with certain asset classes (gold, T-bills, stocks) or pet theories (the U.S. dollar is worthless, capitalism is evil).The problem isn’t that they hold incorrect views, it’s their absolute conviction that they are right that is the major problem.

Insight #4

“Understanding requires not just a moment of perception, but a continuous awareness, a continuous state of inquiry without conclusion.”- Bruce Lee

Premature closure of one’s mind and acceptance of things as true/false is a handicap – not a blessing. Since people’s minds are resolved to remove ambiguity, we create stories to make sense of this world. Your ultimate desire to have mental closure over their investments is a short-term emotional fix that will lead to longer term damage. You must accept that the world is uncertain and highly unpredictable – your beliefs today are likely to be proven wrong in the future. But this should not be viewed as a negative – it’s simply reality and part of our human nature. Acceptance of this fact leads to a tremendous amount of peace and contentment when you abandon the belief that you have to know everything. Instead, you remain in a “continuous state of inquiry” – always ready to update your beliefs and never hesitant to admit your errors.

Insight #5

The second-hand artist blindly follows his sensei or sifu accepts his pattern. As a result, his action and, more importantly, his thinking become mechanical. His responses become automatic, according to set patterns, making him narrow and limited. – Bruce Lee

One of the most influential investors is Charlie Munger. His ideas surrounding mental models has been a beacon of light in an industry polluted with bad ideas and self-serving activities. Bruce Lee also reinforces the Munger’s warning on the limitations of blindly following one ideology, theory, or pattern.

Investors, like martial artists, need to continually expand their circle of competence and actively seek out new theories that disprove their current beliefs. In combat, failure to embrace better methods leads to death. In investing, failure to embrace better methods of analysis and knowledge lead to portfolio destruction. Investors who resolve that they “know enough” and don’t need to learn will succumb to obsolescence and decay.

Summary

1. Have a contrarian mindset - skeptical/questioning during bull markets; calm and decisive during bear markets.
2. Focus on investing’s core principles – stay away from superficial and “flowery” activity.
3. Avoid investing dogma – continuous challenging of your beliefs and desire to seek disconfirming evidence.
4. Accept the never-ending learning process with investing – you will never get to 100% certainty and comfort.

The Resilient Investor: 10 Habits of Mentally Tough Investors

Great investors develop mental toughness through proper mindset and habits. These are 10 guiding principles to condition the mind for investment success. 

1. They Don’t Worry About Issues Outside Their Control 

Much of investing and life is outside your control. Wise investors learn to recognize what they can control and what they can’t. The things that can’t be controlled are ignored. 

2. They Don’t Obsess Over Volatility

It’s a fact: every day markets go up and down. Trying to obsessively negate volatility usually worsens it. The value of every asset you own, including your own human capital, moves up and down every day. Only you don’t see it, so you normally don’t worry about it. Do the same for random market fluctuations. 

3. They Don’t Judge Success by Short-Term Results

Great things take time – going through medical school, becoming a professional athlete, or mastering chess. Investing is no different. The quick wins in investing are usually random and short-lived. Luck rules in the short term, process rules in the long term.

4. They Don’t Blindly Follow Popular Wisdom

Great ideas develop from an independent and thoughtful analysis – and may or may not conform to the crowd. While the crowd is often right, it spectacularly fails when you need it the most. The crowd is not the judge of a good vs. bad decision. Facts and reason are the judge.

5. They Don’t Abandon Their Strategy

All strategies temporarily fail at some time. Even the winningest coaches and athletes have losing seasons and rough periods. Thoughtful investing plans go through the same ups and downs. Investors constantly chase what is working today, only to get in at the peak and bail at the bottom.

6. They Don’t Feel the Market Owes Them Anything

Whatever insight or idea you believe is the next big thing is not as good as you think it is. At best it’s probably mediocre and at worst it’s a disaster. The market does not exist to guarantee a happy retirement. It doesn’t always work out. It doesn’t care how hard you work. Investing success is dependent on accepting that you are entirely responsible for your success or failure.

7. They Don’t Compare Results to Other Investors

There will always be investors richer than you so get over it. When most investors talk about their big winners they are either lying or selectively forgetting about all losers they’ve had. Comparisons to others only inflame ego and emotionally destructive decisions.

8. They Don’t Have Absolute Confidence

Great investors have an understated confidence: confident in their long-term process, humble in their short-term forecasts and market predictions.

9. They Don’t Stress Over Continuously Changing Conditions

As the saying goes, the only constant is change. Great investors embrace unpredictability, amateur investors are paralyzed by it. Success comes not from anticipating change, but adapting to change.

10. They Don’t Live in the Past

Of course the past is obvious in hindsight. Great investors accept their mistakes, omissions, and failures. The past is a sunk cost. All that matters is you learn from the past and then move forward. Focus on today and your plan going forward.

How Investors Should Navigate the Non-GAAP Earnings Confusion

There has been a recent surge in the controversy surrounding non-GAAP earnings. While the debate continues on the proper use of non-GAAP metrics, investors can’t expect outside help and need to take control of their own understanding and interpretation of non-GAAP adjustments. Investors can’t rely on “guidance” from companies or regulators.

The problems run deeper than the GAAP vs. non-GAAP debate. The actual problem is investor’s lack of commitment to a thorough, fundamental understanding of the company. Without adequate understanding, investors will never be able to tell non-GAAP truth from fiction.  There is never a hard and fast set of rules to determine the validity of GAAP exceptions. Like any set of standards, there are exceptions and situations that don’t fit the model. The extreme doubters of GAAP or non-GAAP miss the point: no system is perfect. It’s the investor’s responsibility to determine the best representation of economic reality. Blind devotion to SEC guidance, FASB standards, or company management is a dangerous path.

This article will help guide investors into asking the right questions involving non-GAAP metrics. This advice cannot replace actual analysis, but will give investors a better framework for thinking about these issues.

3 Rules to Remember

1. Always reconcile each adjustment using the GAAP to non-GAAP reconciliation

Regardless of a company’s adjustments, investors should always reconcile to GAAP earnings. This figure, required by the SEC, allows investors to see a clean breakdown of non-GAAP adjustments. Unfortunately, that’s the easy part. The hard part is understanding what items are legitimate and which are not. Analyze every line item on an individual basis to determine its validity. One or two adjustments account for most of the deviations from GAAP. Unfortunately, there are no clear cut answers on which expenses are legitimate and which are egregious. Materiality depends on the company and industry dynamics. The only way to know is to dive deep into the business and financial statements.

1. Pull up and compare reconciliations for the past 5 years

Don’t limit your analysis to the current year. Compare what “recurring”, non-recurring expenses have been consistent over many years. Repeated appearance is clear evidence that these charges are recurring in nature, even as management argues “one-off” or too volatile/unpredictable. In fact, a quick glance at successive reconciliations should show no yearly correlations between line items. Also, understand that the absence of repeated charges doesn’t mean one-time charges are legitimate. Evaluate every adjustment on its own merit.

1. Match the reconciliation to the business model

Serial acquirers should not have their acquisition-related charges excluded. Acquisitions are part of their strategy and the associated expenses are legitimate and recurring. Major problems develop when analysts and management teams guide to high top and bottom line growth without the necessary acquisition spending to support that growth. It’s unfortunate that overconfident/aggressive companies and investors permit this mismatch to make valuation, free cash flow, and EPS more impressive. Some quick investor math on the implied ROICs would show an unsustainable level of ROIC into the future.

A Cheat Sheet for Common Adjustments

I’ve tried to make the case that the legitimacy of non-GAAP measures is dependent on the individual company, the business model, the competitive environment, the management team, etc. There is no one-size-fits-all approach. While that will bother investors who want an easy answer, it’s reality. For those investors who want a quick guide to thinking and interpreting non-GAAP measures, I have compiled a quick guide of questions to ask on each topic.

Reorganization/Transition/Restructuring Expenses

Look for a continued history of these charges. The “serial restructuring” company should be obvious by the year after year disclosure of the same items. Again, the investor’s familiarity with the company and management team will drive the analysis. Restructuring charges were expenses that should have been realized all along in the past. Instead, companies get to kitchen sink these expenses as one-time items. Investors should normalize past profitability by blending the charge through past income statements to get a better gauge of historic profitability. This will lead investors to a better understanding of economic profitability, rather than just ignoring the charges.

Investors need to be realistic in their margin assumptions going forward. While most investors and management teams love to project a never-ending upward trajectory of margin expansion, reality and competition will dictate otherwise. Today, assume that the company you are looking at will likely have their “restructuring moment” sometime in the future, so adjust your understanding and valuation today to avoid getting blindsided in the future.

Options Expense

Why the options debate continues is beyond me. When you give away a claim or an option on company’s equity, that’s an expense. The argument for comparability has no merit in my mind. If one company is giving away more equity than another, the analysis/valuation should reflect that. Ignoring options expense only drives understanding further away from the truth. Because analysts want their models to be nice and clean, it leads to analysis that is borderline worthless.

Consider this example: if company A is paying its employee’s salaries at 2x the level of company B, should analysts back out the “extra” salary for comparability sake? I don’t think so. If a company chooses to pay more or issue more options, reflect that in their numbers.

Foreign Exchange

Companies with significant foreign operations (over 30% of revenue) should treat F/X movements as natural, recurring expenses/benefits. I understand the desire for comparability, but simply ignoring these movements is ignoring reality. Instead, use the company’s disclosures to set a framework for understanding the economic exposure. Given the rapid devaluation in Venezuela, Brazil, Russia, etc, it’s paramount to understand that these losses are more often than not real, economic expense, not just some accounting fiction.

In general, ignoring volatile f/x movements because they don’t model well will just create more unpleasant surprises for the investors in the future. What matters for investors are the long-term economic results, and if f/x movements are continually part of those results, then include them.

Amortization of Intangible Assets– Customer Relationships/Lists, Patents/Technology, Brands/Trademarks

Amortization of Intangibles is often a large component of non-GAAP earnings and the key is to separate and evaluate each intangible.

Patents and technology intangibles are typically always a true expense. The value of these assets declines as competing technologies render the current assets obsolete over time. Often, in a much quicker timeframe than the actual amortization period. Exercise extreme caution if a company claims their technology assets don’t depreciate or need reinvestment.

On the flipside, brands are almost always indefinite and don’t need separate reinvestment as ongoing marketing expense and normal reinvestment will support the intangible value into the future.

The same is true with customer relationships. A company will never have to have an annual budget item for customer relationships to maintain that asset. There is one caveat to ignoring brand and customer intangibles expense. Investors must ensure the business is adequately reinvesting in itself to make the case that brand and customer intangibles don’t need expensing. If the business is underinvesting, the intangibles will lose their value.

Debt Tender/Retirement

Usually, debt retirement is a one-time event since I rarely see consistent debt retirement in material amounts. The key is to look into the future and try to anticipate these costs in advance and work them into your analysis. If it appears that a debt exchange or swap will have material consequences, it’s better to know about it before than after. Again, not a meaningful issue.

Litigation Expense

Depends on the litigious nature of the industry and legal history of the company. For example, constant litigation has hammered big banks since the financial crises. Are these expenses recurring in nature? In banking, I believe they are recurring, but not to the extent of the past five years. Investors would be wise to assume some normal, ongoing expense into the future. The seeds of the next legal war are being planted today, so reserve for them today.

In addition, some companies have one-time, but massive penalties. BP comes to mind. How should investors handle that expense? I would again advise incorporating some reserve expense for future disasters in future cash flows since energy E&P is an unpredictable and volatile endeavor. Of course, this is not an exact science so it will be a subjective guess. But it’s more preferable than ignoring these realities and assuming the good times will last.

Asset/Goodwill Impairments

There are two lines of thinking I use as I approach an impairment situation. First, an impairment is nothing more than the final admission and confirmation that a company overpaid on an asset or acquisition in the past. It’s simple. They paid too much. Companies will argue that any specific impairment charge will not continue in the future. I agree with them. However, the key is that a company with repeated asset write-downs will likely continue making bad acquisitions and will suffer future impairments. Of course, no company will ever admit to that.

Depreciation

In 99.9% of cases, depreciation is a real expense.  If a company is reconciling to EBITDA, that’s fine. The issues with EBITDA are another topic. But if a company is adding back depreciation expense to net income, that’s a red flag. The common exception is excess depreciation on assets that have longer useful lives than GAAP dictates. This is rare in my experience. However, company managements will often claim longer useful lives than normal, knowing that the future costs and reinvestment won’t hit until the future. MLP’s are a great example of trying to push the belief that maintenance capex and associated depreciation is much lower than GAAP suggests. There may be some exceptions, but that’s usually pure marketing spin.

Acquisition-related costs

Look over the past 5 to 10 years and see if the company is a serial acquirer. If they are, include acquisition costs in earnings. It’s a core part of their strategy, and the costs need to be counted. Check to see if it is a “one-off” acquisition that was not made in place of real capex. Acquisitions are often another form of capex needed by companies to remain competitive; however, most analysts treat them as incremental, instead of replacement investment. How do you tell the difference? Look at the competitive nature of the industry and barriers to entry. Most companies need to continually reinvest just to stay in place. If this is the case, an acquisition is likely a “replacement” style expenditure. In addition, if the growth and earnings expectations of the company is dependent on future acquisitions, the future costs need to be included in company valuation.

Gain/Loss on Sale of Assets

This is one charge that is more likely to be non-recurring since so few companies consistently buy and sell assets on a regular basis. Most of these adjustments have less impact than some other big adjustments, and as long as companies are treating both gains and losses in the same manner, there isn’t an issue.

Severance Charges

Just like restructuring charges, these are more recurring in nature than one-off. Many companies I analyze follow a predictable pattern of overexpansion during the good times followed by restructuring/realignment/right-sizing charges in the downtime. So when times are good, especially for cyclical companies like mining and energy, understand those results are likely biased too high. Don’t believe the “this is permanently higher” marketing. Investors should focus on a “normalized” earnings approach, as cyclical companies like mining, agriculture, and energy always correct.

Conclusion

Non-GAAP metrics are useful because they enable better fundamental understanding of the core business. It’s the investor’s job to figure out what is legitimate vs. non-legitimate. It’s not the fault of GAAP, FASB, the SEC, or any other regulatory body. They are doing the best they can to create principles and rules to fit all companies. Quite a tough task. The incessant bashing on the faults of GAAP is misplaced; it’s just the reality of trying to fit diverse companies into one system. Non-GAAP earnings are not bad, and neither are most managements. What’s bad is investor’s blind acceptance of other’s ideas without doing the necessary work themselves.