Inflation Protection for Long-Term Investors

8 Principles to Become an Exceptional Performer

We all experience the joys and frustrations of learning a new skill. From athletics, to music, to our professional lives, we strive to master our craft and improve our ability. Weekend golfers try to take strokes off their game, amateur musicians strive to create new music, and doctors work to better care for their patients.

Some have highly specific goals in mind and devote constant effort to improvement. Others may take a relaxed, less intense approach. Both groups encounter similar frustrations along the way. Why do we often plateau and struggle after a period of time? Why do some people improve at a faster rate than others?

Given our busy lives and competing demands, how can we best improve from average to exceptional?

K. Anders Ericsson has spent his professional life figuring out what separates elite performers from the average masses. As a Florida State psychology professor and author of Peak: Secrets from the New Science of Expertise, Ericsson is the go-to expert behind the principles of exceptional performance. His results and lessons are counterintuitive. What doesn’t matter is innate talent or genetics. What does matter is the deliberate and focused attention we apply to our practice and training.

To preview, we have complete control of our ability to learn any new skill. However, society reinforces the myth that experts are born and not made, making deliberate effort a fruitless endeavor. It’s a mindset instilled when we are young. We rationalize poor performance and deflect personal responsibility. Instead of accepting responsibility, we blame a lack of talent.

Ericsson’s research has proven this wrong. Let’s explore how to apply 8 principles, based on Ericsson’s work, to become an elite performer.

1.      Your Abilities are not Fixed

…both the brain and the body retain a great deal of adaptability throughout adulthood, and this adaptability makes it possible for adults, even older adults, to develop a wide variety of new capabilities with the right training…If you talk to these extraordinary people, you find that they all understand this at one level or another. They may be unfamiliar with the concept of cognitive adaptability, but they seldom buy into the idea that they have reached the peak of their fields because they were the lucky winners of some genetic lottery. They know what is required to develop the extraordinary skills that they possess because they have experienced it firsthand. - Peak: Secrets from the New Science of Expertise

The first idea is the belief that your abilities are not fixed. Once you believe you can influence and change yourself, you see struggles as learning opportunities, not judgments on your self-worth. You must develop the habits and routines to transform struggles into learning lessons to build permanent change.

But we now understand that there’s no such thing as a predefined ability. The brain is adaptable, and training can create skills—such as perfect pitch—that did not exist before. This is a game changer, because learning now becomes a way of creating abilities rather than of bringing people to the point where they can take advantage of their innate ones. In this new world it no longer makes sense to think of people as born with fixed reserves of potential; instead, potential is an expandable vessel, shaped by the various things we do throughout our lives. Learning isn’t a way of reaching one’s potential but rather a way of developing it. We can create our own potential. - Peak: Secrets from the New Science of Expertise

It’s about creating and developing new skills, not uncovering hidden skills. There is no such thing as hidden talent. We have been taught that we should search for our inherent passion because that must be the one thing we will be good at. We now understand there are very few things genetically “set” from the beginning and almost all new skills can be created and developed. The important question is how to create those skills.

2.      Hard Work is not Enough

But sometimes these books leave the impression that heartfelt desire and hard work alone will lead to improved performance— “Just keep working at it, and you’ll get there”—and this is wrong. The right sort of practice carried out over a sufficient period of time leads to improvement. Nothing else. - Peak: Secrets from the New Science of Expertise

“Just Work Hard”. Those three words are misused more often than any other piece of advice. It’s appealing because it makes sense on the surface. Of course nothing meaningful develops with partial effort. Read the histories of great leaders or musicians and you will always find a hard-fought struggle. We are taught this from an early age from our parents or coaches. It’s a good attitude to cultivate.

But there’s a problem. The growth benefits of hard work stop after a certain amount of time. No matter how much hard work we put in, our ability stops improving. It’s a frustrating situation. Why is something that worked in the past all of a sudden not working?

It stops working because we no longer direct that hard work into routines that stretch and expand our skills. We just repeat what we know, without embracing new challenges. Our abilities no longer respond to traditional hard work. We need something else…

Why should the teaching techniques used to turn aspiring musicians into concert pianists have anything to do with the training that a dancer must go through to become a prima ballerina or the study that a chess player must undertake to become a grandmaster?

The answer is that the most effective and most powerful types of practice in any field work by harnessing the adaptability of the human body and brain to create, step by step, the ability to do things that were previously not possible. - Peak: Secrets from the New Science of Expertise

The underlying habits and principles behind world class performance apply equally to athletics, music, or entrepreneurship. While the day-to-day activities are different, the principles of training design and growth are constant across domains.

If you wish to develop a truly effective training method for anything—creating world-class gymnasts, for instance, or even something like teaching doctors to perform laparoscopic surgery—that method will need to take into account what works and what doesn’t in driving changes in the body and brain. - Peak: Secrets from the New Science of Expertise

We miss harnessing the power to optimize how our mind incorporates and masters new skills. We’ve been coasting along, using vague ideas like “working hard” without realizing it’s only half the equation. The other half, based on Ericcson’s research, is too often neglected.

3.      Showing Up is not Enough

We all follow pretty much the same pattern with any skill we learn, from baking a pie to writing a descriptive paragraph. We start off with a general idea of what we want to do, get some instruction from a teacher or a coach or a book or a website, practice until we reach an acceptable level, and then let it become automatic. And there’s nothing wrong with that. For much of what we do in life, it’s perfectly fine to reach a middling level of performance and just leave it like that. - Peak: Secrets from the New Science of Expertise

So far, so good. With the help of a coach and some instruction, we practice and make progress. As Ericsson stated, that works for most activities in life. We don’t have to be superb at everything. But what about the skills we do want to be superb at? Why do we struggle to progress beyond good enough?

But there is one very important thing to understand here: once you have reached this satisfactory skill level and automated your performance—your driving, your tennis playing, your baking of pies—you have stopped improving. - Peak: Secrets from the New Science of Expertise

Most of us reach an acceptable level without knowing it. We keep practicing and assume we are improving, yet our real-world performance never improves.

How do we overcome this? Testing and feedback. We need to continually test our skills to provide objective feedback on our current ability. Without testing, we are left to guess at our skill level. And guesses don’t work for elite performers.

Testing provides feedback, giving us the direction and data to redirect our routines and practice. Our practice habits must evolve and adapt. If we keep the same static practice routines, we never develop new ways to improve our weaknesses.

People often misunderstand this because they assume that the continued driving or tennis playing or pie baking is a form of practice and that if they keep doing it they are bound to get better at it, slowly perhaps, but better nonetheless. They assume that someone who has been driving for twenty years must be a better driver than someone who has been driving for five, that a doctor who has been practicing medicine for twenty years must be a better doctor than one who has been practicing for five, that a teacher who has been teaching for twenty years must be better than one who has been teaching for five.

But no. Research has shown that, generally speaking, once a person reaches that level of “acceptable” performance and automaticity, the additional years of “practice” don’t lead to improvement. If anything, the doctor or the teacher or the driver who’s been at it for twenty years is likely to be a bit worse than the one who’s been doing it for only five, and the reason is that these automated abilities gradually deteriorate in the absence of deliberate efforts to improve. - Peak: Secrets from the New Science of Expertise

The dirty secret of “experience” is that people with 20 or 30 years of experience are often no better than those with 10 or 15 years of experience. We may want to believe that more is better, but have we ever tested or validated that assumption? Probably not. Most likely, we have assumed we must be better because we need to justify the years of effort and time invested. It’s agonizing to think about spending 20 years doing something and not improving. But we have to face reality, not what’s comfortable, if we want to grow.

This brings back the importance of testing and feedback. We must have objective guidance on our ability. If we assume or guess, we are fooling ourselves into believing we are something that we are not. And that is the downfall of anyone striving to become exceptional at their skill.

4.      Engage in Purposeful Practice

Purposeful practice has several characteristics that set it apart from what we might call “naive practice,” which is essentially just doing something repeatedly, and expecting that the repetition alone will improve one’s performance.

Purposeful practice has well-defined, specific goals. Our hypothetical music student would have been much more successful with a practice goal something like this: “Play the piece all the way through at the proper speed without a mistake three times in a row.” Without such a goal, there was no way to judge whether the practice session had been a success. - Peak: Secrets from the New Science of Expertise

By using goals, you transform random action into deliberate processes. Goal-based practice can be tracked and measured, providing valuable feedback. By focusing on specific goal-driven processes, we build practical skills.

Purposeful practice is all about putting a bunch of baby steps together to reach a longer-term goal.

Purposeful practice is focused.

Purposeful practice involves feedback. You have to know whether you are doing something right and, if not, how you’re going wrong.

Purposeful practice requires getting out of one’s comfort zone.

- Peak: Secrets from the New Science of Expertise

These four ideas move your actions beyond showing up and instead direct your effort into long-term progress. Small steps, focus, feedback, and uncomfortability are necessary for growth.

5.      Get Comfortable with being Uncomfortable

This is a fundamental truth about any sort of practice: If you never push yourself beyond your comfort zone, you will never improve…Generally the solution is not “try harder” but rather “try differently.” It is a technique issue, in other words.

The best way to get past any barrier is to come at it from a different direction, which is one reason it is useful to work with a teacher or coach. Someone who is already familiar with the sorts of obstacles you’re likely to encounter can suggest ways to overcome them. - Peak: Secrets from the New Science of Expertise

Purposeful practice focuses on things we can’t do well. If we keep repeating the things we are good at, we never overcome the obstacles that hold us back. Confronting our weaknesses is painful. It requires honesty and humility about our shortcomings. Practicing our weak points isn’t fun. It’s much easier to practice the things we are good at, since it’s inherently enjoyable to succeed. But we don’t progress when repeating the things we are good at.

If you can’t find a coach to provide feedback, you must create your own feedback to leverage. If it’s a physical skill, a video recording provides an impartial, outside look at your performance. If it’s academic/knowledge based, testing delivers valuable feedback. You may be tempted to skip these ideas and just “trust” your instincts. Unfortunately, you will be stuck wondering why you don’t see the progression you expect.

6.      Separate Knowledge from Skills

When you look at how people are trained in the professional and business worlds, you find a tendency to focus on knowledge at the expense of skills. The main reasons are tradition and convenience: it is much easier to present knowledge to a large group of people than it is to set up conditions under which individuals can develop skills through practice. - Peak: Secrets from the New Science of Expertise

Always separate knowledge from skill. It’s easy to add knowledge and confuse that with skill improvement. When we think of learning, we assume knowledge accumulation is good. But knowledge accumulation that doesn’t transfer to applied skills doesn’t help us. We may feel confident in the moment but we are mistaking that confidence for progress. Think about this. Of all the books you have read in your lifetime, how many have delivered actionable improvement? Have you converted that knowledge into long-term, applied skill?

From the perspective of deliberate practice, the problem is obvious: attending lectures, minicourses, and the like offers little or no feedback and little or no chance to try something new, make mistakes, correct the mistakes, and gradually develop a new skill. It’s as if amateur tennis players tried to improve by reading articles in tennis magazines and watching the occasional YouTube video; they may believe they’re learning something, but it’s not going to help their tennis game much. Furthermore, in the online interactive approaches to continuing medical education, it is very difficult to mimic the sorts of complex situations that doctors and nurses encounter in their everyday clinical practice.

It is not just the medical profession that has traditionally emphasized knowledge over skills in its education. The situation is similar in many other professional schools, such as law schools and business schools. In general, professional schools focus on knowledge rather than skills because it is much easier to teach knowledge and then create tests for it. The general argument has been that the skills can be mastered relatively easily if the knowledge is there. One result is that when college students enter the work world, they often find that they need a lot of time to develop the skills they need to do their job. Another result is that many professions do no better a job than medicine—and in most cases, a worse job—of helping practitioners sharpen their skills. Again, the assumption is that simply accumulating more experience will lead to better performance. - Peak: Secrets from the New Science of Expertise

As an investing professional, I’ve struggled to convert information into skill improvement. I’ve found it’s easy and seductive to absorb information, but much more challenging to find evidence my investing skill has actually increased. That’s the challenge for all knowledge workers. How do you ensure your skills are improving?

7.      Create Daily Routines

The hallmark of purposeful or deliberate practice is that you try to do something you cannot do—that takes you out of your comfort zone—and that you practice it over and over again, focusing on exactly how you are doing it, where you are falling short, and how you can get better. Real life—our jobs, our schooling, our hobbies—seldom gives us the opportunity for this sort of focused repetition, so in order to improve, we must manufacture our own opportunities. - Peak: Secrets from the New Science of Expertise

Deliberate and focused effort doesn’t happen by itself. We all have busy lives with little free time. Without consciously directing our behavior towards building expertise, we will never create consistent time for improvement. The first step must be a conscious decision to allocate time to this process. You will have to give something up. No one said this will come without at cost.

A similar thing is true for those who maintain purposeful or deliberate practice over the long run. They have generally developed various habits that help them keep going. As a rule of thumb, I think that anyone who hopes to improve skill in a particular area should devote an hour or more each day to practice that can be done with full concentration. Maintaining the motivation that enables such a regimen has two parts: reasons to keep going and reasons to stop. When you quit something that you had initially wanted to do, it’s because the reasons to stop eventually came to outweigh the reasons to continue. Thus, to maintain your motivation you can either strengthen the reasons to keep going or weaken the reasons to quit. Successful motivation efforts generally include both. - Peak: Secrets from the New Science of Expertise

Habits, routines, and schedules provide a necessary structure to enable commitment and persistency of the task at hand. Relying on willpower, luck, or fate won’t last. By creating a consistent habit to practice one hour a day, at a regular time, we stop trying to fit it in our schedule but rather fit our schedule around the practice. Once our routine is locked in our schedule, there is no ambiguity or uncertainty of when it will be done.

One of the best bits of advice is to set things up so that you are constantly seeing concrete signs of improvement, even if it is not always major improvement. Break your long journey into a manageable series of goals and focus on them one at a time—perhaps even giving yourself a small reward each time you reach a goal. -Peak: Secrets from the New Science of Expertise

Instead of trying to tackle a hundred things at once, practice the building blocks one at a time. Focus each practice day on one unique aspect of your skill. Do this over the course of a year and you have a solid foundation of practical skills. Avoid the urge to do too much at one time. We all want to overachieve, but trying to do too much causes burnout and unfocused effort. Trust the process and commit to improving one thing at a time.

8.      Take Charge of Your Success

We need to start now. For adults who are already in the work world, we need to develop better training techniques—based on the principles of deliberate practice and aimed at creating more effective mental representations—that not only will help them improve the skills they use in their current jobs but that will enable them to develop new skills for new jobs. And we need to get the message out: you can take charge of your own potential. But it is the coming generations who have the most to gain.

The most important gifts we can give our children are the confidence in their ability to remake themselves again and again and the tools with which to do that job. They will need to see firsthand—through their own experiences of developing abilities they thought were beyond them—that they control their abilities and are not held hostage by some antiquated idea of natural talent. - Peak: Secrets from the New Science of Expertise

Success results from conscious and deliberate effort to improve our skills. No one will do this for you. As the world becomes more competitive and meritocratic, it’s your responsibility to grow your skills and demonstrate expertise. The idea of genetics or innate talent limiting your potential isn’t the real constraint. We have 10x the potential if we learn and grow using the principles of exceptional performers.

Peak Takeaways:

1.      Your Abilities are not Fixed

2.      Hard Work is not Enough

3.      Showing Up is not Enough

4.      Engage in Purposeful Practice

5.      Get Comfortable with being Uncomfortable

6.      Separate Knowledge from Skills

7.      Create Daily Routines

8.      Take Charge of Your Success

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:

Add description

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

How Deep Work Can Transform Your Life: 7 Powerful Principles

Becoming exceptional is hard. The professional world is competitive, full of intelligent and ambitious people vying for the same top positions.

To make things more complicated, there isn’t one exact set of rules we can follow that guarantees success. Hundreds, if not thousands of books are published every year promoting magic formulas for success. But how many of these books create lasting change?

How many of us really achieve the success we expect?

Where do we go wrong?

What do we need to change if we don’t like the path we are on?

Do we practice becoming exceptional like we practice golf, triathlons, or public speaking?

No. We assume mastery is something that just happens. We go about it in a haphazard way while our frustration and struggles build when we don’t progress. We don’t treat mastery as a skill that can be improved. We just work hard and hope it happens.

Here’s the good news. There is a way to change your habits and behaviors that create lasting success and builds exceptional talent. The bad news is we must overcome significant mental and societal pressures to cultivate deep work.

If you are looking to make this shift from mediocre to exceptional, one of the best resources on creating success is Cal Newport. His blog, studyhacks.com, is a must read if interested in practical principles to achieve success. His latest book, Deep Work: Rules for Focused Success in a Distracted World, is my best recommendation to create permanent changes to do great things. (Note: All italicized quotes in this article are from Newport’s book, Deep Work)

The following 7 Principles, based on Cal’s book, can be used by anyone to improve the odds of becoming truly exceptional.

Principle 1: Identify Shallow vs. Deep Work

A lot can be explained by another type of effort, which provides a counterpart to the idea of deep work: Shallow Work: Noncognitively demanding, logistical-style tasks, often performed while distracted. These efforts tend to not create much new value in the world and are easy to replicate…To remain valuable in our economy, therefore, you must master the art of quickly learning complicated things. This task requires deep work.

To set the stage for this discussion, we need to define what deep work is. Here’s Cal’s definition:

 “Professional activities performed in a state of distraction-free concentration that push your cognitive capabilities to their limit. These efforts create new value, improve your skill, and are hard to replicate.”

Why is this important? Ask Cal mentioned, to remain valuable in this economy, master the art of quickly learning complicated things. Mastery comes from deep, deliberate work applied in a consistent and focused manner. We erroneously assume mastery will just come to us if we show up regularly or get enough experience. Certainly, we will gain some knowledge that way. But to become truly exceptional and stand above the rest, apply deep work principles.

Distinguish between shallow and deep work. If we can’t, we will never be able to properly transition into deep work. By minimizing or compartmentalizing shallow work, we create a maximum focus on deep work.

This compressed schedule is possible because I’ve invested significant effort to minimize the shallow in my life while making sure I get the most out of the time this frees up. I build my days around a core of carefully chosen deep work, with the shallow activities I absolutely cannot avoid batched into smaller bursts at the peripheries of my schedule. Three to four hours a day, five days a week, of uninterrupted and carefully directed concentration, it turns out, can produce a lot of valuable output.

Shallow work is inevitable. As much as we hate busywork, there is a certain amount we must manage. So how do we manage through? As Cal advises, we batch our shallow work into blocks where we do nothing else but get through as much as possible. Think of this like a sprint – as soon as we start, we embrace the distracted nature and work to accomplish as much shallow work as possible. As soon as the sprint is over, we stop the shallow work and re-engage in deep work.

Principle 2: Produce Good Work

The second reason that deep work is valuable is because the impacts of the digital network revolution cut both ways. If you can create something useful, its reachable audience (e.g., employers or customers) is essentially limitless—which greatly magnifies your reward. On the other hand, if what you’re producing is mediocre, then you’re in trouble, as it’s too easy for your audience to find a better alternative online.

Because of social media and the internet, anything we do can be quickly disseminated throughout the world. This is the key to building our brand and reputation as a rare and exceptional talent. When we create valuable writing, advice, art, etc, we can share the work with the world. The more people that benefit from what we do, the more valuable we become and the more we control our destiny.

The flipside is also important. Our competition – especially people vying for your job, have the same opportunity to share valuable work. Competition has become meritocratic. We are judged on our actual ability rather than where we went to school or who we know. Anyone in the world can compete with us. There are no geographical or physical boundaries that apply. The brutal competitive environment just got tougher and wont get any easier for us.

The longer you wait to accept this the further back you will put yourself. Eventually, competition will arrive and we will be separated by who can deliver and prove their value and who can’t.

In a seminal 1981 paper, the economist Sherwin Rosen worked out the mathematics behind these “winner-take-all” markets. One of his key insights was to explicitly model talent—labeled, innocuously, with the variable q in his formulas—as a factor with “imperfect substitution,” which Rosen explains as follows: “Hearing a succession of mediocre singers does not add up to a single outstanding performance.” In other words, talent is not a commodity you can buy in bulk and combine to reach the needed levels: There’s a premium to being the best.

There really is a benefit to becoming exceptional at one thing. You don’t have to master every field or become an expert in everything. That’s impossible. The world will reward you if you are exceptional at one thing.

Just being “good enough” doesn’t set you apart. You are still a commodity and are expendable.

Two Core Abilities for Thriving in the New Economy

1. The ability to quickly master hard things.

2. The ability to produce at an elite level, in terms of both quality and speed.

As Cal states, once we master hard things, we then have to prove our mastery. If we keep our mastery inside our head and never tell anyone, no one will ever know. It’s our responsibility to show the world our talents and value. No one else will make sure we get what we deserve.

We see this with college graduates. Just because they have a degree, graduates assume the world will recognize their genius and reward them appropriately. But degrees are becoming totally irrelevant. 20 years ago, it was safe to assume that a college degree led to differentiated skills. It was so much rarer then as it is now. With the proliferation of colleges and the ease of getting a degree, employers are rightfully skeptical of new graduates providing value from day one.

It doesn’t matter where you are in your career. We must take the initiative and prove to world what we can do.

Once you do the hard work of becoming exceptional, don’t neglect to share your work.

Now consider the second core ability from the list shown earlier: producing at an elite level. If you want to become a superstar, mastering the relevant skills is necessary, but not sufficient. You must then transform that latent potential into tangible results that people value.

Principle 3: Utilize Deep Work to Magnify Results

This brings us to the question of what deliberate practice actually requires. Its core components are usually identified as follows:

(1) your attention is focused tightly on a specific skill you’re trying to improve or an idea you’re trying to master;

(2) you receive feedback so you can correct your approach to keep your attention exactly where it’s most productive.

Most people understand the first requirement, even though it’s often hard to put into practice. Deep work requires undivided and sustained attention to your skill. It’s an unnatural habit and mindset that doesn’t come easy. If you struggle at first to maintain focus, don’t give up. Today’s environment doesn’t favor deep work. You are not alone in this struggle. If needed, start with 15 minutes of focused activity, and then aim to increase that by 5 minutes the next time you study. Track your progress on your calendar. Tracking provides a solid record of your progress and provides valuable feedback on your progression.

Don’t think you can switch focus every 5 minutes over the course of a couple hours. This effort needs to be concentrated in one time period. As Cal stated, “…though Grant’s productivity depends on many factors, there’s one idea in particular that seems central to his method: the batching of hard but important intellectual work into long, uninterrupted stretches.”

It takes time to get into the flow with deliberate practice. It’s almost like we need a mental warmup like we would with a physical workout. If we only work for 5 or 10 minutes at a time and then switch our focus, we have to keep starting over every time we re-engage. So make it a habit to start once and continue for 30-60 minutes.

The second requirement is typically missed. We assume by showing up and working hard we will achieve success. But attaining mastery requires a different approach. This approach includes objective and unbiased feedback. Feedback delivers guidance and suggestion and what needs improvement and how to adjust. Without feedback, you are operating blind – you are just showing up and hoping that your actions are leading to improvement. Feedback connects the actions you take with the results you get. If there is no link, you can’t be sure how much success you are achieving and the source of that success.

If you remember one formula, remember this from Cal:

High-Quality Work Produced = (Time Spent) x (Intensity of Focus)

We need to clarify one possible point of confusion. We haven’t said anything about increasing the quantity of hours worked; we have focused just on quality. Quality is reflected in the intensity, focus, and deliberate nature of our practice. While we may need to allocate more time to our skill, first look to optimize the time we already invest. That alone should vault us to the top echelons of our skill. Afterwards, we can add in more time if necessary. But given our competing schedules, it’s not always possible to add more time. So remember, it’s always quality over quantity - focus on improving the time you already spend (quality) before thinking about adding more time (quantity). As Cal mentions below, top students don’t become best just by working longer, they work smarter.

The best students understood the role intensity plays in productivity and therefore went out of their way to maximize their concentration—radically reducing the time required to prepare for tests or write papers, without diminishing the quality of their results.

Principle 4: Design Your Environment to Enable Deep Work

The Principle of Least Resistance: In a business setting, without clear feedback on the impact of various behaviors to the bottom line, we will tend toward behaviors that are easiest in the moment.

Busyness as Proxy for Productivity: In the absence of clear indicators of what it means to be productive and valuable in their jobs, many knowledge workers turn back toward an industrial indicator of productivity: doing lots of stuff in a visible manner.

Cal’s two principles highlight a major roadblock against deep work. Our environments, especially professionally, are poorly designed to enable deep work. It’s a constant barrage of emails, interruptions, and scattered meetings. When we show up to work and attempt to “willpower” our way into deep work, we may find some short-term success, but will ultimately succumb to behaviors and actions that are the easiest and offer the least resistance. Instead of toughing this out, we need to rethink how we design our work environment to enable deep work, and not shallow work, to be the default mode of action.

As Cal stated, without clear feedback, we can’t separate deep work from shallow busywork. When we deliberately set up practice that delivers immediate feedback and results in clear, unambiguous progress indicators, we have begun engaging in deep work. There is an easy test to determine if work is shallow or deep:

Does our work:

1)     provide feedback?

2)     provide verified, measurable progress?

For example, email provides no feedback and no measurement of getting better at anything.

However, writing and publishing an article through an email list does – people will respond with comments and feedback. You can track open rates and other metrics to judge readership progress. The goal is to always engage in some project that allows you to receive feedback and measurable results.

Testing is another great example. For example, if you are studying for your CPA exam, practice tests provide both feedback (you’re able to compare your answer to the correct answer, often with explanations showing where you went wrong) and measurement (you can track your scores over time and see an unbiased measurement of your progress.

If you believe in the value of depth, this reality spells bad news for businesses in general, as it’s leading them to miss out on potentially massive increases in their value production. But for you, as an individual, good news lurks. The myopia of your peers and employers uncovers a great personal advantage. Assuming the trends outlined here continue, depth will become increasingly rare and therefore increasingly valuable.

Not only does deep work provide better engagement, it provides a huge advantage over your competition. The benefits are double. Deep work provides more long-term satisfaction on a personal level, and provides a sustainable competitive advantage in your career.

As Cal states, “Human beings, it seems, are at their best when immersed deeply in something challenging.”

Principle 5: Schedule Your Day

Seinfeld began his advice to Isaac with some common sense, noting “the way to be a better comic was to create better jokes,” and then explaining that the way to create better jokes was to write every day. Seinfeld continued by describing a specific technique he used to help maintain this discipline. He keeps a calendar on his wall. Every day that he writes jokes he crosses out the date on the calendar with a big red X. “After a few days you’ll have a chain,” Seinfeld said. “Just keep at it and the chain will grow longer every day. You’ll like seeing that chain, especially when you get a few weeks under your belt. Your only job next is to not break the chain.”

As the Seinfeld lesson shows, showing up every day, in a consistent manner, can produce incredible results. But how can you ensure that you show up every day? We’ve all resolved to stick to a diet or workout plan, but most of us fail after only a few days. How can we approach this differently?

One idea is to schedule out your day hour by hour. This may sound extreme, but top performers use specific schedules to thoroughly plan their day. Without an exact schedule, you simply fill in your day with whatever is convenient. Sure, there might be good days where you engage in deep work. But most days end up like we described in lesson 6. You fill your day with the activities that are the most painless, not the most productive. Deep work can be painful because it’s intense and focused. It takes a certain amount of dedication to commit the energy to focus. It doesn’t appear naturally or easily, which is why we must schedule our deep work sessions.

I should admit that I’m not pure in my application of the journalist philosophy. I don’t, for example, make all my deep work decisions on a moment-to-moment basis. I instead tend to map out when I’ll work deeply during each week at the beginning of the week, and then refine these decisions, as needed, at the beginning of each day (see Rule #4 for more details on my scheduling routines). By reducing the need to make decisions about deep work moment by moment, I can preserve more mental energy for the deep thinking itself.

At the beginning of each week, we map out our Monday through Friday hour by hour. This won’t be perfect. Changes are to be expected as the week won’t unfold exactly like we planned it. But this schedule gives us the best chance to prioritize deep work time instead of trying to fit it in. 

There is a popular notion that artists work from inspiration—that there is some strike or bolt or bubbling up of creative mojo from who knows where… but I hope [my work] makes clear that waiting for inspiration to strike is a terrible, terrible plan. In fact, perhaps the single best piece of advice I can offer to anyone trying to do creative work is to ignore inspiration. In a New York Times column on the topic, David Brooks summarizes this reality more bluntly: “[Great creative minds] think like artists but work like accountants.”

Scheduling doesn’t reduce our creativity or spontaneity. Scheduling deep work and creativity reinforce one another. By blocking off time for deep work, we stop worrying about how we will get everything done. Instead, we build contentment by actively choosing our schedule and not letting life choose our priorities.  

[J.K] Rowling’s decision to check into a luxurious hotel suite near Edinburgh Castle is an example of a curious but effective strategy in the world of deep work: the grand gesture. The concept is simple: By leveraging a radical change to your normal environment, coupled perhaps with a significant investment of effort or money, all dedicated toward supporting a deep work task, you increase the perceived importance of the task. This boost in importance reduces your mind’s instinct to procrastinate and delivers an injection of motivation and energy.

Copy Rowling’s habit of using a grand gesture – any environment or ritual that gets you in the right mindset to create deep work. Simplicity is key. A separate, dedicated room just for deep work. A sacred time, off limits to other activities. It can be working in the same coffee shop or library. Any activity or environment that triggers the mental state of deep work is fine. Don’t overthink this.

Principle 6: The 4 Disciplines of Deep Work

Cal referenced the book, The 4 Disciplines of Execution, which provided 4 disciplines to enhance deep work. Implement these immediately in your routines.

Discipline #1: Focus on the Wildly Important

As the authors of The 4 Disciplines of Execution explain, “The more you try to do, the less you actually accomplish.” They elaborate that execution should be aimed at a small number of “wildly important goals.”

If you try to do everything you will end up doing nothing. It’s hard to cutoff of choices and not do certain things. To become exceptional, you must focus your activities on the elite few.

Warren Buffet’s Advice

Warren Buffet once discussed career objectives with his personal pilot, Mike Flint. Flint wrote down his 25 top goals and Buffet had him circle his top 5. Flint described how he would begin working on his top 5 right away, but would work on the other 20 when he found time.

Buffet quickly admonished Flint, saying, “No, you’ve got it all wrong, Mike. Everything you didn’t circle became your Avoid-At-All-Cost list. No matter what, these things get no attention from you until you’ve succeeded with your top 5.”1

As Buffet makes clear, avoid spreading your attention to wide. You can’t do everything and attempting to do so will ensure failure.

Discipline #2: Act on the Lead Measures

Lead measures, on the other hand, “measure the new behaviors that will drive success on the lag measures.” In the bakery example, a good lead measure might be the number of customers who receive free samples…In other words, lead measures turn your attention to improving the behaviors you directly control in the near future that will then have a positive impact on your long-term goals…For an individual focused on deep work, it’s easy to identify the relevant lead measure: time spent in a state of deep work dedicated toward your wildly important goal.

Always measure the most direct actions you are taking towards your goal. If you are writing, it is time spend in deep writing. If it’s sports, it’s time spent in deep practice. These are the lead measures that will produce exceptional results. Focus on consistent progress on your lead measures, and you won’t have any trouble reaching your long-term goals.

Discipline #3: Keep a Compelling Scoreboard

As each week progressed, I kept track of the hours spent in deep work that week with a simple tally of tick marks in that week’s row. To maximize the motivation generated by this scoreboard, whenever I reached an important milestone in an academic paper (e.g., solving a key proof), I would circle the tally mark corresponding to the hour where I finished the result.* This served two purposes. First, it allowed me to connect, at a visceral level, accumulated deep work hours and tangible results. Second, it helped calibrate my expectations for how many hours of deep work were needed per result. This reality (which was larger than I first assumed) helped spur me to squeeze more such hours into each week.

A scorecard keeps an accurate tally of your deep work hours and tracks your major milestones. You never want to keep this in your head. A written record of your effort and progress is powerful. It forces you to track and analyze how well you are really doing. If you don’t write it down, it doesn’t count.

Discipline #4: Create a Cadence of Accountability

The 4DX [The 4 Disciplines of Execution] authors elaborate that the final step to help maintain a focus on lead measure is to put in place “a rhythm of regular and frequent meetings of any team that owns a wildly important goal.” During these meetings, the team members must confront their scorecard, commit to specific actions to help improve the score before the next meeting, and describe what happened with the commitments they made at the last meeting.

Your own personal accountability should be measured weekly by diligently assessing your progress and noting the success and failures. This exercise is meant to inform you of repeated, consistent roadblocks that hinder your progress. It’s not a judgment, it’s a reflection. It’s not meant to be personal, just to keep you unbiased and objective.

Principle 7: The Difference Between “What” vs. “How” (or why so much advice is worthless)

There is, however, a lesser-known piece to this story. As Christensen recalls, Grove asked him during a break in this meeting, “How do I do this?” Christensen responded with a discussion of business strategy, explaining how Grove could set up a new business unit and so on. Grove cut him off with a gruff reply: “You are such a naïve academic. I asked you how to do it, and you told me what I should do. I know what I need to do. I just don’t know how to do it.” As Christensen later explained, this division between what and how is crucial but is overlooked in the professional world. It’s often straightforward to identify a strategy needed to achieve a goal, but what trips up companies is figuring out how to execute the strategy once identified.

My biggest critique of self-help and management books is the focus on the “what” instead of the “how”. We all know we should be better leaders, more effective managers, more inspirational, more forward-looking, and so on. The challenge is how to actually do that in real life. Most advice never advises you on how to actually become a better leader or a master of your skill. They are full of clichés and vague one-liners. They never give you step-by-step instructions on practical steps. They seem to think by knowing what you need to do, you will just figure out how to do it. That’s exactly where progress stops. Most of the time, we know exactly what we need to do. It’s how to do it that’s the problem.

The goal of this article was to convert the “what” (7 principles) into the “how” (practical implementation steps). Here’s a quick summary of the 7 Principles:

Principle 1: Must Identify Shallow vs. Deep Work

Principle 2: Produce Good Work

Principle 3: Utilize Deep Work to Magnify Results

Principle 4: Design Your Environment to Enable Deep Work

Principle 5: Schedule Your Day

Principle 6: The 4 Disciplines of Deep Work

Principle 7: The Difference Between “What” vs. “How” (or why so much advice is worthless)

1Story from http://jamesclear.com/buffett-focus.