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:

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

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

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

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

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

Here’s Buffett from the 2017 Annual Letter:

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

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