Investing: simple but not easy

As Warren Buffett said, investing is simple, but not easy.

The concepts are simple to understand, but executing those simple concepts isn’t easy.

People shoot themselves in the foot by paying too-high fees, trying to time their entry and exit from the market, and by picking lousy advisers.  Our psychology makes us our own worst enemy.

Instead of doing the homework necessary to get and stay on the right track, most want short-cuts.  Those short-cuts lead to a ditch.

When picking an adviser, the most important thing to know is their character.  Not their credentials, not their schooling, not even their knowledge.  Smart people with bad character are just better at ripping you off.

How do you know a person’s character?  It’s not easy, but it is simple.  Look at how they are compensated.  Find out if they follow their own advice.  Talk to their current and former clients.  Are they willing to admit their own mistakes?  Are they forthright, or evasive?  Does such homework take some extra work?  Yes.  Is it worth it?  Yes.

If they have credentials, are those credentials legitimate?  Seeing that someone has some letters after their name is not due diligence.  Some programs are a sham done over a weekend.  Others take years and are excruciatingly difficult to get through.  If you don’t know the difference, how do you know how your money will be handled?

What is an adviser’s investment process?  Can they explain it, or do they talk patronizingly to you as if you were a 5-year-old?  Does it make sense to you, or does it sound shady?  If you don’t know how they do what they do, then you’ll panic at the first difficulty–and there will always be difficulties.  

Respecting and admiring your investment adviser is important; thinking that you’d like to spend your free time with them isn’t.  You aren’t looking for a buddy, you’re looking for sound financial advice.  If you want a loyal friend, get a dog.  Nothing is more likely to prevent you from reaching your goals as not wanting to hurt a friend’s feelings.

Be objective in this process.  Pick character first, check up on an adviser’s background, know and agree with their process at some level, and pick someone you respect over someone that seems oh-so-nice.

Reaching your financial goals is too important to take short-cuts.  Do the work, reap the benefits.  It’s not easy, but it is simple.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Investing: simple but not easy

Counter-intuition

To most people, good investing seems frustratingly counter-intuitive.

When the economy is on its back, looking like it will never recover, and the stock market is hitting new lows–that’s the best time to invest. When the economy is breaking growth records and the stock market is hitting new highs–that’s the absolute wrong time to pile in.

Or, as Warren Buffett more succinctly put it: “be greedy when others are fearful and fearful when others are greedy.” (He should know, you don’t become one of the richest people in the world and the most successful investor over the last 60 years if your approach is fundamentally flawed.)

But, most people can never really get their brain around this paradigm. They easily accept that they know nothing of particle physics, brain surgery and rocket science, but they just can’t accept the notion that investing and economics are similarly complex.

To most, investing is counter-intuitive.

But, to me, this counter-intuitiveness makes perfect sense. Investing is not like physics, surgery, rockets, home building, plumbing or most other things people do. In most fields, man is competing with nature.  

A physicist is trying to understand the rules of nature with mathematical precision such that it can be harnessed. The surgeon wants to understand disease and human physiology such that he can operate to restore health. A rocket scientist uses the rules discovered by physicists to harness nature’s power to propel and guide a payload into space. A home builder seeks to erect a structure that will keep out the elements and provide a comfortable and convenient abode for its dwellers. A plumber desires to harness water to serve man’s needs within buildings. All of these fields are concerned primarily with overcoming nature.

Investing is different. It’s more like sports or warfare in that it is inherently a competition of man against man. And that, I believe, is why it seems counter-intuitive to most.  

With investing, you are not just trying to figure out which company will survive and thrive, but how other people perceive that company. The price you pay is not based solely on a company’s underlying fundamentals, but on how investors in general understand and interpret those fundamentals (or just plain feel about a company).  

When people are excited about an investment, like Apple, they tend to bid the price up above underlying fundamentals. When they hate a company or think it is going the way of the dodo, they bid its price down below fundamentals.

When they think the economy will go ever higher, they want to be fully invested. When they think it will never improve, they want to pull all their money from the market–right now!

But, this herd-like behavior is almost always reflected in prices before such people buy and sell. The price they pay or receive is for the perception of a company or the economy, not just the underlying fundamentals.

In the long term, however, the fundamentals win out. As Benjamin Graham put it, “in the short run, the stock market is a voting machine, in the long run, it’s a weighing machine.” In other words, stock prices reflect human emotion in the short run and underlying fundamentals in the long run.

Which is why successful investing seems counter-intuitive. When everyone is selling and it seems like things can never get better (2009), you want to be buying. When everyone is buying and it seems like a new era of non-stop growth has dawned (2000), you probably want to be selling.

Because most people will never get their brain around this, counter-intuitive investing will continue to work for those who can harness other people’s short-term emotions. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Counter-intuition

Gold is money, but that doesn’t make it a sound investment

“Gold is money.  Everything else is credit.” – John Pierpont Morgan

I must admit, I’m a bit of a gold bug. 

After studying economic and financial history for over 16 years, it’s quite clear to me that wealth is not pieces of paper, but economic goods.  And money–as a store of value or medium of exchange–is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants. 

Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange. 

Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).

After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is–inflation.

Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation.  And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie–metal or metal-backed currency.

Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement–but faster.  Since the 1930’s, U.S. currency has not been redeemable in specie.  Since the early 1970’s, U.S. currency has not been backed by specie at all.  Want to guess why the 1970’s witnessed a huge spike in inflation?

Look at a dollar bill some time and you’ll see written across the top “Federal Reserve Note.”  A note, for those of you who don’t live on planet economica perpetua (I do!), is a debt instrument–in other words, credit.  As Mr. Morgan put it, gold is money and everything else is credit.

With that overlong introduction, you get an idea of why I believe gold is money.  But, let me be clear, that doesn’t necessarily make it a good investment.

I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting.  He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate. 

In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.

I place gold firmly in the second category, which makes sense.  You expect gold to maintain value regardless of inflation, but you don’t expect it to grow in value relative to the value of other things.  Gold is money, so it is a store or protector of value, not a grower of value. 

You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value.  Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing. 

A farm continues producing corn, regardless of how corn is priced.  Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time.  Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma.  You get the idea. 

I know gold is money, but that doesn’t make it a great investment.  Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset.  You may speculate in gold prices, but that’s not investing.  For my money, I want growth, not standing still or speculation.

Gold is money, no doubt, but that doesn’t make it a sound investment.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Gold is money, but that doesn’t make it a sound investment

The Foolishness of Forecasting

“Prediction is very difficult, especially about the future” – Niels Bohr, Danish physicist

“…the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Benjamin Graham, value investing “Dean”

Warren Buffett, probably the most successful investor alive, doesn’t make earnings forecasts.  He doesn’t do what every MBA student is taught: build a model that forecasts future earnings over time.  That doesn’t mean the future isn’t important to him.  Quite the contrary.  He is obsessed about the future!

But, that doesn’t mean he makes forecasts.  Why?  Because forecasting is notoriously difficult.  The records of various forecasters, whether historians, economists, political scientists, financiers, social scientists, and, especially, government bureaucrats, are terrible!

My own record here is exhibit #1.  I like to forecast political and social outcomes, but my forecasting record is as dreadful as everyone else’s.

But, isn’t successful investing about forecasting the future?  Doesn’t one have to know what sector of the economy, which asset class, etc. will do best?  No.

In fact, the records of those who try to do the above are as poor as everyone’s.  Those selling such forecasts want you to believe the future can be forecast, but if they were any good at it, they’d be making a fortune doing it instead of selling forecasts. 

I can guarantee you, knowing the future would make you rich.  But, that makes the rather huge assumption that you can do it successfully.  I’ve never met or read about anyone who can.  Like ESP, tons of people seem to think it’s possible, but when submitted to scientific testing, proves lacking.

So what does Warren Buffett do?  He studies the historic record intensely so that he understands a company, its industry, its competition, its competitive advantages and threats, its management, etc., then he pays a cheap price relative to that historic record. 

He doesn’t forecast earnings growth explicitly, but he does buy businesses with a record of growth and with all the expectations of future growth behind them.  Its a qualitative rather than quantitative assessment. 

Most importantly, he doesn’t pay for future growth.  The price he pays has a margin of safety, rendering an accurate forecast of the future unnecessary.  If he pays a low enough price today, he’ll get an acceptable return no matter what.  If growth continues, and he spends gobs of time focusing on this qualitative aspect, his return will be better–perhaps much better. 

That’s it.  No magic flutes, no crystal balls, no whirling dervishes.  Just understand intimately a particular business (and no one understands what makes businesses tick like Buffett), pay a fair price for it, and let the qualitative tailwinds blow you on to wealth.

This is very contrary to what most investors, both professional and individual, do.  Most investors spend the vast majority of their time trying to figure out what the future holds instead of studying the past and present with the same intensity.  They make elaborate models with spreadsheets to forecast all the potential variables to the fourth decimal place.

The result isn’t just that they don’t understand the important variables of the past, the result is forecasts that are notoriously bad. 

The average Wall Street analyst over-estimates business growth by 50% (businesses they study with great intensity and with unique access to industry insiders). 

The average economist considers himself a hero if he gets the DIRECTION (not magnitude) of economic variables correct, and almost always miss major turning points (they have models of such mathematical complexity that physicists are intimidated by them). 

I could go on, but you get the point.  Forecasting is a dead end.

Contrary to all investing lore and conventional wisdom, this does not suggest broad diversification.  Don’t get me wrong, diversification is the right way to ride economic growth at minimum cost.  But, if you want to do better than that, you need to concentrate on the very few things you can understand better than others. 

As you may have guessed, that’s an understanding of the past and present, not a brilliant forecast of the future. 

If you study every cell phone company in great detail from quarter to quarter, and understand each of their technological, managerial, competitive, economic aspects, and you realize that one stands head and shoulders above the others, yet is selling at a very reasonable price, you may have a good investment.  If, on the other hand, you recognize that the technological or competitive dynamics are such that you can’t figure out who is and will stay on top, then you should move on to an industry where you can.

A tremendous amount of study and intellectual honesty is required to do this, but so few put in the effort that thar’s gold in them thar hills.

Don’t forecast.  Study intensively the past and present, and pay a low price.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Foolishness of Forecasting

Invert, always invert

I’m very proud of my investing record over the last 6 years as a professional (beating roughly 80% of my competitors) and the last 15 years as an individual (beating the S&P 500 by over 4.5% annualized), but it could always use improvement.  For, as Goethe put it, “he who moves not forward, goes backward.” 

With that in mind, I’ve spent a lot of the last few months reviewing my investment process and looking for ways to improve.  One of the most important lessons I have derived is the importance of not investing in things that go down a lot.

Now, this may seem perfectly obvious to you, but it’s hard when one is busy with day to day research and portfolio management to focus on the downside instead of the upside.

In fact, I’d go so far as to say that most people focus too much on the upside–myself included.  Most people seem to believe that hitting the ball out of the park is the way to win baseball games, when in fact it has more to do with not striking out and getting base hits.

So it is with investing.  I’m a devoted fan of Warren Buffett, so this thinking should be more implicit in what I do.  Buffett describes his two investing rules quite simply:

  • Rule #1: don’t lose money
  • Rule #2: don’t forget rule #1

Or, as Alice Schroeder, Buffett’s authorized biographer, described it in a presentation at the University of Virginia: Buffett’s first step is to look for catastrophic risk.  If he sees any possibility of catastrophic risk, he just stops right there and moves on to other ideas.

I was struck recently with how little I’ve devoted to this side of the process.  How do you not lose money?  Don’t invest in things that go down a lot.  If you avoid blow-ups, then the upside will take care of itself.

Charlie Munger, Buffett’s business partner, likes to quote famed German mathematician, Carl Gustav Jacob Jacobi, on this issue.  Jacobi told his students to “invert, always invert” (the quote on Wikipedia is “man muss immer umkehren,” which I translate as “one must always invert”).  What Jacobi meant was that many problems can be solved backwards by inverting the problem.

For example, do you want to know how to be happy?  Instead of trying to figure out how to be happy by examining happiness or looking at what happy people do, look for what you absolutely know will make you unhappy and then don’t do that.  See the subtle difference?

If I study business successes, I may find out what common characteristics business successes possess, but that’s not the whole picture.  I must also look to see if business failures share those same characteristics to avoid hasty generalization.  Perhaps 5 businesses were successful by selling widgets and 95 were failures, so looking only at the 5 successes may lead me to falsely conclude that selling widgets is the way to success.  I must also study the failures to see the full truth. 

With that in mind, I can invert the problem as Jacobi suggests.  What causes businesses to fail?  If I know the answer well, and that business successes don’t do it, then I can avoid blow-ups by avoiding businesses with failure characteristics.  Invert, always invert, indeed.

So, not surprisingly, I’ve decided to become a student on what makes businesses fail.  By inverting the problem to avoid failures, I will ensure greater success in my investing results. 

Thank you Buffett, Munger and Jacobi.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Invert, always invert

Capital preservation

Investing is not as complex as most in the field like to make it out to be.  Economists, financial planners, market strategists, professors of finance and economics, etc. like to make the field seem more difficult to grasp than it is.  Not surprisingly, this serves their interests.

In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine.  If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church.  This served the church’s interests well.

And, so it is now with investing.  Today’s clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms.  Their efforts are not to clarify, but to obfuscate; for, if you’re completely confused, then you’ll need their help! 

(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn’t writing in a sufficiently high-minded way.  He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level.  When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!) 

So, why do I claim that investing is simple?  I read a description of investing 16 years ago that made perfect sense and was simple, and I’ve used it ever since.  This description, from Benjamin Graham and David Dodd’s Security Analysis, 1934:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative.”

No mention of alpha, beta, standard deviation, diversification, macro-economic forecasting, the efficient frontier, small cap blend, negative correlation, optimized portfolios.  You’re investing if you 1) do thorough analysis, and 2) invest in securities that promise a) safety of principal and b) a satisfactory return. 

If you don’t do thorough analysis or hire someone who doesn’t, it’s not investing, it’s speculation.  No stock tips, no hunches, no astrology, no gut feel, no “I just know…”, no buying lots of everything–just thorough analysis.

If you invest in securities that don’t promise–first–safety of principal and–second–a  satisfactory return, then you’re not investing, you’re speculating.  A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).

Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs.  This lip service to capital preservation is frequently waved away with the magic of diversification.  If you put your eggs in many baskets, they say, then there’s no way all your eggs will break at once.

2008, or any other financial crisis in history for that matter, should put that notion to rest.  Unfortunately, it hasn’t.  Putting your eggs in poorly built baskets, no matter how many of them, is unwise.

Capital preservation is also framed in terms of volatility.  If the basket goes up and down a lot, they say, you’ll get scared.  Fear is a relevant issue, but it’s not the same as capital preservation.  Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.

Capital preservation means you get back what you put in.  Not volatility, not fear, but whether you get back what you put in.  The price of an investment may go up and down and all over, but it’s still capital preservation if you get back what you put in. 

Risk, as Graham defined it, is the permanent loss of capital.  Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital.  Not eggs jostled or raised and lowered, but eggs BROKEN.

If your investment returns the capital you put in, then capital has been preserved.  If not, or if the safety of that capital, upon thorough analysis, is suspect, then it’s not investing.

This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital.  Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital.  If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it’s not capital preservation. 

Many incorrectly think of cash or bonds as being the soundest means of capital preservation.  In most cases it is, but not if inflation occurs.  If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection.  Cash and bonds, by themselves, don’t cut it.

Most investing experts focus too much on secondary, tertiary, etc., issues.  They focus on diversification, statistical “guarantees,” unexamined impressions, recent history.  But, investing just isn’t that complex. 

You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you’d like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in). 

It’s not rocket science or brain surgery–it’s quite simple.

But, as Warren Buffett put it, investing is simple, but not easy.  Which means: knowing how to invest is not complex, but doing it well is difficult.  Losing weight requires you to consumer more calories than you put in–that’s simple.  But doing it isn’t easy–it’s very difficult (especially around Christmas!).

Perhaps Buffett’s investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Capital preservation

Manic-Depressive Mr. Market

Benjamin Graham, Warren Buffett’s mentor, had a wonderful parable for thinking about the stock market.  He called it the parable of Mr. Market:

“Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”

“You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings…” (Graham, The Intelligent Investor, 1973)

The market has been particularly manic-depressive lately, and this has reminded me of the parable of Mr. Market.

One day, the market seems to foresee another recession on the horizon–the market sinks as investor sentiment tanks.  Another day, the market foresees an economic boom on the horizon–the market leaps and investor sentiment soars.

Is the data really that self-contradictory, or is the market just that short-sighted.  I believe the latter.

Much economic data, like unemployment claims, housing market numbers and income growth, indicate an economic slowdown.  Not a recession, mind you, just a slowdown.

Other economic data, like railroad traffic, commodity prices and industrial capacity utilization, indicate an economic expansion.  Not a boom, per se, but an expansion.

Mr. Market, in his manic-depressive way, takes these data points as signs of a collapse or boom.  As a result, market commentators have referred to the stock market’s reaction as risk-on/risk-off.  It’s either one or the other, and nothing in between.

What is the reality?  Not too surprisingly, given the data and my build-up, something in between.  The slowdown could turn into a recession, but hasn’t, yet.  The expansion could turn into a boom, but it isn’t at present.

Mr. Market should be more sober-minded and focus on the long term instead of the short term.  There is neither reason to dive for cover nor party like its 1999 (can you tell I’m about to turn 40?).

Given the data and a long term view, it is best to be cautiously optimistic.  The market is mildly over-valued, but nothing like it was in 2000 or 2007.  In fact, long term returns look promising, especially when compared to bonds or speculations like gold. 

Mr. Market needs to take a chill-pill, relax and take a deep breath.  Lucky for sober-minded investors, he probably won’t, and this will provide ample opportunities to exploit Mr. Market’s manic-depressive tendencies.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Manic-Depressive Mr. Market