The “I know” school people believe they can discern what the future holds, and in their world investing is a simple matter:

• First you decide what the economy is going to do in the period under consideration.
• Then you figure out what the impact will be on interest rates.
• From this you infer how the securities markets will perform.
• You choose the industries that will do best in that environment.
• You make judgments about how the industries’ companies will fare in terms of profits.
• Based on all of this information, you pick stocks that are bound to appreciate.

End of story. Of course, the usefulness of this approach depends entirely on people’s ability to make these decisions correctly. What if you’re wrong about the economy? What if you’re right about the economy but wrong about its impact on a company’s profits? Or what if you’re right about profits but the valuation parameters contract, and thus the price? The bottom line is that the members of this school think these things are knowable. Lots of people are perpetually and constitutionally optimistic about both the long-term future for stocks and their ability to make these judgments correctly.

The “I don’t know” school in short,

• Feel it’s impossible for anyone to know much about a vast number of things.
• Consider it especially difficult to outperform by guessing right about the direction of the economy and the markets.
• Spend our time trying to know more than the next person about specific micro situations.
• Think more about what can go wrong than about what can go right.

In contrast to the “I know” school, people in this group are more cautious and feel a strong need for downside protection.

Classic Investment Mistakes

• Borrowing short to buy long
• Confusing paper profits with real gains
• Being seduced by loss limitation
• Misjudging liquidity
• Ignoring the impact of others
• Underestimating correlation

Fire Sale Process

• Take on short-term capital
• Invest it in longer-term or illiquid assets
• Experience price declines and writedowns that eliminate your resolve to hold, unsettle your suppliers of capital and/or jeopardise your capital adequacy
• Receive a margin call or capital withdrawal notice
• Need to raise cash on a day of market chaos
• Be forced to sell into an inhospitable market regardless of price

Take advantage of opportunities in a collapsing market

• Have a firm well-reasoned estimate of an asset’s intrinsic value
• Recognise when the asset’s price falls below its value and buy
• Average down if the price goes lower
• Be right about the value

Quotes

“There can be few fields of human endeavour in which history counts for so little as in the world of finance.” John Kenneth Galbraith

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” John Kenneth Galbraith

“The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.” Warren Buffett

“People get into trouble when they forget that in the long run, stocks won’t appreciate faster than the growth in the corporate profits.” Warren Buffett

“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.” Amos Tversky

“Markets can remain irrational longer than you can remain solvent.” John Maynard Keynes

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” John Maynard Keynes

“A speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.” John Maynard Keynes

“Nobody goes to that restaurant anymore; it’s too crowded.” Yogi Berra

“Most of financial history has taken place within two standard deviations, but everything interesting has occurred outside of two standard deviations.” Ric Kayne

“In economics things happen slower than you expected they would, but when they finally do, they happen faster than you imagined they could.” Larry Summers

“Improbable things happen all the time, and things that are supposed to happen often fail to do so.” Bruce Newberg

“Those who cannot remember the past are condemned to repeat it.” George Santayana

“Risk means more things can happen than will happen.” Peter Berstein

“What the wise man does in the beginning, the fool does in the end.”

“The six-foot tall man who drowned crossing the stream that was five feet deep on average.”

“The more you bet, the more you win when you win” Las Vegas maxim (… and the more you lose when you lose.)

“It’s essential to remember that the fact that something’s probable doesn’t mean it’ll happen, and the fact that something happened doesn’t mean it wasn’t improbable.”

“I have given up on trying to get people to do what I tell them to do; they do what I pay them to do.”

“He knows the price of everything but the value of nothing.”

“In times of crisis, all correlations go to one.”

“Experience is what you got when you didn’t get what you wanted.”

“Being too far ahead of your time is indistinguishable from being wrong.”

“History doesn’t repeat itself, but is does rhyme.”

Follow the practical way,
George

A bit above average performance is not that bad if you can consistently do it for many years. You do not need to swing for the fences in order to achieve long term gain. If you are willing to take huge bets on assets to gain the spectacular results you should be ready to fail some times and then have huge losses. That will give you an average return over the years, unless of course you can be right about the future most of the times. Not an easy task to accomplish.

Therefore, if you keep getting a bit above average over the years and your down years are not that much different from your up years (in percentage points), you will get a good return overall. In the good years it is good enough to be average, because the average investor makes a lot of money. The time to outperform is in falling markets. Most of the investing careers that produce the best records are notable at least as much for the absence of losses and losing years as they are for the spectacular gains. The challenge is that these virtues usually become apparent only in big downdrafts. But certainly they figure greatly in long term.

I believe that in many cases, the avoidance of losses and terrible years is more easily achieved than repeated greatness, and thus risk control is more likely to create a solid foundation for superior long-term track record.

Above average investment performance (in any market) has to be the result of either unusual insight into values or the intersection of risk taking and luck. It is hard to tell the difference between the two in the short term, but the truth always becomes clear in time, because luck rarely holds up for long.

When someone achieves a high return you need to question it. “How much risk did he take in order to generate that?” The problem is that few people find high returns worrisome.

Unusual risk-adjusted returns are not made by buying what everybody likes. They are made by buying what everybody underestimates.

Leverage does not make investments betters; it just magnifies the gains and losses.

Ensuring the protection of capital under adverse circumstances is incompatible with maximising returns in good times, and thus investors must choose between the two.

Everyone dreams of return without risk. But where can it be found? Not in markets that are working properly – that is, markets that are efficient. Not in leverage, which should be expected to cut both ways, magnifying both risks as well as return. Not in doing what everyone else is doing, or in buying the product du jour that’s being touted broadly and purchased unquestioningly. At best it can be found, with regard to markets that are less than fully efficient, in possessing – or aligning yourself with investors who possess – that scarce attribute: personal skill … superior insight…alpha.

People who think excess return is readily available fail to ask a few simple questions:

• Why should a free lunch exist despite the presence of thousands of investors who are ready and willing to bid up the price of anything that is too cheap?
• Why is the seller of he asset willing to part with it at a price from which it will give me an excessive return? Do I really know more about the asset than he does?
• If it is such a great proposition, why has not someone else snapped it up?
• Why is the broker offering it to me (rather than grabbing it for his prop desk)?
• If the return appears so generous in proportion to the risk, might I be overlooking some hidden risk?

At what price?

In investing there is no such thing as a good or bad idea. Only a good idea at a price. Anything can be a good idea at one price and time, and a bad one at another. There is no investment idea so good that it can not be ruined by a too-high entry price. And there are few things that can not be attractive investments if bought at a low-enough price.

It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.

Investment success doesn’t come primarily from “buying good things”, but rather from “buying things well” (and the difference isn’t just grammatical).

The thing to think about isn’t whether you’d rather have junior or senior securities in a recession, or fixed rate securities versus variable ones in deflation. The question is which securities are priced right for the future possibilities: which ones are priced to give good returns if things work out as expected and not lose a lot if they don’t? You mustn’t fixate on a security’s intrinsic merits, but rather on how it’s priced relative to those merits.

The attractiveness of one investment relative to another doesn’t come from what it’s called or how it’s positioned in the capital structure, but largely from how it’s priced relative to the other.

There are two key concepts that investors must master: value and cycles. For each asset you are considering, you must have a strongly help view of its intrinsic value. When its price is below that value, it is generally a buy. When its price is higher, it is a sell. In a nutshell, that is value investing. But values are not fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. Further, security prices are greatly affected by investor behaviour; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle.

Investors generally overestimate their ability to see the future, and the worst of them act as if they know exactly what lies ahead. It is important to worry about what’s coming next. The fact that we don’t know what it is shouldn’t permit us to think there’s nothing to worry about. Low asset prices allow us to invest aggressively, without much consideration given to worrisome fundamentals and the possibility of negative surprises. But as prices rise, so should our degree of concern over these things. The bottom line is this: the fact we don’t know where trouble will come from shouldn’t allow us to feel comfortable in times when prices are full. The higher prices are relative to intrinsic value, the more we should allow for the unknown.

When there’s too much money chasing too few deals, asset prices are driven up, prospective returns are driven down and risk rises.

Follow the practical way,
George

Making market forecasts on a consistent basis is not an easy thing. Many people try and none succeed on it. If you are always crying ‘wolf’ then at some point you will be right, but that does not tell us about your ability to forecast market movements. A useful market forecast is only useful if it is in contrary to popular belief. If everyone predicts it then this is already reflected in the price of assets. So in order to profit, you must find someone who consistently makes predictions that are contrary to popular belief, they are correct and you must have the courage to act on them. Not many people have the stomach to go against the crowd and feel confident about it.

When you try to predict the future you must be able to predict the future events and the timing of when they will happen. If you can not predict the timing your predictions are as good as the false ones.

People who know the future repeatedly ignore the fact that (a) the future possibilities cover a broad range, (b) some of them – the “black swans” – can’t even be imagined in advance, and (c) even if it’s possible to know which outcome is most likely, the others have a substantial combined probability of occurring instead.

The key is to view the future as a range of possibilities, no a reliable point estimate. If an investor prepares for a single future and attempts to maximise under the assumption that his view will prove right, he will be in big trouble if it does not. The investor who backs off from the maximising position is likely to do better when negative surprises occur. Thus it’s essential to realise a few things:

• It is not sufficient to think about surviving “on average” – investment survival has to be achieved every day, under all circumstances.
• The ability to survive under adverse conditions comes from a portfolio’s margin for error.
• Ensuring sufficient margin for error and attempting to maximise returns are incompatible.

Risk

According with the academicians who developed Capital Market Theory, risk equals volatility, because volatility indicates the unreliability of an investment. This definition of risk is not the best. Academicians use volatility to measure risk because it is convenient. It is a number that is objective and can be ascertained historically and extrapolated into the future. Volatility though is not the risk that most investors care about. Risk is the likelihood of losing money.

People believe that by increasing risk they will get higher returns. Riskier investments can not be counted to deliver higher returns, because if riskier investments reliably produced higher returns, they would not be riskier. Riskier investments offer the prospect of higher returns or higher promised returns or higher expected returns. But there is absolutely nothing to say those higher returns have to materialise.

Therefore what investors should look for are risk-adjusted returns. Can you achieve higher returns without assuming higher risk? This is very difficult to do in efficient markets, but in markets that are not efficient the risk and the return is not correlated the traditional way. It is possible to get higher returns and assuming lower risk.

Modern portfolio theory tells us that the market prices assets so they will offer returns that are proportional to their risk. In inefficient markets mistakes are made such that risk and return need not be strictly proportional. As a result, it becomes possible to achieve superior and inferior risk-adjusted returns.

It is not a matter of finding winners, but of building a portfolio where upside potential is accompanied by downside protection. In order to decide how well a portfolio had performed, you have to access how much return was achieved and how much risk was borne.

“I would not buy that at any price – everyone knows it is too risky.” Most investors think quality, as opposed to price, is the determinant of whether something is risky.

Taking too little risk can cause you to underperform your peers – but that beats the heck out of the consequences of taking too much risk at the wrong time. No one ever went bankrupt because of an excess of risk consciousness.

Risk comes from the combination of what you buy and how you finance it. You can buy very risky assets, but if you don’t lever up to do so, you’ll never lose them to a margin call. Or you can buy fundamentally safe assets, but the combination of enough leverage and a sufficient hostile environment can cause a meltdown. In other words, investing in “safe” assets isn’t necessarily safe, particularly if you’ve borrowed to buy them.

Investment safety doesn’t come from doing safe things, but from doing things safely.

Leverage + volatility = dynamite

Investors face two main risks: (1) the risk of losing money and (2) the risk of missing opportunity. Investors can eliminate one of the other, but not both. More commonly, they must consider how to balance the two. How they do so will have a great impact on their results. This is the old dilemma – greed or fear? – that people talk about so much. When most people think that the worst imaginable outcome is failing to participate fully in gains, the result is risky behaviour. They’re inevitably reminded that there’s worst, but it can take a long time to happen. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasise the right one at the right time.

Follow the practical way,
George

Efficient Markets

The main function of the markets is to drive out excess return by bringing buyers and sellers together at prices from which the return will be just fair. Realising that makes scepticism an indispensable ingredient in superior investing. Most investment failures are preceded by a dearth of it.

A lot is said about the markets been efficient over the years. The markets are efficient in the sense that information is quickly and correctly reflected in the price. Even though some times the markets misprice assets it is very difficult for someone who is working in the market with the information that everyone else has to consistently have views different from the consensus and closer to being correct.

Some markets are inefficient because:

• Information is not disseminated evenly
• Investors are not many or not objective
• They are complicated and a high degree of skill is required

Assets may be mispriced relative to their risk, relative to their intrinsic value and relative to each other. In inefficient markets, “low risk” does not have to mean “low return”. In these markets hard work and skill can pay off.

There are times when the markets are wrong or the risk-adjusted return of an asset is far out of line with the rest. The inefficiency of the markets does not guarantee that someone will achieve above average returns, but it provides a starting point for people to try. Because investing is a zero sum game, for every person who achieves the above average returns another one must achieve the opposite. So it is essential to have superior skill to take advantage of such markets. While that price is often wrong, very few investors are capable of consistently knowing when it is, and by how much, and in which direction.

An inefficient market can offer the ability to achieve a higher return without bearing more risk. Also, it can offer the ability to achieve the same return as the benchmark while taking less risk. Here the manager’s value added comes not through higher return at a given risk, but through reduced risk at a given return.

Market Cycles

One thing that has not changed in 200 years of investing is the market cycle. Markets move up and markets move down. That is a fact of the markets that people forget some times and they are reminded of it in the most painful way. This time things are not different.

The higher prices will always attract more buyers who will bid up the prices. This is the start of the greed cycle. People will be scared of missing the boat and buy assets without caring about the price. At some point the prices will move so high that people will stop buying and start selling to capture gains. This will start the prices to starting moving down and more people will sell to avoid been left behind. This is the start of the fear cycle. People will run for the exits because they do not want to be the last one to leave. This will make the prices move low and at some point buyers will come back to buy bargains and the cycle starts again.

The market is like a swinging pendulum that moves from one side to the other. No one knows how long it takes to reverse direction, but the sure thing is that it will. Although the midpoint of its arc best describes the location of the pendulum “on average”, it actually spends very little time there. It always swings towards or away from the extremes of its arc.

What is important in the cyclical markets is not to be ale to predict the future but to know where we are at the moment. As investors we might not know where we are going, but we better have a good idea where we are. By knowing in which part of the pendulum swing we are at the moment we can decide what to do.

Cycles are inevitable, often profound, and the most reliable feature of the business and investment worlds. We cannot know how far the trend will go, when it will turn, what will make it turn, or how far things will then go in the opposite direction. But every trend will stop sooner or later. Nothing goes on forever. Trees do not grow to the sky and neither do many things go to zero and stay there. Success carries within itself the seeds of failure and failure the seeds of success.

It is folly to think we know in advance just what it is that will cause the market pendulum to stop swinging in one direction and start in the other, but it is even greater folly to think that nothing of that nature will happen.

Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.

Overestimating the longevity of the up legs and down legs is one of the mistakes that investors insist on repeating.

The tendency to expect trends to continue is typical of investor behaviour, especially with regard to phenomena that should instead be expected to regress toward the mean.

The cycle isn’t unknowable or unbeatable.

Follow the practical way,
George

Philip Fisher was in investor for many years and he was a very successful one. In his book “Common Stocks and Uncommon Profits” he outlines some of his ideas that have helped him to be a successful investor.

He regularly used to go out on the field and speak with employees of the companies, with suppliers, competitors and the management and was able to gather valuable information from them. Of course, he did a lot of preparation work before he went to the meetings to show to people that he was a serious investor.

Here are 15 points that he was looking for in companies that he wanted to invest in. Many of them are more difficult to quantify than a simple P/E ratio, but none the less very important.

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of current attractive product lines have largely been exploited?

3. How effective are the company’s research and development efforts in relation to its size?

4. Does the company have an above-average sales organisation?

5. Does the company have a worthwhile profit margin?

6. What is the company doing to maintain or improve profit margins?

7. Does the company have outstanding labor and personnel relations?

8. Does the company have outstanding executive relations?

9. Does the company have depth to it management?

10. How good are the company’s cost analysis and accounting controls?

11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

12. Does the company have short-range or long-range outlook in regard to profits?

13. In the foreseeable future will the growth of the company require sufficient equity financing that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?

14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when trouble and disappointments occur?

15. Does the company have a management of unquestionable integrity?

These 15 points will help you to come up with potential companies to buy. Then you had to decide on what to buy, when to buy it and when it is time to sell it.

Follow the practical way,
George

1. Too much capital availability makes money flow to the wrong places. When capital is scarce and in demand, investors are faced with allocation choices regarding the best use for their capital, and they get to make their decisions with patience and discipline. But when there’s too much capital chasing too few ideas, investments will be made that do not deserve to be made.

12. Investment survival has to be achieved in the short run, not on average over the long run. That’s why we must never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Investors have to make it through the low points.

Follow the practical way,
George

Why do the mistakes repeat? That’s a good question, but not much of a mystery. First, few investors have been around long enough to recognize reoccurrence of the errors of twenty or forty years ago. And second, the greed that argues for ignoring “the old rules” easily trumps caution; hope truly does spring eternal. That’s especially true when the good times are rolling. The tendency to ignore the rules invariably reaches its apex in periods when following them has cost people money. It is thus, as Galbraith points out, that those who harp on the lessons of the past are dismissed as old fogies. What are some of the recurring mistakes investors make?

Follow the practical way,
George

Mark Howard of Oaktree Capital Management wrote in one of his memos that a lot of people ask him what is the most important thing he has learned throughout his years of investing. After been asked this question a lot, he decided to compile a list of the answers he has given to various people, because he has given various answers. Here is the list:

Follow the practical way,
George

Mark Howard of Oaktree Capital Management wrote in one of his memos some very good ideas about building a successful partnership:

If an organization is to be the best, it must find, train and retain the best. Not only does turnover drain off your best people, but it also takes their institutional memory and leaves you bogged down in hiring and training their replacements.

So the recipe’s simple: shared values and complimentary skills; mutual respect and an appreciation for each other’s contribution; and people with whom you enjoy associating.

Follow the practical way,
George

If you look at the tables below you will see some examples on how compounding works. Compound interest depends on 3 factors:

• The initial amount you deposit.
• The rate of compounding.
• The frequency of compounding.

In example A that I use as a basis, you see the effect of compounding for an initial amount of £100, given a return of 10% for 20 years. At the end you will have £673. Compare this with example B where the rate of compounding is doubled. At the end you will have £3834. This return is about 5 times more. In example C, the time period is doubled; the final amount is £4526 and that is about 6 times more. The same effect you can achieve if the interest is applied more frequently than once a year. In example D, we double the initial investment to £200 and the final amount is £1345. This is about 2 times the original investment.

From the above examples you can see that the increase in the time of compounding has the biggest effect on the return. The second best return you achieve by increasing the rate of compounding and the least one is by putting a bigger initial investment. By this, I hope you can see the mistake that many people make when they are saving for their old age. They do not start saving early enough and they lose on the biggest accelerator of wealth. When they realise this, they try to make up by increasing the amount they invest, but as we have seen this has the least effect.

It is not always easy to achieve a higher rate of compounding without increasing the chances of permanent loss of capital and thus you need to take care when you try to achieve a better rate.

As you can see from the graph, if you plot the returns from compounding and the time it takes to achieve these returns you will get an exponential graph. This shows the power of compounding. The start is slow and boring. This is where most people get discouraged and they give up because not much is happening and they do not believe in magic. Once you pass a certain threshold though, the magic begins. The gains are becoming larger and larger and the power of compounding kicks in. As with any exponential graph after a certain point the growth is mind blowing.

Only investors who have patience can get these returns and enjoy them.

Follow the practical way,
George