The Most Important Things in Investing
1. Second-Level Thinking
Anyone can achieve average investment performance, all you have to do is to invest in an index fund that buys a little of everything. That will give you what is known as “market returns”, merely matching whatever market does. But successful investors want more. They want to beat the market.
What is the definition of successful investing: doing better than the market and other investors. To accomplish that either you need good luck or superior insights. Depending on luck isn’t much of a plan, so you’d better concentrate on insight.
In basketball, they say that you can’t coach height, which means all the coaching in the world won’t make a player taller. It’s almost as hard to teach insight. Just Like any other art form, some people just understand investing better than others. They somehow managed to acquire that necessary, trace of wisdom.
Aspiring investors can take courses in Accounting and Finance, and read widely. If they are fortunate, they can receive mentoring from someone with a deep understanding of the investment process. But only a few of them will achieve superior insight, intuition, sense of value, and awareness of psychology that required for consistently above-average results. Doing so requires second-level thinking.
What is second-level thinking?
First-level thinking says that It’s a good company, let’s buy the stock, whereas Second-level thinking says, It’s a good company, but everyone thinks it a great company, and it’s not. So the stock is overrated and overpriced, let’s sell.
First-level thinking says that the outlook calls for low growth and rising inflation, so let’s sell our stocks, whereas, Second-level thinking says, the outlook stinks, but everyone else is selling in a panic, so let’s Buy.
First-level thinking says that I think the company’s earnings will fall, so let’s sell, whereas, Second-level thinking says, I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock, so let’s buy.
First-level thinking is simplistic, so everyone can do it, a bad sign for anything involving an attempt at superiority, whereas Second-level thinking is deep and complex.
The difference in the amount of the work to be done between first-level and second-level thinking is clearly heavy, and the number of people having the ability of the latter is very small compared to the number capable of the former.
First-level thinkers look for simple formulas and easy answers. Second-Level thinkers know that success in investing is the direct opposite of simple.
If you want your performance to be better than the market and other investors, then your portfolio has to be different and as well as better.
Being Different and better: that’s a pretty good description of second-level thinking.
The oldest rule in value investing is: “buy low, sell high.”
It simply means that you should buy something at a low price and sell it at a high price. But, how do you determine, what’s high and what’s low?
There has to be some objective standard for high and low, and i.e., stocks intrinsic value. Now, the rule becomes clear, buy at a price below intrinsic value, and sell at a price higher than intrinsic value.
But, to do that, you’d better have a good idea of what intrinsic value is. Thus, sensible investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.
Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets, and enterprise value and emphasize buying cheaply on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy it’s stock when it can do so cheaply.
3. Understanding risk
According to Elroy Dimson, “Risk means more things can happen than will happen”.
Investing consists of precisely one thing: dealing with the future. And because none of us can know the future with certainty, the risk is inescapable. So, dealing with risk is an important element in investing.
Thus, assessing risk is one of the most important things in investing because, the risk is a bad thing, and sensible investors want to avoid or minimize it. Return tells just half the story when considering an investment, your decision should be based, not only on the possible return but also on the risk that involved in earning that return. An investor should determine whether the given investment justifies taking the risk.
4. Recognizing Risk
Great investing need both generating returns and controlling risk. And recognizing risk is absolutely necessary for controlling it.
Recognizing risk often starts with understanding when investors are paying it too little attention, being too optimistic and paying too much price for a stock. High risk comes primarily at high prices. Whether it is an individual stock or entire market, participating when prices are high, is the main source of risk.
Second-Level thinking is very helpful in recognizing the risk. When most investors think that investing in stocks or markets is low risk, and pays a high price, that is the time, in fact, it is highly risky. In contrast, When investors think that investing in the market is too risky and sell their stock or wait in the side-line, that is the time, it is low risky since you can buy solid companies at cheap prices.
5. Controlling Risk
Investor’s first job is to intelligently control risk and earn high returns. Doing it well is what separated the best from the rest.
Great investors produce high returns with moderate risk, moderate returns with low risk.
But someone who produces high returns by taking high risk is not considered great. Because great investors take less risk and generate a high return. For them,
High risk is not equal to high return, but they make sure, to produce high return than perceived risk.
In order for a portfolio to make it through tough times, the risk has to be well controlled.
a. Know that the future is uncertain and it is inescapable.
b. Never pay a high price, always buy below intrinsic value.
c. In estimating the Intrinsic value of a stock, use conservative assumptions.
d. Say no to leverage, because, “VOLATILITY+LEVERAGE=DYNAMITE”.
e. Make sure to have fewer losers in your portfolio.
The mark of the superior investor is skillful risk control.
To buy when others are selling in panic and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.
Most investors in the stock market are trend followers. Superior investors are the exact opposite.
Warren Buffett’s quoted advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He is urging us to do the opposite of what others do: to be contrarians.
The key to investment success is in doing the opposite: in diverging from the crowd. Investors who recognize the errors that others make can profit enormously through contrarianism.
Accepting the broad concept of contrarianism is one thing, putting it into practice is another. Because,
a. Contrarianism isn’t an approach that will make you money all of the time. Most of the time you don’t have great market excesses to bet against.
b. Markets can be over or underpriced and stay that way or more so, for years.
c. It can be extremely painful when the trend is going against you.
So, to be a contrarian, one has to be strong emotionally.
It’s our job as contrarians to catch falling knives, hopefully with skill and care. That is why knowing the intrinsic value of the stock is so important. If we hold a view of intrinsic value that enables us to buy when everyone else is selling, and if our view turns out to be right, that’s the way to earn the greatest rewards with the least risk.
7. Patient Opportunism
Peter Bernstein says that the market is not a very accommodating machine, it won’t provide high returns just because you need them.
There aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism, waiting for opportunities, is often your best strategy.
So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them. Wait patiently till stocks trade at less than their intrinsic value, then buy. An opportunist buys things because they are offered at bargain prices. There’s nothing special about buying stocks when the prices aren’t low.
Sometimes greed and fear, optimism and pessimism, and credulousness and skepticism are balanced, and thus clear mistakes aren’t being made. Rather than obviously overpriced or underpriced, most stocks may seem roughly fairly priced. In, that case.
During such a period, it’s better to be inactive, and practice, patient opportunism. Because you simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns and give back your profits in the process. If it’s not there, hoping won’t make so.
8. Avoiding Pitfalls
“An investor has to do very few things right as long as he avoids big mistakes” – Warren Buffett.
Trying to avoid losses is more important than striving for great investment successes.
With a risky portfolio, a downward fluctuation may make you lose faith or be sold out at low. Having a portfolio that has too little risk can make you underperform in a bull market, but no one ever went bust from that.
To avoid losses, we need to understand and avoid pitfalls that create them.
In many ways, psychological biases are some of the most interesting sources of investment error. They greatly affect investors’ behavior and can influence stock prices. Because of these psychological biases, investors make errors in their decision making. These forces can make stock prices go too high or way too low. This is the origin of bubbles and crashes.