As part of my “A Dozen Things I’ve Learned” series of blog posts I thought I would take on a list put together by Barry Ritholtz . My self-assigned task is to add my support to what Barry wrote http://www.ritholtz.com/blog/2012/10/ritholtzs-rules-of-investing/, while staying with my usual 999 word limit for any given blog post. The task I assigned to myself is to elaborate on what he has written (rather than just repeating what Barry wrote) since the best support for the investing maxims themselves comes from Barry himself. Given Barry’s towering intellect, this is a scary exercise.
1. “Cut your losers short and let your winners run.” Loss aversion is highly dysfunctional for investors since it causes people to hold on to “losers” for too long to avoid the pain of a loss. The first half of Barry’s first maxim pushes against that aspect of loss aversion. Cutting losses short pushed against a tendency to hold tightly to losers hoping that they recover before then need to acknowledge the loss. The second half of Barry’s first maxim helps lower transactions costs, fees and taxes, but is also about the value of opportunity cost analysis. Charlie Munger once put it this way: “There is this company in an emerging market that was presented to Warren. His response was, ‘I don’t feel more comfortable buying that than I do of adding to Wells Fargo.’ He was using that as his opportunity cost. No one can tell me why I shouldn’t buy more Wells Fargo.”
2. “Avoid predictions and forecasts.” The less complex the system you are trying to understand, the greater the likelihood you can make a bet which is both non-consensus and correct. Making a bet which follows the consensus and it correct will only deliver beta. The most complex system of all is the macro economy since it is composed of a nest of complex adaptive systems rife with both uncertainty (probabilities unknown) and ignorance (probabilities not computable). On a relative basis, the most tractable system on which one can make an investment and try to generate alpha is an individual company. Very few people can make non- consensus bets which are also correct at a company level, but its is at least possibl;e if you are smart and work hard. 90%+ of people are better off buying a low fee index even when it comes to making bets on individual companies. The greatest for investors often comes from the fact that 70% of people think they fall withion the 10% who can generate alpha. When it comes to self-appraisals humans are too often vastly over generous.
3. “Understand crowd behavior.” Humans often herd. People like what others like (path dependence) and especially in the presence of uncertainty or a requirement that they actually do some work, will follow other people. Most notably when diversity of opinion breaks down, crowds are often *not* wise. Buying when others are fearful and selling when others are greedy. is wise.
4. “Think like a contrarian (occasionally).” As I noted in my post about Howard Marks, http://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/ you must both adopt a view that is contrarian *and* be right to outperform the market. Being a contrarian for its own sake is a ticket to losses since the crowd is often right.
5 . “Asset allocation is crucial.” The amount you allocate to each investing category is a more important decision than the individual assets you pick within that category. My thoughts on asset allocation for muppets are here: http://25iq.com/2013/05/13/asset-allocation-for-muppets-with-a-401k/ Giving advice to “know something investors” is something I have not yet tackled since they are know-something investors already (seems like bringing coals to Newcastle).
6. “Decide if you are an active or passive investor.” My thoughts on active vs. passive are here: http://25iq.com/2013/01/16/charlie-munger-on-investment-concentration-versus-diversification/ As Dirty Harry said to the cornered criminal in the movie Magnum Force: ”A man’s got to know his limitations.” “I feel lucky” is not the way a genuine investor conducts his or her affairs.
7. “Understand your own psychological make up.” As Feynman famously said, the easiest person to fool is yourself. Genuine self-knowledge is hard-won knowledge since no one has perspective on yourself by definition. On this topic it is wise to read Charlie Munger http://25iq.com/charlie-munger-book-to-date-chapters-1-5/
8. “Admit when you are wrong.” Heuristics like “public commitment consistency” bias cause us to hold on to positions long after a reasonable analysis by a neutral observer would have concluded that we were wrong. For example, once you say publicly “X is going up” it gives your brain a shot of stupid juice when it comes to concluding that you might be wrong.
9. “Understand the cycles of the financial world.” Barry seems in agreement with Howard Marks http://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/ on this point. Nothing good or bad goes on forever. As Billy Preston sings in the well-known song things “go round in circles.” Mr. Market is bipolar and for that reason market swings will always happen. By focusing on the intrinsic value of individual investments And tuning out the talking heads blathering about their macroeconomic forecasts, market swings can become your friend. The irony is: the more you focus on what is micro in nature, the more you will benefit from macro trends.
10. “Be intellectually curious.” It is in “the micro and the obscure” where one can learn things which others do not know. To make a bet that is contrary to the consensus of the crowd you must possess knowledge that the consensus has not adopted. You will mostly likely find that non-consensus knowledge on the frontiers of your own knowledge. Really great investors read constantly and actively seek out alternative viewpoints. Shutting out views you disagree with is a step toward an echo chamber.
11. “Reduce investing friction.” John Bogle formed Vanguard on the basis of the “cost matters hypothesis” not the efficient market hypothesis. On that you might want to read http://www.vanguard.com/bogle_site/sp2004AIMRefficientMrkts.html. Paying high fees, costs and commissions is one of the simplest investing errors to correct.
12. “There is no free lunch.” There is no substitute for hard work and rational decision making.