My views on the market, tech, and everything else

A Dozen Things I’ve Learned From Seth Klarman

1. “Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed.” A tiny number of hard working and emotionally disciplined people who understand how to value a business can earn financial returns that are better than the market. It is highly unlikely that you are one of those people, but it is possible. The greatest danger lies in those last three words since far too many people believe “possible” applies in their case.

2. “Investors are human and do make mistakes… value investing is predicated on the belief that the financial markets are not efficient.” Only fools and the models of some economists assume markets are “always” efficient instead of “often” efficient.  As Howard Marks points out: “Markets are made up of people, with their emotions, insecurities, their tendency to go to extremes, and their other foibles. Thus, they often make mistakes and swing to erroneous extremes.”

3. “Resist crowd psychology.” Keynes believed that devoting intelligence “to anticipating what average opinion expects the average opinion to be” in a way that outperforms the market is folly. Such skill arguably the rarest of human qualities, if it exists at all. People who try to predict the behavior of crowds are “speculating” which is not “investing.” The existence of George Soros is cited by some people as evidence that successful financial speculation is possible, but what are the odds that you are George Soros? In any event, an argument that Soros ignores value and instead is a purely a speculator is mistaken. Klarman said in an interview: “The economics, the valuation of the business, is not hard. The psychology — How much do you buy? Do you buy it at this price? Do you wait for a lower price? What do you do when it looks like the world might end? Those are the harder things.” Since these things are hard to do you want to do them carefully via a deliberative process.

4. “Look to Mr. Market as a creator of investment opportunities [not] for investment guidance.” The irony is that the mistakes of speculators create the opportunity for value investors. Warren Buffett writes: “The more manic-depressive [Mr. Market] is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.”

5. “Attempting to outperform the market in the short term is futile.” Most people are way too focused on the short term. The biggest beneficiaries of a short term focus are brokers who generate greater fees. Klarman makes medium to long term investments and on that points out: “Buying is easier. Selling is hard.”

6. “To investors stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses.” Too many people treat an investment like they would a rare baseball card or a lottery ticket. The valuation of a business is determined by cash flows in the long term. To understand cash flows you need to understand the underlying business.

7. “[Value investing is] “the strategy of investing in securities trading at an appreciable discount from underlying value.” Buying something for less than it is worth is wonderful.  Genuine value investors like declining prices of a stock or bond because it allows them to buy more. If you do not feel this way about declining prices you are probably not a value investor. It is far better to be approximately right, than precisely wrong.

8. “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” People screw up.  A lot. Having a cushion against mistakes and studity is valuable, especially since methods for valuing a stock are imprecise.

9. “An investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings…. you diversify most of the diversifiable risk away from a portfolio by owning 20 or 25 positions. “ How many stocks can an individual follow in a sufficiently deep way so that you understand the underlying value of the business? Marty Whitman once suggested that it was limited to ten. With investing partners investing in more securities is possible, but at some point so many stocks are owned that you inevitably become a “closet indexer.” Once a portfolio has 40 or so names in it, the closet indexing risk is high. It is important to note that indexing is fine if you are a “know nothing investor, and most all people are know nothing investors. But you should *not* be paying a high fee to own an index.

10. “Once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling.” By focusing solely on the value of a business and avoiding attempts to make predictions based on crowd psychology an investor can benefit from a system which allows the investor to profit from inevitable market swings caused by the speculation of opthers. Blocking out the “noise” attributable to speculators is fundamental to value investing.

11. “The trick of successful investors is to sell when they want to, not when they have to.” There are times in life when liquidity is extremely valuable and planning ahead for those times is wise. Owning the right amount of very liquid assets like US Treasury bonds when you are likely to need cash is a good idea.

12. “Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.” One of the biggest, if not the biggest risks in investing, is your own behavior. Overconfidence and over optimism are nearly inevitable elements of the human condition. Be careful out there. As always, think in terms of expected value like Warren Buffett: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.”

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