1. “’I don’t know’ are three of the most underused words in investing.”
“What’s really interesting about finance – and I think this is true for a lot of fields whether you’re in physics, math, chemistry, history, or whatever it is – the more you learn, the you more you realize how little you know.”
There is nothing more fundamental to investing than understanding that risk comes from not knowing what you are doing. And as Morgan Housel is saying here: the more you know, the more you know that there is even more that you do not know. If you are not getting more humble as you: 1) get older, 2) grow as a person, or 3) learn, then you are not paying attention. The best investors keep their circle of competence tightly defined and limited in scope. Skills can atrophy or become outdated. New competencies can be developed with time and effort.
What you are doing when you are investing is buying an ownership interest in an actual business. No matter how hard you may work to know everything about that business, the phenomenon effecting that business, and the markets in which it competes, there always be much that you do not know. Even if you may chose an index-based approach to investing, you are making choices about what types and amounts of assets to buy. The very best investors have been able to develop systems that deal effectively with the fact that investing is probabilistic process. The best systems are designed to enable the investor to buy and sell assets in a way that is “net present value positive” over time after fees and expenses. Systems that do not produce net present value positive results over time after fees and expenses, are speculation and are not investing.
2. “There are no points awarded for difficulty.”
The best investors make frequent use of a “too hard” pile when it comes to investing. One of the many things that investors like Morgan Housel have learned from great investors like Charlie Munger is how much investing performance can be improved by just avoiding some of the boneheaded mistakes made by other investors. For example, there is no shame in admitting that a given business can’t be valued. There are plenty of other businesses that are understandable which present investment decisions that are not very difficult. Most of the time what an investor should do is nothing. And there is no better time to do nothing than when something is difficult.
On this point Warren Buffett likes to say “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.” These 1-foot bar jumping opportunities with big financial payoffs don’t appear very often, but when they do, it is wise to bet big.
3. “Three of the most important variables to consider are the valuations of stocks when you buy them, the length of time you can stay invested, and the fees you pay to brokers and money managers.”
“The single most important variable for how you’ll do as an investor is how long you can stay invested. I’m always astounded when I think about compound interest and the power that it has for investing. Time is massively powerful.”
Each of the points made here by Morgan Housel has a major champion. On the first point, Howard Marks points out: “It shouldn’t take you too long to figure out that success in investing is not a function of what you buy. It’s a function of what you pay.” On the second point, Charlie Munger puts it simply: “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.” On the third point there is John Bogle: “You get what you don’t pay for.”
An excerpt of a Motley Fool post called I Prefer to Keep Things Simple, by Morgan Housel helps explain compounding:
“What [too often] happens … is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact.
You’ve probably heard the story about the guy who invented the game of chess.
It goes like this: An inventor brought his chess board to the emperor of China, who was so impressed he offered to grant the man one wish. The inventor had a simple wish: He requested one grain of rice for the first square on the board, two grains for the second square, four for the third, eight for the fourth, and so on. Sounding like a modest proposal, the emperor agreed. But filling the chess board’s last 10 squares would have required 35 quintillion grains of rice – enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.
While I doubt the story is true, its message is important to understanding the power of compound interest: When things grow exponentially, gains look tiny at first, modest in the middle, and then — very suddenly — they shoot utterly off the charts.”
4. “[Investing] is just buying and waiting.”
It is hard for some people to understand the difference between 1) waiting and 2) predicting. Fundamentally, the difference between waiting and predicting is the difference between focusing on what to buy by finding an asset selling at a discount to value right *now* versus trying to guess about *when* in the future the value might rise. Price is not the same thing as value. Price is what you pay for an asset and value is what you get in buying an asset. Only rarely doe price equal value. James Montier adds: “We need to stop pretending that we can divine the future, and instead concentrate on understanding the present, and preparing for the unknown.” We have lots of information about the present and exactly zero information about the future. To work hard to understand the present moment in time is not to think you can predict when something will happen in the future. You may be working from an assumption that sometime over a ten year period Mr. Market will raise price of as asset so it is equal to or greater than value. But it is a fool’s errand to try to predict precisely when it will happen. When it happens, it happens. You will “know it when you see it” if you understand value.
5. “It’s much easier to say ‘I’ll be greedy when others are fearful’ than to actually do it. But those who can truly train themselves to be skeptical of outperformance and attracted to underperformance will likely do better than most. They have an advantage.”
Buying stocks when Mr. Market is fearful is easier to say than do. You can’t simulate investing. The best way to learn to invest is to invest. The feelings involved in investing are primal and often hard to control. For example, humans are simply not hard wired to be contrarian when others are full of fear. You can read all the books, articles and speeches about being fearless when others are fearful and yet fail to be calm when the time comes. This presents a fundamental problem in that this is the best time to be buyer of assets. The best investors are actually nostalgic for times like March of 2009 when the market was rife with fear and uncertainty. Screaming buys based on valuation like those that existed in March of 2009 may appear only two to three times in an investing lifetime. By the time you get good at this key skill you may be too old to take advantage of the opportunity.
6. “The most important thing to know when you look at long term financial history is that volatility in the stock market is perfectly normal.”
Anyone who believes in the Mr. Market metaphor understands that volatility is both inevitable and the source of an opportunity for a rational investor. Charlie Munger: “To [Ben] Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.” It is volatility that creates the mispriced assets which present an opportunity for investors. Volatility is one type of risk. For example, if you’re retiring or have tuition bills to pay at a certain time. While volatility is one type of risk you must face, it’s not the only risk. Why do some investment managers try to equate risk with volatility rather than just considering it as one important type of risk? They want you to believe that volatility is equal to risk because volatility is a major risk for them since, if assets drop in price, investors will flee from their services. They also want you to believe that risk can be expressed a number and controlled by magic formulas with Greek letters in them you do not understand.
7. “Saving can be more important than investing.”
“The most powerful way to grow your money is learning to live with less, since you have complete control over it.”
It is reasonable to assume that over long periods of time the return on stocks will be about 6% more than the return on cash. You can quibble with that estimate but not too much. The idea that you can invest your way to retirement is simply not possible without savings. This is especially true since most investors chase performance and earn less that an average return of the market, especially after fees and expenses. “Boston College’s Center for Retirement Research found that the two most important factors for creating a retirement nest egg are one’s savings rate and the age of retirement. “If people could work until they’re 70, they would have a much higher chance of having a secure retirement. Social Security is higher if you wait until age 70, and it gives your 401(k) assets a longer chance to grow, and it reduces the number of years you have to support yourself,” says Alicia Munnell, the center’s director. Less important was the rate of return earned on investments.”
8. “Most financial problems are caused by debt.”
“Most people’s biggest expense is interest, which comes from living beyond your means, and buying things you think will impress others, which comes from insecurity. Avoid these two, and you’ll grow richer than most of your peers.”
Debt causes many problems, the worst of which is that the magic of compounding is working against you instead of for you. Leverage can also create situations where underperformance takes you completely out of the investing process. Since “staying invested” is a key to financial success anything that takes you out of the process is a very bad thing. As Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” James Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad. When you are leveraged you can run into volatility that impairs your ability to stay in an investment which can result in “a permanent loss of capital.”
9. “It can be difficult to tell the difference between luck and skill in investing.”
Investing involves both skill and luck. Sorting out how much of a given result is skill versus luck is neither easy or always possible. The very best books on this topic have been written by Michael Mauboussin, including The Success Equation. Howard Marks also has useful view on the difference between luck and skill and investing: “Success in investing has two aspects. The first is skill, which requires you to be technically proficient. Technical skills include the ability to find mispriced securities (based on capabilities in modeling, financial statement analysis, competitive strategy analysis, and valuation all while sidestepping behavioral biases) and a good framework for portfolio construction. The second aspect is the game inwhich you choose to compete. You want to find games where your skill is better than the other players. Your absolute skill is not what matters; it’s your relative skill.” Warren Buffet describes the object of the process simply: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect but that’s what it’s all about.”
10. “Investing is overwhelmingly a game of psychology.”
“Almost invariably the best investors are the people who have control over their emotions.”
Most mistakes in investing are psychological or emotional in nature. Being rational about investing is a task that has no finish line – it is a constant struggle for any human to be rational. It is harder for some people to be rational than others, but everyone is not rational at times. My post on Daniel Kahneman and James Montier examine this in greater depth. Housel elaborates: “Investing is very complicated. It’s an interaction of psychology and math and history and politics, and it’s all just mushed together and it’s really complicated. It’s always more complicated than we think it is. My journey has been one towards growing gradually more humble over the years. I would say each year that goes by, I realize that I know less and less.”
11. “Daniel Kahneman’s book Thinking Fast and Slow begins, ‘The premise of this book is that it is easier to recognize other people’s mistakes than your own.’ This should be every market commentator’s motto.”
It is an unfortunately aspect of human nature that we do not have perspective on ourselves. Humans have developed a series of heuristics that make it hard for us, especially in a modern world, to see our own mistakes. If you have an interest in exploring this topic, Daniel Kahneman explains why this is true in this excerpt from his book:
“I’m better at detecting other people’s mistakes than my own…. When you are making important decisions and you want to get it right, you should get the help of your friends. And you should get the help of a friend who doesn’t take you too seriously, since they’re not too impressed by your biases.”
Having a posse of people around you who are afraid to tell you that the emperor has no clothes is not helpful in overcoming this bias. Morgan Housel cites Charlie Munger’s wisdom on this problem: “Only in fairy tales are emperors told they’re naked.” Pavlovian association and other heuristics Morgan has written about acting together in the form of a lollapalooza make things worse.
12. “When you think you have a great idea, go out of your way to talk with someone who disagrees with it. At worst, you continue to disagree with them. More often, you’ll gain valuable perspective. Fight confirmation bias like the plague.”
“Starting with an answer and then searching for evidence to back it up. If you start with the idea that hyperinflation is imminent, you’ll probably read lots of literature by those who share the same view. If you’re convinced an economic recovery is at hand, you’ll probably search for other bullish opinions. Neither helps you separate emotion from reality.”
“Charles Darwin regularly tried to disprove his own theories, and the scientist was especially skeptical of his ideas that seemed most compelling. The same logic should apply to investment ideas.”
I have always loved this Charlie Munger quote on confirmation bias: “Most people early achieve and later intensify a tendency to process new and disconfirming information so that any original conclusion remains intact. …The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. … And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head.” The trick is to really listen to other people who you trust. Ray Dalio’s investing process is very focused on this approach. Set out immediately below are two paragraphs on Dalio’s view:
“There’s an art to this process of seeking out thoughtful disagreement. People who are successful at it realize that there is always some probability they might be wrong and that it’s worth the effort to consider what others are saying — not simply the others’ conclusions, but the reasoning behind them — to be assured that they aren’t making a mistake themselves. They approach disagreement with curiosity, not antagonism, and are what I call ‘open-minded and assertive at the same time.’ This means that they possess the ability to calmly take in what other people are thinking rather than block it out, and to clearly lay out the reasons why they haven’t reached the same conclusion. They are able to listen carefully and objectively to the reasoning behind differing opinions.
When most people hear me describe this approach, they typically say, “No problem, I’m open-minded!” But what they really mean is that they’re open to being wrong. True open-mindedness is an entirely different mind-set. It is a process of being intensely worried about being wrong and asking questions instead of defending a position. It demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.”
Both Morgan Housel and Charlie Munger cite Darwin as a model for people working hard to avoid confirmation bias. Here’s Munger: “The great example of Charles Darwin is he avoided confirmation bias. Darwin probably changed my life because I’m a biography nut, and when I found out the way he always paid extra attention to the disconfirming evidence and all these little psychological tricks. I also found out that he wasn’t very smart by the ordinary standards of human acuity, yet there he is buried in Westminster Abbey. That’s not where I’m going, I’ll tell you.”