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There's no perfect way to invest. Find what works for you & ignore everyone else

The first rule of investing is…that there are no rules. Seriously, NO RULES! With all apologies to Mr. Buffett, there are guidelines, suggestions and simple math, but no rules.

It doesn’t always seem that way. There is no shortage of talking heads (journalists, bloggers, analysts, financial advisors, etc.) telling you what to do with your hard-earned savings. But in the end it’s your money. You can invest it (or spend it) however you see fit.

  1. If you want to hold stocks if they hit Japan-like bubble valuation levels. You can do that.
  2. If you already moved 20% into cash in anticipation of a correction that never came. You can do that.
  3. If you are up to your eyeballs in entrepreneurial risk and want to hold other safe assets. You can do that.
  4. If your career is just getting started and you’re not ready to own stocks. You can do that.
  5. If you want to put 5% of your portfolio into a basket of cryptocurrencies. You can do that.

As Meb Faber writes: “Remember, when Mr. Market shows up at your door, you don’t have to answer….” That being said there are some simple things you can do to improve your financial life without messing with the stock market.

  1. If your employer offers a match for 401(k) contributions, get every penny you can.
  2. If choosing between two similar investment vehicles: choose the cheaper one.
  3. If someone ever says an investment can’t lose or is guaranteed. Walk the other way.
  4. If you have have a young family, buy some low cost, term life insurance.
  5. If you have high rate credit card, work to eliminate that debt ASAP.

A Few Notes on The Little Book of Behavioral Investing

The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy, author James Montier states: “I…highlight some of the most destructive behavioral biases and common mental mistakes that I’ve seen professional investors make. I’ll teach you how to recognize these mental pitfalls while exploring the underlying psychology behind the mistake. Then I show you what you can do to try to protect your portfolio from their damaging influence on your returns.” Biases he surveys include: action bias, bias for stories, confirmation bias, conformity bias (herding or groupthink), conservatism (including sunk cost fallacy), disposition effect, empathy gap, endowment effect, hindsight bias, illusion of control, inattentional blindness, information overload, loss aversion, myopia, overconfidence, overoptimism, placebo effect, self-attribution bias and self-serving bias). Value investing provides the context for discussion. Citing a number of studies, he concludes that:

“…we should do our investment research when we are in a cold, rational state–and when nothing much is happening in markets–and then pre-commit to following our own analysis and prepared action steps.”

“…fear causes people to ignore bargains when they are available in the market… The ‘battle plan for reinvestment’ is a schedule of pre-commitments…”

“We should get used to asking ‘Must I believe this?’ rather than… ‘Can I believe this?’” (more…)

Who Really Beats the Market?

Survivorship bias, or survival bias, is the logical error of concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not because of their lack of visibility. This can lead to false conclusions in several different ways. – Wikipedia

There is survivor bias in looking at trading and investing performance and then there are the traders and investors that have an edge. People with an edge end up with the losses of those that rely on luck for profits.

This article is from an edited transcript of a talk given at Columbia University in 1984 by Warren Buffett.

Investors who seem to beat the market year after year are just lucky. “If prices fully reflect available information, this sort of investment adeptness is ruled out,” writes one of today’s textbook authors.

Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor’s 500 stock index. The hypothesis that they do this by pure chance is at least worth examining.

I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping. (more…)

Peter Lynch’s Rules

Find your edge and put it to work by adhering to the following rules:

  • With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play, or a value play? Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.
  • Pay attention to facts, not forecasts.
  • Ask yourself: What will I make if I’m right, and what could I lose if I’m wrong? Look for a risk-reward ratio of three to one or better.
  • Before you invest, check the balance sheet to see if the company is financially sound.
  • Don’t buy options, and don’t invest on margin. With options, time works against you, and if you’re on margin, a drop in the market can wipe you out.
  • When several insiders are buying the company’s stock at the same time, it’s a positive.
  • Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.
  • Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.
  • Enter early — but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the lineup is announced, you’re taking an unnecessary risk. There’s plenty of time (10 to 15 years in some cases) between the third and the seventh innings, which is where the 10- to 50-baggers are made. If you buy in the late innings, you may be too late.
  • Don’t buy “cheap” stocks just because they’re cheap. Buy them because the fundamentals are improving.
  • Buy small companies after they’ve had a chance to prove they can make a profit.
  • Long shots usually backfire or become “no shots.”
  • If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.
  • Investigate ten companies and you’re likely to find one with bright prospects that aren’t reflected in the price. Investigate 50 and you’re likely to find 5.

12 Things said by Jesse Livermore

1. “An investor looks for safety… The speculator looks for a quick profit.” Livermore is saying that what differentiated him and other speculators from investors was: (1) a willingness to make bets with short duration and (2) not seeking safety.  Anyone reading about Livermore must remember that he was not a person who often/always followed his own advice. He eventually shot himself leaving a suicide note which included the sentence: “I am a failure.”

2. “A professional gambler is not looking for long shots, but for sure money…Since suckers always lose money when they gamble in stocks – they never really speculate…”  Livermore believed he was not a gambler since he only speculated when the odds were substantially in his favor (“sure money”).   Livermore’s statement reminds me of a quotation from Peter Lynch: “An investment is simply a [bet] in which you’ve managed to tilt the odds in your favor.” Livermore’s statement also reminds me of the poker player Puggy Pearson who famously talked about need to know “the 60/40 end of a proposition.”  When the odds are substantially in your favor you are not a gambler; when the odds are not substantially in your favor, you are a sucker.

3. “I trade in accordance to my means and always leave myself an ample margin of safety. …After I paid off my debts in full I put a pretty fair amount into annuities. I made up my mind I wasn’t going to be strapped and uncomfortable and minus a stake ever again.”  Livermore is not referring here to seeking a Benjamin Graham style “margin of safety” on each bet but rather to this: once you establish a big financial stake as a speculator, setting aside enough money so you don’t need to “return to go” financially is wise.  Livermore wanted a margin of safety in terms of safe assets so that he would always have a grubstake to start over in his chosen profession of speculation. On this point and others, he failed to follow his own advice.

4. “Keep the number of stocks you own to a controllable number. It’s hard to herd cats, and it’s hard to track a lot of securities.” There is only so much information a single person can track in terms of stocks whether you are in investor or a speculator. By focusing on a smaller number of stocks you are more likely to (1) know what you are doing (which lowers risk) and (2) find an informational advantage you can arbitrage.

5. “Only make a big move, a real big plunge, when a majority of factors are in your favor.” Only bet when the odds are substantially in your favor. And when that happens, bet in a big way.  The rest of the time, don’t do anything. (more…)

Benjamin Graham on RISK

“It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds. From this there has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bear on his task.”

—-Benjamin Graham, The Intelligent Investor (New York: HarperBusiness, 2003), p. 88.

Universal Lessons

What follows are some of the most well-known investment disciplines along with a lesson or two from each that every investor should be able to use in their own strategy.

Focused Value Investing: Buying stocks that are underpriced in relation to their intrinsic value.
Lesson(s): It’s important to invest from the perspective that stocks represent an ownership interest in a business. You get your share of corporate profits from the stocks you own and over the long-term the value of the business should be reflected in the stock price.

Quantitative Investing: Using a systematic, mathematical approach to make buy and sell decisions within a portfolio.
Lesson(s): A rules-based, objective approach to investing is a great way to take out the emotions which can trip up so many investors and introduce biases into the investment process. Automating good decisions can reduce costly mistakes.

Technical Analysis: Studying charts, past prices and volume for security and market analysis by using patterns.
Lesson(s): An understanding of the history of the financial markets is extremely important to be able to define your tolerance for risk and gain the correct perspective on what couldhappen in terms of gains and losses. And at the end of the day markets rise and fall because of supply and demand.

Index Investing: Owning the entire market/index at a low cost.
Lesson(s): Beating the market is hard. Keeping your expenses, activity and turnover to a minimum is a prudent way to earn your fair share of the market’s return over time. (more…)

Legacy of Benjamin Graham- Video

Last week I stumbled across this excellent video about Graham which includes old clips from his investment classes as well as some of his former students (including Warren Buffett, Rob Brandes and Irving Kahn) giving interviews about the effect the legendary investor had on them:

50 Shades of Warren Buffett

I am about to embark on my 11th annual trip to Warren Buffett’s Omaha. This year I have something unique to share with you: an excerpt from a chapter I contributed to a brand new book, The Warren Buffett Shareholder. Let me tell you a little bit how this chapter came about.

In the early 2000s I taught graduate investment classes at the University of Colorado. As a class assignment I had students do presentations on Warren Buffett’s annual letters to his shareholders. We broke up 30-some years of Buffett letters into six time periods and divided the class into six groups. Each group had to present the most important lessons they learned from Buffett’s letters.

The day of presentations was not my finest moment as a teacher. It started out great, but soon all the presentations started to sound the same. Here is why: Buffett’s letters are full of wisdom, and each letter has a new insight or two. But value investing philosophy rules (just like the Ten Commandments in the Bible) are the same now as they were 50 years ago. Buffett simply adds a new shade of grey onto the same wisdom in each letter. Here is the thing with shades: You see them only as shades next to other shades, not as colors in their own right.

Then I discovered that Lawrence Cunningham had edited Buffett’s letters into a book, 50 Shades of Warren Buffett. Okay, the actual name of the book was The Essays of Warren Buffett. When people ask me for the one book they should read about Warren Buffett, my answer is always The Essays of Warren Buffett – it’s as close to an autobiography of Buffett as you’ll get.

(By the way, if you haven’t read “The Six Commandments of Value Investing” – an excerpt from my next book – you can sign up here to read it. I’ve been asked, why six, not ten? My deeply Talmudic answer is, “Value investing is about quality not quantity.”) (more…)

Index Investing Unmasked: 96% Of Stocks Are Garbage

Warren Buffett released his annual letter over the weekend, in which he praised Jack Bogle as his “hero” for promoting index investing. The irony is that investors would have been better off buying Berkshire shares. Over the last 10 years, Berkshire stock is up 139% while the S&P 500 is up 71%. The real question is why Buffett just doesn’t tout his own stock rather than promote index investing. He tries to explain himself:

 “Charlie and I prefer to see Berkshire shares sell in a fairly narrow range around intrinsic value, neither wishing them to sell at an unwarranted high price – it’s no fun having owners who are disappointed with their purchases – nor one too low.”

Buffett is doing something every skilled salesman does: managing expectations. Buffett’s own performance is compared against the S&P 500, and what better way to win that game than by putting a floor under the Berkshire price with the promise of share buybacks and then putting a ceiling on the stock by promoting index investing? The real secret is Buffett is talking his book by not talking it: Rather than tell investors to buy Berkshire at any price, he tells people to invest passively through an index, which leads to the very market inefficiencies that he profits from.

The great appeal of index investing is its low fees, but like buying a cheap pair of shoes that falls apart after 6 months, investors will find that index investing is the most expensive thing they ever did. Vanguard promotes its rock bottom expense ratios, but what is not published is market impact costs that are incurred when the fund rebalances. Since these rebalances are often announced ahead of time, they are extremely vulnerable to front running. Christophe Bernard, PhD Senior Scientist at Winton Capital Management, estimates that front running costs index investors 0.20% per year. That’s 4 times the official expense ratio of Vanguard’s S&P 500 ETF.

In his latest research, finance professor Hendrik Bessembinder discovered that 58% of stocks don’t even outperform a Treasury bill. This study was based on 26,000 stocks from 1926 to 2015. Just 4% of stocks accounted for all of the $31.8 trillion in gains during this period. That means 96% of stocks were complete garbage. Even worse, shares of unprofitable companies outperform their profitable counterparts, which is why you have a marketplace that is dominated by Twitters and Teslas.

Index investing means buying a box of garbage stocks sprinkled with a few hope and glamour stocks whose price gains are solely a result of underperforming fund managers grasping for quarterly bonuses and retail investors juicing up their portfolios in a doomed attempt to catch up on their retirement targets.

While mom and pop buy a Vanguard index with their $500,000 and get front run all day by proprietary traders, the capitalist televangelist Warren Buffett will continue to actively trade billions while preaching the miracle of buy and hold investing.