FOR BEGINNERS (PART IV)

III. Markets & Psychology 


Note that I skipped Parts II (Understanding of Business) and III (Business Valuation) because I want to work on them longer.

I would break down Markets & Psychology discussion in 3 sub-sections: a) market model parables; b) market valuation and long term trend; c) psychological misjudgments.

III. a) Market Model Parables.

W. E. Buffett referred to 3 chapters essential for investing. Those are:

1. Chapter 12. The State of Long-termExpectations from “The General Theory of Employment, Interest and Money” by John Maynard Keynes: 

“Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

2. Chapter 8. The Investor and Market Fluctuations from “The Intelligent Investor” by Benjamin Graham: 

“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. 

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

3. Chapter 20. Margin of Safety as the Central Concept of Investment from “The Intelligent Investor” by Benjamin Graham. 

“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”

A dollar is worth a dollar. When you cannot say how much a thing is worth exactly, it makes sense to be careful and pay less. The concept of margin of safety was first introduced in investing in this chapter. It was routinely used in engineering though. Bridges are designed with backup systems and extra capacity to prevent failures.

4. I would add George Soros lectures to the list. It is an interesting read, can satisfy your philosophical needs and suppress a bias to act. 

“Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information.”

 “Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.”

THE ARLINGTON MAN

HT to David Merkel on the 400% Man article.

I enjoyed the story a lot. Perfect article – you get a very good feeling after reading it. You almost feel that you can do this too and it is about you (especially, if you make money when the market goes nowhere, like last year). But that is the problem. You almost hear 100% of what you want to hear. The guy in a romantic armchair, creature of habit, long & hold, no spreadsheets, concentrated portfolio, 4x in 12 years (admittedly, 12% IRR, yes – indexes went nowhere), and of course a major struggle in the middle of success (Overstock.com). Almost - too good to be true.

Despite this skepticism by inversion, I am inclined to believe the story. I agree with David that it is much better to fund a stable of new hungry managers with existing limited track record than to “conserve” money in a conventional way. I would add an element of more aggressive hedging than investment grade bonds, though. If you know what a good investment is, you should distinguish an outlier prone for downside, as well. Up and down complement each other like light and dark.

Now try to imagine what an investing FoF or family office “pro” would think about an edge of such a guy like Allan Mecham. What could be his edge?

> Longer time horizon?

> Temper? Patience? Discipline? Brain?

> Smaller scale = bigger universe = more inefficiency? (it does not seem so from his holdings)

> No technical restrictions (e.g. minimum number of holdings)?

I am not talking about technical - numbers skills, ability to distinguish bad business from good, etc. Those are must haves but they are ubiquitous. Good communication skills are prevalent among better marketers and talkers than closed thinkers. The listed “edges” can be unique (especially in combination) in a sense of absolute returns potential but close to impossible to quantify and measure. Yet, track record could be attributed to luck. You can mitigate that with a clear process, which can be fully controlled if you can control a real talent - you definitely can, if there is a mutual interest.

You cannot open one's mind, though.

Sharing this frustration of risk misperception by people with money, I tagged the blog “investing without edge”. Should there be any frustration? Not really. Hard work, humbleness, sound judgment, patience, and a bit of luck should translate into absolute returns and bring in understanding customers.

FOR BEGINNERS (PART I)

Today I will start a series of articles providing good foundation for anyone willing to study and practice investing.

If anyone had introduced me to value investing 10 years ago, I would have been able to engage into things I love (or "retire") much earlier. Yes, early independence is of the significant importance to me. Who would not love to have the best boss in the world – yourself? If you are not interested in becoming independent early, you should stop reading this immediately.

I did not have such a mentor and had to find book-mentors on my own instead. Accidentally, I was able to compound at ~20% from my graduation (bought a flat in 1996) but I could have done better than that. At 23% compound rate, 50c turns into $1m in 70 years. We need to remember that we will be living longer. Think about the cost of trading-up to a more expensive brand instead of getting "good enough", especially at a young age. Consequences are huge. Compounding is great.

Thus, if you know anyone who is tireless in reading, did not start smoking when the entire class did, is not afraid of numbers, and is open-minded, please make him a favor and introduce value investing. You either get the value thing in 10 minutes or you do not get it ever. There is always a chance to propel someone's life.

What is value? It is a philosophy of life. Live within means, study life, and leave everything to civilization (except of a few millions for your off-springs). In simple terms, value is buying $1 worth things for 50c. It is really possible but not easy.

There are very few essential things which you should understand (you must study life continuously, though). In W. E. Buffett’s opinion, there should be only 2 classes in a business school: I) how to understand and value business, and II) psychology and how stock markets work. I will post a collection of articles and list books potentially leading to your personal nirvana.

One man said that without value thing in life you are like a one-legged-man in an ass kicking contest. He also said that if you mix raisins with turds, you still get the same thing. This value thing is lots of fun, also. You will find about harems, naked swimming, badminton, and ...what a heck, search for yourself.

READING RECOMMENDATIONS (i)

Warren Buffett recently wrote great article about investing in gold.

"In God We Trust" may be imprinted on our currency, but the hand that activates our government's printing press has been all too human.

John Hussman is one of a must weekly readings. Over the weekend he put it simple but not too simple about the current recovery:

Each time underlying credit strains emerge, demand backs off as consumers and businesses become averse to spending. Then, each time central banks launch some massive new intervention, there is a jolt of pent-up demand that is interpreted as sustainable growth.

Intro

"Openmind" stands for being able to do what makes sense without any limits of size, geography, product, share price, liquidity, you name it. This can be one of real advantages of any retail investor.

"Creativity comes from open-mindedness and centeredness--seeing things in a nonemotionally charged way". (Ray Dalio). I called my blog so not because of this quote. I repeatedly read "open-mindedness" mentioned by most of successful investors.

I tagged it "investing without edge" because retail investors never have a real edge and should not fool themselves about that. If price is falling materially without news you never know if it is a forced seller or an inside leak or both. Any investor can have a "soft" edge though. Like an investment horizon and such a vague word like patience, which is completely inappropriate if you want to impress a professional operator.

I do not intend to write frequently, follow up and respond to comments but I promise to change my mind if anybody gives me new facts. It's a journal of thoughts, a trail of records. Why I do this? I cannot write it better than Barry Ritholtz here. It is closer to the end of the post: “Helping to quiet down the voices in my head” and “I write to find out what I think.” (Daniel Boorstin). Sometimes it is just better to write it down.

In the picture on the right side you can observe that open mind is not always a good thing or it is not clear in which place it is open and how (can see it here).