Investing Paradigms
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Key Knowledge Areas
To start with you will need a reasonable knowledge of financial statements and how to read them. These include:
Valuation metrics;
Financial ratios;
Balance sheets;
Cashflow statements;
Income statements;
And other key quantitative measures.
You will need to know how and when to use these to obtain information about businesses you may want to purchase. This knowledge is probably best learned by taking a course in accounting and finance, which will provide a solid basic understanding of these fundamentals. Alternatively, you can review information from these sources and learn through research, online resources, and self-directed learning. Generally, reading many statements from many different types of companies will help you gain familiarity with these concepts.
You will need knowledge of annual and quarterly reports. This can generally be gained by reading annual and quarterly reports. As you read many of these reports you will gain insight on what areas to focus on and what areas to limit your exposure to when reviewing investment opportunities.
You will need some understanding of understanding of probability. There are probabilistic elements to making investment decisions and have a good understanding of probability is useful. You definitely do not need to be an expert in probability to do investing well, but some knowledge will go a long way in understanding possible decisions. It should be noted that humans are naturally very bad at understanding probability, our minds are not wired for it, and first reactions to understanding probabilities are often wildly incorrect. Probability assessment often requires deliberate thought and mapping to get right. One way to learn about probability is a basic statistics course or similar. Self-teaching probability is likely to be quite challenging because of the often counter intuitiveness of the subject area, but there is more than enough free information available to do so if you are sufficiently motivated.
You will need to understand some basics regarding risk and risk management strategies. Risk is often misunderstood because of the many different ways the word risk is used in common language. The key element of understanding risk is that each risk has a probability of occurring (a reason to understand probability) and a level of impact if it does occur. If you are able to separate these components of risk, management of risk becomes more straight forward. There are many sources to learn from on risk, and many professions have some element of risk management. However, this is probably something that can reasonably be self-taught using the myriad of free sources available.
Basic Principles
Once armed with this information there are some guidelines and principles that should be kept in mind when considering investments:
Understand that you are buying a business, not a piece of paper or just a “stock”. Values go up and down in the long run in relation to business performance. “The market is a voting machine in the short run, and a weighing machine in the long run”.
Understand what your circle of competence is. You cannot invest in things you do not understand. You also do not have to understand everything to make good investments in some things.
Understand fear of missing out bias. This happens frequently in the markets when some individuals have made solid gains on a stock and others pile in behind them. This can lead to dramatic losses if investing behind these cycles when they inevitably correct.
Understand Margin of Safety. Because you will always have imperfect information and be subject to both unforeseen and uncontrollable events, you must always require a margin of safety for your investments to account for this. Specifically, you must buy things below what you think their current fair value is.
Do not lose money. While it may sound obvious, most investors do not behave with this principle in mind. In investing, if you focus on limiting or eliminating your downside risk, your gains will tend to take care of themselves. Alternatively, you are looking for opportunities that have limited or no downside, with very high or unlimited potential upside.
Do not use spreadsheets. If you are looking at all the details of a potential investment to the point where you are using Excel or a similar tool to determine if the opportunity is a good one, it probably isn’t. Most good opportunities do not require that level of analysis to determine if they are good, and you will probably get that level of detail wrong in most of your analysis.
Only invest if your expected holding period is more than 3 years. Trying to determine if a specific investment will pay off in the short run is very difficult and subject to the volatility in the market. There are armies of individuals using sophisticated techniques, very advanced computer software, and extremely high-end connections who try to win in the short run. They have only a limited possibility of doing better than the market in the long run and your probability of beating them using their approach is much, much lower. Do not play that game.
Understand that most investment information is noise. The incentives of day traders, news cycles, professional fund managers, Wall Street, and others lead them to desire minute by minute, hour by hour, day by day, and month by month information. Most participants in the market are compelled to be obsessed by quarterly or less returns, and by extension information that is relevant for that duration or less. Focusing on long term gains frees you from this distraction and allows you to focus on underlying fundamentals that will allow you to beat the market in the long run. (exception - sometimes short term negative mania in the market does present buying opportunities for long run investors)
A degree of ignorance can be a superpower. Being apart from the market and the constant flow of information will prevent you from failing to see the forest for the trees and allow you to see opportunities when market group think takes over and pulls the market much too far in any specific direction. While diligence is always required before any investment, not being subject to prevailing market sentiments will allow you to see things the market is temporarily blind to. There is a reason that many great investors are not in New York on Wall Street.
Always understand the simple reason to make an investment. As a general rule, you should be able to write on a small sheet of paper the reason to buy an entire business for its current total value. This helps put in perspective if the current total valuation makes sense, and that you have clear and understandable reasons for making the investment. If you cannot complete this exercise, either the business is overvalued, or you do not sufficiently understand the opportunity.
You do not have to invest – there are innumerable opportunities that can be pursued. However, there is no obligation to pursue any of them. You can wait for the right opportunity to come along, that you fundamentally understand, and can determine is a great opportunity. If you continually act on unexceptional investments, not only will you receive lower returns, but you will also not be in position to act on great opportunities when they occur. The greatest investors are often waiting on the sidelines with large amount of funds waiting for the right opportunity and feel no obligation to pursue mediocre investments that are difficult to assess.
When you have the right opportunity act decisively – once you have identified an opportunity that you fundamentally understand, your thorough review is complete, you know the investment is a great long term opportunity with outsized upside potential (no or very low downside), you cannot be afraid to act decisively and obtain a material position relative to your portfolio size. These do not come around very often and not acting, or only acting in a small amount will significantly detriment your long run returns.
It is supposed to be boring – there is a high probability that you are doing it wrong if you find that you are regularly excited by the activities related to investing and making investments. It is not supposed to be exciting, and when done right emotions should not be significantly involved. You may find satisfaction in the activity, but it is unlikely to be exciting most of the time.
Where to find investment opportunities
There are many places to find investment opportunities. If you have skills in a certain area, that is often the best place to start, as you will have knowledge and insights that others don’t. Barring having access to special skills there are some general methods for discovering opportunities:
“Start with the A’s” – you can look at as many stocks as you can, completing preliminary analysis on each one an filtering the ones that seem most interesting. This can be akin to a scavenger hunt and if this is something that interests you then it is a good way to discover opportunities that other may have missed.
13F filings – these are reports that some of the best and largest investors have to file quarterly. These reports detail the buying and selling activities of those individuals and organizations that are required to file them. You can review these filings for investment ideas directly – if very capable and accomplished individuals are making investments then perhaps it is a good investment. Additionally, you can see what these individuals are doing, learn how they are assessing investments, and apply that to your own activities. Special note, there is a significant delay to when the investor filing the 13F makes their buy or sell decision and when they are required to make the 13F report, and things can change that may affect the viability of the potential investment during that time – you must still do your own research.
Out of favor stocks – the market is subject to volatility, cyclicality, overdone negative news, hype, and a myriad of other conditions leading to stocks falling out of favor. Sometimes this is irrational or overdone and the underlying business remains a quality business with solid future prospects, but in the short run the overall market isn’t giving these quality factors sufficient weight. There can be opportunities when this happens. This can apply at the individual stock level, the sector or industry level, or at the market level overall. The news cycle can sometimes point to stocks that are out of favor that could be worth investigating. Note that often businesses, sectors, or the market deserve to be out of favor so doing your own research on the potential opportunity is key.
Understanding the difference between uncertainty and risk – in investing there is a difference between uncertainty and risk. Risk can be thought of as all the things that can happen that may affect your projections and by extension your understanding of the valuation of the opportunity. Uncertainty on the other hand is not being able to know the outcome ahead of time. This is a difficult concept for many to wrap their minds around, however understanding that the market despises uncertainty and that this doesn’t necessarily constitute risk can lead to uncovering amazing opportunities. This aversion to uncertainty can cause the market to significantly undervalue opportunities, simply because the magnitude of an outcome cannot be known. These tend to look like opportunities that have no downside, but unclear upside potential.
Paying attention to what you do and purchase – there is a good chance that there are a number of companies that you regularly interact with and purchase from. The more you interact with a company the more likely it is that it is a quality company. Often professional investors will not be as exposed to typical individual’s behavior and may not have the insight into current behavior patterns. Simply by investigating companies you interact with frequently, you may find that some of them are great opportunities that have not yet been uncovered.