Weekend Reading

Wise Words from Edwin Lefevre

Edwin Lefevre is most well-known for his classic book “Reminiscences of Stock Operator”. His talent was turning Wall Street stories and anecdotes he collected over the years into lessons on human nature. He pointed out the errors that plagued investors throughout the market cycle. He covered market history, uncertainty, probability, and he even dabbled in a little value investing. It turns out, Lefevre had a way with words. Below is a collection of his wit and wisdom.
1. All booms are alike. The stage setting varies, but fundamentally they are as drops of water. Customs, like costumes, change from the force of environment and economic conditions, but human nature remains the same.
2. The stock ticker knows more than everybody. It deals with results. It satisfies your cravings for action. It makes life worth living. And when it says that you are an ass, it convinces even you of it.
3. A man who has bought a stock against the advice of a conservative broker, and has doubled his money in a fortnight, finds his suspicions turned into convictions by that impartial judge, the stock ticker.
4. Knowledge, indeed, is the enemy of a speculator during a boom.
5. It is one of the maximums of speculation that stocks never go up, but must be put up.
6. After many years of studying Wall Street’s victors and victims, I must conclude that the American public still insists on losing its savings every time the old hook is baited with the immortal easy-money worm. After every smash, the blame is laid on the hook and not the hunger. In reality, the fault is seldom with the machinery of speculation and is usually with the psychology of speculators.
7. The higher the price goes, the less desirable the investment becomes as an investment.
8. Buying stocks of prosperous concerns may be good business — but only at a certain price. But if you will make sure you know what you are getting for your money, you will be doing what nobody does in a bull market.
9. You know that nine out of ten people who talk about the market talk about their profits. They crave applause for their cleverness.
10. From hardship to comfort, the gap is a million miles wide. From comfort to luxury, the step is only four inches long. Ask any man who has made easy money.
11. It is not the certainty of disaster ahead but the uncertainty of better days to come that keeps the investor from buying.
12. It is only fair to admit that the commonest and most expensive blunder that all exceptionally brilliant businessmen make is being right too soon.
13. Within obvious bounds, the average investor’s most valuable adviser is fear; not the panic variety but the kind you call caution or conservatism, for, after all, prudence is a wise and desirable fear if it smothers greed.
14. Consider investments of every period in history and you will find that a great adverse factor has always been the change, which is something nobody can prevent.
15. “Easy money” means only one thing when it means money that has come easy: It means the money goes even more easily than it came.

Source: www.novelinvestor.com

Portfolio Turnover is the Price of Progress

Portfolio Turnover – Investopedia describes portfolio turnover as a measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by taking either the total amount of new securities purchased or the number of securities sold (whichever is less) over a particular period, divided by the total net asset value (NAV) of the fund. The measurement is usually reported for a 12-month time period.

Ian Cassel writes that he believes there is an over-glorification of buy and hold investing among active managers. With the rise of private equity and venture capital, everyone is trying to invest in public markets with the same permanent capital mantra. The lower the turnover, the more cerebral and thoughtful you appear to be with initial investment decisions. Nothing looks better than being right from the very beginning. More often than not, low turnover is shown as a badge of honour. Many investors feel great pride and joy being a loyal shareholder of a company. It feels good to say you’ve held a company for 5-10-20 years. But in reality, what really matters is performance.

A big part of what made many investors great was spotting when they were wrong quicker. Successful stock picking isn’t just picking winners. It also means picking out the losers in your portfolio. The greatest advantage in public markets is “You can sell”. But you have to know when to sell.

We normally sell a position for three main reasons: Sell when the story changes for the worse; Sell when we find something better; Sell when a company gets very overvalued.

Investors aren’t going to be right all the time. Acknowledging this fact isn’t a justification for not doing upfront due diligence. What we do acknowledge is that we are willing to accept a degree of uncertainty for the sake of speed – getting in early. Often, an opportunity is an opportunity because the conditions aren’t perfect yet. The price of certainty can be expensive as it relates to discovery and valuation. When we find a business that aligns with what we like – speed is more important than certainty.

Our initial due diligence might get us into a position, but it is our maintenance due diligence that will keep us invested and/or save us from big losses. Our future returns are based on our ability to course correct and adapt to new information. We are going to have turnover because turnover is the price of progress.

Sometimes when you sell you have gained and sometimes you have losses. Cassel says he learned a long time ago to not let small losses bother him. A big part of being a successful investor is your ability to admit when you are wrong on a company while not letting it crush your confidence and slow you down.

When should I use a financial advisor?

Michael Batnik writes to debunk something that is probably common in a lot of people’s minds. An advisor cannot beat the market any more than you can. If you find an advisor who happens to deliver higher returns once adjusting for risk, then consider yourself lucky. But if that’s your expectation going into a new relationship, then sooner or later you’re going to be disappointed. So if you can’t beat the market and neither can an advisor, then why even bother? Because an advisor can tell you the most important thing. Am I going to be okay? Can I live the type of life I want to live? That’s it. That’s the job.

If you’re not sure you’re ready to have this question answered, below is an incomplete list of ways to know when the time is right.

When You Made A Big Mistake: You know you need to take your hand off the steering wheel when you can no longer be trusted to get to your destination. Past behaviour is the best indicator of future behaviour. We can learn from mistakes, but you pretty much are who you are. If you panicked last time and convinced yourself you’re going to be fine next time, you’re probably not being honest with yourself.

When you’re worried about your spouse: If you handle the finances in your household and are worried that your spouse would be unprepared to deal them in your absence, it’s probably a good idea to find an advisor. Even if you’re not ready to relinquish control, it makes sense to find somebody that your spouse can turn to in the event of your death.

When you’re tired of it: If you trade stocks long enough, you’ll realize at some point that despite the time, energy, and anxiety of it all, you would have done just as well if not better in an index fund. And if you’re sick and tired of checking prices during the day, of reading headlines at night, and of wondering what the election might mean for your portfolio, then you’re probably ready to hand over the keys.

When you don’t have the time for it: If you work long hours and come home to a family that needs your time and attention, the last thing you want to be doing is stressing out about which fund to buy. Or when is the best time to rebalance? When your life is being pulled in a million different directions, then it might make sense to reach out to a financial advisor.

When the stakes have gotten real: If you’re a young person with an Rs5,000 portfolio, a mistake like panicking in a bear market is something that you can recover from. If you’re older with more money and less time to replenish that lost money, it’s harder to come back from that.

When you feel paralyzed: If you’ve been meaning to sell your underperforming stocks but just can’t pull the trigger, or you’ve been waiting for the right time to put the cash to work, you could probably stand to consult with somebody. If nothing else, taking the emotions out of the equation will force you to finally take action.

When you want to get specific about your goals: If you want to buy a second home in ten years and retire in 20, an advisor can tell you whether or not this is possible. Of course, nobody has a crystal ball, but an advisor’s job is to let you know if it’s possible, or break it to you that you’re not even close.

Are you still playing by the old rules?

Jonathan Clements explains that there are many investors, and indeed financial advisers, who are still playing by the old rules. Are you one of them? Do you know those timeless financial principles? Sometimes they don’t age so well. Indeed, if you’re still hewing to the financial wisdom of the 1980s, you’re likely hurting yourself today. Here are three examples:

Goodbye, Star fund Manager: Many investors continued to hunt for the next superstar fund manager. Investors would scour past mutual fund performance, confident that it would be a reliable guide to future results. Today, that confidence has largely evaporated — with good reason: Most fund managers lag behind the market and, among those who don’t, there’s no surefire way to identify the winners ahead of time or distinguish the truly skilful from the merely lucky. Indeed, the proliferation of index funds over the past two decades hasn’t just offered investors an alternative to actively managed funds. It’s also given folks a measuring stick against which to compare those active managers—and, year after year, the managers keep coming up short. What’s amazing isn’t that investors have lost confidence in past performance and their belief in exceptional money managers. Rather, what’s amazing is that it took so long.

Broken Yardsticks: Starting in the 1990s, stock market valuations broke out of their historical range and climbed skyward. Old-timers warned that valuations would soon come crashing back to earth. They’re still waiting. To be sure, rising price-earnings ratios and declining dividend yields can be partly explained by falling interest rates, which have made stocks more attractive relative to the main alternative — bonds. But it seems some enduring financial trends are also driving the rise in stock valuations, including falling investment costs, ever more capital available to invest, a rising appetite for risk, corporations’ growing preference for stock buybacks over dividends, and the move to spend less on plant and equipment and more on research and development. This last change has resulted in lower reported earnings and hence higher price-earnings multiples. The upshot: Today’s stock market valuations are undoubtedly rich by historical standards. But it’s hard to know what to do with that information or whether we should even worry—because it doesn’t tell us anything about short-term returns and it may not be that important to long-run results.

Today’s tiny bond yields: The biggest impact is on retirees. Indeed, the core strategy for many retirees — buying bonds and then paying the household bills with the interest — simply doesn’t work anymore. After all, how many retirees are rich enough to live off a portfolio of high-quality bonds, which today would likely kick off less than 6% in India? It’s time to stop thinking about bonds as a standalone investment. Instead, their sole remaining role is as a complement to stocks. They can provide offsetting gains when the stock market nosedives, a rebalancing partner for stocks, and a way to raise cash if it’s a bad time to sell shares. Clements’ advice for retirees: Forget investing for yield and instead aim to earn a healthy total return by allocating at least half your portfolio to stocks. In buoyant years for the stock market, look to harvest gains. In rough years, get your spending money by selling bonds and cash investments.

Enduring a decline in share price in wonderful companies

In his blog, Jon reminds investors that the stocks of great companies are not immune to a deep decline in the share price. In fact, it’s practically guaranteed to happen more than once. Hendrik Bessembinder followed up on previous research with a deep dive into the greatest companies ever. His first conclusion shouldn’t be too surprising. The most successful company investments in terms of wealth created for shareholders at the decade horizon also involved a very substantial peak-to-trough decline in the share price. Even those investments that are the most successful at long horizons typically involve painful losses over shorter horizons.

Bessembinder looked at the top 100 companies based on shareholder wealth creation by decade since 1950. He then measured the largest decline in share price shareholders faced in that decade. Investors in the greatest companies faced a decline of 32.5%, on average, despite being one of the greatest decades of performance ever. That was just the largest decline, on average. It says nothing of the second, third, and so on a decline during the same decade. AT&T shareholders got off easy, seeing a decline of only 5.9% (over 7 months) in the 1950s. However, Netflix shareholders suffered the worst — a 79.9% drawdown (over 16 months) in the 2010s.

Bessembinder also looked at the decade, prior to the greatest decade of wealth creation, and found shareholders suffered an average decline of 51.6%. Again, that was just the largest decline for the previous decade. The duration of the decline fell in a wide range. They lasted anywhere from a month to three years in the same decade of the company’s greatest wealth creation. In the prior decade (to the greatest decade), in some cases, the decline exceeded eight years!

There are a few important takeaways from this:

First, sometimes great companies stumble. It can take management years to fix the problem (see Microsoft) or come up with a new product/innovation (see Apple) before the company moves in the right direction again. This can create multiple periods of massive wealth creation by the same company as seen in the table above.

Second, sometimes the market gets way ahead of itself in the short term. It gets the growth story right (see Amazon) but the timing is off by a decade. Expectations send the stock price soaring but once instantaneous growth is off the table, the price corrects, sometimes to the opposite extreme.

Third, and not surprising, long term shareholders must endure multiple, and sometimes painfully long decline to reap great rewards. This would confirm that the hardest part of investing is often just holding on.

Fourth, investors have multiple chances to buy great companies at wonderful prices. They usually have ample time too. Now, the usual caveats apply. Neither the buying opportunity nor the greatness of the company is always obvious at the time. But the fact stands. Declines in share price are buying opportunities for patient investors who have done the work and identified great companies in advance.

The broader point is this. It’s up to investors to separate the company from its stock price because declines are inevitable. But a great company’s stock will not only recover but go on to be extremely rewarding.

Your financial portfolio and Japanese principles

Writing in Fortune, Sandeep Das leverages principles from Japanese culture to build an effective financial portfolio. Japanese culture is leveraged upon sustainability, longevity, humility, and quality—exactly what most working professionals crave for today.
Don’t be ashamed of wealth creation: Buddhism, one of the major religions in Japan, advocates that individuals need not be ashamed of or feel guilty about wealth creation. It is not morally inappropriate to try to create immense wealth. The only folly individuals should be careful about is not to be enslaved by that desire or to lead a life with the single-minded focus on wealth creation or excessive flaunting.

Imbibe financial minimalism: A derivative of the above principle is Japanese minimalism—or having things that are absolutely necessary and removing all forms of clutter from one’s life. A direct analogy to financial portfolio management involves avoiding having too many investments in each asset class. In case of investing in a debt asset class, one or two low-risk debt instruments should suffice rather than a dozen of them. Similarly, with equities, one or two mutual funds should suffice for domestic and international markets. This also applies to other financial habits, implying that having one or two credit cards and one or two bank accounts only.

Wabi-sabi, leading a perfectly imperfect life: The principle of wabi-sabi (wabi implying rustic simplicity and sabi implying taking pleasure in the imperfect) corresponds to accepting imperfections in life, making the most out of them, and moving on. Bad investments are commonplace for almost all individuals and it is essential to embrace these mistakes and move on. Rarely does anyone get all their investment decisions correct. It is detrimental to perennially live with a deep sense of financial regret. However, over a period, the proportion of risky investments (including equity) should be consciously brought down and relative safety of the portfolio should be consciously increased.

Avoiding karoshi, death caused by overwork: In financial parlance, it translates to being excessively obsessed on the financial returns leading to hourly portfolio tracking. It is highly advisable to avoid reading too many hot tips or opinion pieces and following the hyperactive journalists screaming all day on television promising you financial nirvana. Too much churn or regular tracking only adds to daily misery. It is suggested to track your portfolio once a year, at best, and avoid making too many transactions.

Follow your Ikigai: Ikigai translates to living your purpose every day is one of the biggest exports of Japanese culture. At the end of the day, pursuing money can rarely be someone’s Ikigai as it leads to a very shallow and meaningless life. Ideally, money should be treated as an effective enabler while the individual follows his Ikigai—an intersection of what someone is good at, what he enjoys, what the world is ready to pay for, and what the world needs, ruthlessly.

Times that try stock picker’s soul

Drew Dickson points out that there is one way to generate excess stock market returns over the long term, and it isn’t to “own winners at any price.” Sure, in hindsight it was, but that is very convenient. It’s very convenient to now ignore the stocks we thought were winners but weren’t. It’s also very convenient to draw parallels between past winners and newer companies as if it is a foregone conclusion they too will win in a similar fashion. Nor do excess returns come from “owning good companies at any price” or “owning high-quality companies at any price.” The “one way” to outperform is to buy a concentrated portfolio of securities that Mr Market doesn’t own; names which are shunned because Mr Market has become overly pessimistic about the fundamental prospects for businesses that are better than he believes or realizes. That’s it. That’s the formula.
This often isn’t sexy, it often isn’t fashionable, and it often isn’t fun. However, a successful investor outperforming Mr Market over the long term owns companies that, by definition, Mr Market believes are pretty stupid to own.
Instead, Mr Market often thinks growing, glamorous, names are much smarter to own. They definitely are smarter looking. And it is surely more entertaining to own these stocks. It’s also easier to sleep at night. They are obviously more dynamic companies and, in many cases, they indeed are better companies. And there are periods where these growing, good and glamorous names do tremendously, well. During these episodes, it downright sucks to be a fundamentally-driven value investor. Equity markets had one of those periods in 1998-1999, and – in Dickson’s view – they may be having another one of them now. Paraphrasing Thomas Paine, these are the times that try stock-pickers’ souls.
The stock market, at least at the moment, seems most sensitive to whether or not a company is classified as a “good” or “bad” business. And “good” means your stock has already appreciated, is already expensive, and is showing even the slightest degree of business momentum. And no price is high enough for “good”. Because good is good, so why wouldn’t you own it? “Bad” is the opposite. Bad is an already-inexpensive stock that has already sold off, and one that has already exhibited fundamental weakness, even if it’s likely a short-term phenomenon. And no price is low enough for “bad”. Because bad is bad, so why would you own it? As maddening as this behaviour is, it is typical of investor psychology at peaks and troughs; and consequently, the “price” of growth is higher than it has ever been.
Dickson asserts that there is no new era. Stocks are still worth the present value of their future cash flows. While narratives can dominate in the short term, and while the short term is sometimes longer than we like, the fundamentals eventually matter. They have to. We are buying fractions of the equity value of large, liquid, listed, enterprises. The fundamentals “have to matter” because these fractions of equity, these shares, are worth the present value of all future cash flows to that fraction of ownership. We have no idea when “eventually” is going to arrive. Whether or not we are three days or three years away from this growth bubble popping, he doesn’t know. But he is tremendously confident that it isn’t “different this time.”

Think Like a Winner

As an individual investor, what’s the key to success? It’s a question Adam Grossman hears a lot, especially in volatile times like this. The answer, he thinks, is that there isn’t just one key, but rather five. The most successful investors seem to be equal parts optimist, pessimist, analyst, economist and psychologist. Together, he calls these the five minds of the investor. If you can develop and balance all five, that—Grossman believes—is the key to investment success.

  1. Optimist. When Grossman thinks of financial optimists, he immediately thinks of Warren Buffett. Now, you might imagine that it’s easy to be an optimist when you’re a billionaire. But he thinks it’s because Buffett is an optimist that he’s a billionaire. His secret—which really isn’t such a secret—is to bet on the long-term growth of the stock market. When the economy is in a recession, as it is today, with millions out of work, it’s easy to feel dispirited. It is scary, and I don’t want to diminish everything that’s going on. But as Buffett wrote in that 2008 article, “Fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.” Of course, you can’t have 100% of your money in stocks. That brings us to the role of the pessimist.
  2. Pessimist. Many people view themselves as either a glass-half-full or glass-half-empty kind of person. But for investment success, he thinks you want to be a little of each. You’ll notice that Buffett referred to the stock market’s long-term potential. That’s an important qualification. As we’ve seen this year, things can—and do—happen that interrupt the market’s growth. That’s why it’s important to pay as much attention to your inner pessimist as to the optimist. What’s the best way to accomplish that? It isn’t complicated: You just want to keep enough of your assets outside of stocks to help you weather these interruptions. That will give you both the financial ability and the mental fortitude to get through tough times.
  3. Analyst. If the optimist believes that stocks will grow over time, and the pessimist knows that they can’t grow all the time, how do you balance the two? That’s where the analyst comes in. The role of the analyst is that of a mediator—to consider the needs of both the optimist and the pessimist. Your inner analyst should be dispassionate, focusing on the facts of your individual situation. This includes your income, expenses, assets, liabilities and goals. In short, the analyst’s job is to strike the right balance between optimism and pessimism to develop an investment strategy that’s the best fit for you.
  4. Economist. Economics isn’t exactly a scientific field and anyone’s ability to forecast the future is necessarily limited. But successful investing does incorporate certain economic concepts. At a high level, these include fiscal policy (the government’s ability to set tax rates and spending levels) and monetary policy (the Central Bank’s ability to set interest rates). And finally, it includes a sense of economic history and financial cycles. None of this means you’ll be able to predict where the economy is going. None of us can. But it does mean you’ll be better equipped to respond to events as they occur.
  5. Psychologist. Colourful commentary and dramatic predictions are all around us. That’s why the fifth, and maybe most important, ingredient for investment success is to channel your inner psychologist. Among other things, this will help you to understand the motivations—both conscious and unconscious—of others, and to see the subtext of what they’re saying and not saying. This will help you to tune them out, as needed, so you can stick to your plan.

Is investing easy? No, he doesn’t think anyone would (truthfully) claim that. But if you successfully balance these five ideas in your mind, Grossman believes you’ll tilt the odds in your favour.

Good things taken too far

Morgan Housel reminds investors that good things can be taken too far – helpful at one level and destructive at another. They can be more dangerous than bad things because the fact that they’re good at one level makes them easier to rationalize at a dangerous level. A lot of things work like that, don’t they? Good things – praise-worthy things – that in a high enough dosage backfire and become anchors?

A few Housel sees in investing:

  1. Contrarianism is great because the masses can get it wrongBut constant contrarianism is dangerous because the masses are usually right. Identifying and avoiding times when millions of people have been derailed by bad incentives and a viral narrative is a wonderful thing. Most investment fortunes come from a bout of contrarianism. But a larger group of investors has turned contrarianism into something closer to cynicism. Their contrarianism is constant – at all times, for all things. The quirk is that if you survey the list of extraordinarily successful investors, entrepreneurs, and business owners, virtually everyone has been a contrarian. But none – not a single one – is always a contrarian. There’s a time to bet against mass delusion, and (more frequent) times to ride the progress that comes from billions of people collectively searching for the truth.
  2. Optimism is great because things get better for most people over time. But it’s dangerous when twisted into the belief that things will never be bad, which is never the case. A lot of people pick optimism because they rightly, correctly, get excited about the long history of progress mixed with confidence in their own skills. But when optimism is taken so seriously that it assumes things will never be bad – that every period long or short will work out in your favour – it turns into complacency. It encourages leverage and promotes denial. It leaves you without backup plans. Worst, it causes you to wrongly second-guess your long-term optimism when faced with an inevitable setback. You can be right about optimism in the long run but fail to ever see it because you overdosed on it in the short run.
  3. Being open-minded is great because the truth is complicated. But being too open-minded backfires because objective and immutable truth exist. Every smart attempt to be open-minded has to be accompanied by a strong nonsense detector. The detector should go off when any of a handful of laws are violated when the author’s incentives favour an outcome, and when a complex answer is given if a simple one would suffice. You have to be firm enough in your views to make confident decisions while being open to new views in a way that lets you occasionally update and change those decisions. “Strong beliefs, weakly held” as they say.

What Risk Isn’t

Nick Maggiulli asks the investors what is the risk? Wikipedia defines it as “the possibility of something bad happening.” In the investment industry, we commonly associate risk with standard deviation, or how often an investment’s return varies from its average return.  More simply, if investment A has annual returns of +4%, +4%, +4% and investment B has annual returns of +4%, -9%, +19%, then investment B would be deemed “riskier” than investment A despite having the same long-term growth rate. But is the standard deviation the best definition of investment risk?  Not necessarily.

For any prudent investor, the difference between volatility and risk comes down to what is known versus what is unknown.  As Donald Rumsfeld once said: There are known knowns; things we know we know. There are known unknowns; things we know we do not know. But there are also unknown unknowns — things we don’t know we don’t know.

Volatility is a known unknown, while the risk is an unknown unknown. Volatility is a known unknown because though we cannot predict future volatility, we can make reasonable guesses about its future range. This is why Maggiulli doesn’t equate risk with volatility.  People will say that an investment is “too risky” for them, but what they usually mean is that it is too volatile.  Some investors prefer the predictability of bond income while others want the thrill of individual stocks, options, and leverage.  This isn’t about risk, but about the kind of expected returns, an individual investor prefers.

But, the risk is another beast entirely.  Because risk is about the things that happen that can’t be expected.  As Josh Wolfe has preached many times: Failure comes from a failure to imagine failure. That’s where risk lives. Maggiulli says that 2020 has made him realize that black swans (an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences) are the only kind of risk that matters.  Why?  Because they are the only kind of risk that can’t be prepared for, and, thus, the only kind of risk that can cause catastrophic loss.

Maggiulli asks so how do you prepare for something that can’t be prepared for?  You try the best you can.  Do scenario planning.  Have ample liquid savings.  Search for flaws in your investment hypotheses.  If you spend time to think about what is possible, then you might just be able to save yourself from some of these black swans. Yes, there will always be future scenarios that you can’t conceptualize or account for initially.  But, where is the harm in trying?  Because risk isn’t the possibility of something bad happening.  Risk is the possibility of something bad happening that you didn’t plan for.