Sound Money

Great practical investment advice that pushed me to reflect on my thinking and approach to investments. Well worth a read! For now, I don’t think I can do the insights any more justice than merely summarising a number of the key points.

Marks didn’t set out to write a manual for investing. The book is a statement of his investment philosophy, his creed, which has served him as a religion over the years. The philosophy was honed over 4 decades and been implemented by 4 skilled individuals who share culture and values. A philosophy like this emerges from going through life with your eyes wide open, being aware of events, and their results. In this way, investors are able to put to use those lessons again in the future when similar conditions arise. “Experience is what you got when you didn’t get what you wanted. Good times only teach bad lessons; that investing is easy, that you know the secrets, that you don’t need to worry about risk.” The goal of the book was not to simplify investing but to make it clear just how complex it is. Those who over-simplify investing do their audience a great injustice.

Few people have what it takes to be great investors. Some people can be taught but not everyone. No rule always applies and circumstances almost never repeat exactly. Anyone can achieve average investment performance. The definition of successful investing is beating the market. To accomplish this you either require good luck, which is impossible to achieve consistently, or superior insight. What makes you believe that you have superior insight? What Ben Graham terms “a trace of wisdom”… Second level thinking is essential to generate insights that are advantageous relative to the highly competitive market. Thinking in this way is deep, complex and convoluted. Many things must be taken into account:

• The range of possible outcomes and the probability that they will occur?
• Favoured outcome; yours and the consensus?
• Difference between your expectation and consensus? Why?
• How does the current asset price compare with consensus expectations and yours?
• Is the consensus psychology too bullish or bearish?
• What will happen to the asset price if expectations are correct? Yours and consensus?

Markets have efficiencies – like the ability to evaluate a new piece of information and incorporate a new consensus interpretation of that information quickly. The consensus view is not necessarily correct though. Market inefficiencies also exist. It is important to question those inefficiencies. Why should a bargain exist given the presence of thousands of smart investors? What are the hidden risks? Why is the seller selling? Do you really know more than them?

You cannot do the same things as others and outthink consensus. “In every game of poker there is a fish. If you have played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is true about investing. Unconventional thinking is critical to outthink consensus but it shouldn’t be a goal in itself but rather a mindset.

Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of a conviction that their current value is high relative to the price. Growth investors buy stocks (even those with a low current value relative to price) out of a conviction that the value will grow fast enough in the future to produce substantial appreciation. The choice is actually between value today and value tomorrow! Compared with value investing, growth investing entails looking for big winners that will produce big growth in the future. If growth isn’t in the offing, why take the risk of guessing a highly uncertain future? The batting average for growth investors should be lower than value but it is funny that the experience of the post-2009 world is the opposite where value investors batting average has been lower.

Fundamental value is the most NB factor when determining if a price is right but most of the time a securities price will also be affected by psychological and technical factors too. Forced selling, for example, is a great technical time to purchase. Unfortunately, these opportunities rarely present themselves but they also highlight the importance of not being a forced seller oneself.

Investing is a popularity contest. The most dangerous thing to buy is something at the peak of its popularity. The safest and potentially most profitable asset to buy is something that is unpopular.

Risk is a topic that Marks dwells on for a while. He takes note of the many shortcomings of this subject, integrating Nassim Taleb excellently. Volatility is a convenient measure of risk for academics but is entirely inappropriate for real investing. Investors are primarily worried about a permanent loss of capital, or poor returns, not price volatility. Other risks to bear in mind:

• Falling short of the goal
• Underperformance, but this is also a natural consequence of trying to beat the BM and should be expected from time to time
• Career risk emerges if underperformance is extreme
• Unconventionality – there are risks to being different, particularly if it results in underperformance
• Illiquidity is a major problem for some people

The most common bell-distribution is the normal distribution but they are not the same. A normal distribution is a specific bell-shaped distribution where events in the distant tails happen infrequently. Financial market distributions are heavily influenced by humans and are more likely to have fat tails than a normal distribution.

Additional problems with risk: Investment risk is largely invisible before the fact and can remain unseen even after the investment has been exited. We don’t know what we never saw. For example, house insurance is a “waste of time” until the rare fire takes place. Risk only exits in the future and it is impossible to know what the future holds. For example, historical fires that almost took place are no longer a risk. People underestimate the potential for change and can underestimate risks as a result – we tend to extrapolate the most recent past, forecasting little change. For example, there were no fires in the last 10 years, so maybe there won’t be any fires in the next 10 years? The longer we are from the last crisis, the more complacent we become that another crisis won’t emerge but exactly the opposite is often true. For example, numerous small forest fires reduce the probability of a big devastating forest fire but a long period without a forest fire leads to a build-up of dead wood that risks creating a devastating forest fire. A similar relationship exists in complex human systems like economies where small but regular failures reduce the chances of systemic failures. For example, a steady rate of failures creates a resilient or, in the words of Taleb, anti-fragile economic system. By contrast, propping up failing companies with bailouts, low-interest rates and supportive fiscal policy creates economic fragility and greater probability of systemic failure.

Worst case scenarios often turn out to be too conservative. The historical worst-case scenario only holds until it is surpassed, so focusing on the worst-case scenario is very risky. When risk shows up, it can be lumpy and all at once. People overestimate their ability to gauge risks. Many investors see risk take as primarily a way in which to make money. While return seeking usually implies bearing risk, risk bearing doesn’t actually produce the return. If it did, risky investments would not be risky!

A central element to risk creation is the belief that risk is low, or perhaps gone. Macro risk will only be low if the majority of investors are acting prudently. So we have to ask ourselves, “what is the risk mood?” Are there high/low levels of scepticism/optimism? Are markets tending to respond positively/negatively

Investing, like economics, is more art than science. An investment approach must be intuitive and adaptive rather than fixed and mechanistic.

Just about everything is cyclical. Mechanical things can go in a straight line but only when adequately powered. Humans create processes like history and economics. Humans are emotional and inconsistent, not steady or clinical. An overvalued asset or bubble usually starts with a good fundamental idea or an objectively attractive asset but as people raise their opinion of the asset, the price often goes up and more people want to own it as a result. The process feeds on itself, reinforcing and exacerbating the cycle. By contrast, a bargain usually displays an objective defect or weakness. The orphan asset becomes ignored or scorned over time and investors fail to assess the asset objectively or fairly. People start saying things like, “who would want to own that?” First-level thinkers extrapolate the past negative performance and become psychologically scarred by the bad performance but, in reality, the asset got cheaper when the price fell and more attractive as a result!

We must be able to combat negative influences. Marks focuses on the psychological aspects, like the desire for money, which at it’s extreme results in greed. There is nothing wrong with making money but greed can overcome common sense, risk aversion, prudence and memory of past lessons, which are the tools that can help an investor get out of trouble. For example, greed causes an investor to throw his/her lot in with the crowd at exactly the time when they should stick to their positioning. Conversely, fear is problematic, causing willing suspension of disbelief and a lack of decision making. Investors need a healthy dose of scepticism in order to avoid just following the crowd. Brevity of financial memory is a major cause of investors ignoring lessons from the past. Investors are always looking for a free-lunch, the silver-bullet or the Holy Grail but everyone wants this and it almost never exists. Nevertheless, people fall into this trap during every cycle and forget to ask why it hasn’t been arbitraged out already. Hope springs eternal but is a bad investment strategy. Conforming to the herd is comfortable but is causes investors to drop their independence and scepticism, which is where the true value lies. Envy is perhaps an even stronger emotion than greed. It is terribly hard to sit and watch others do well. Often the comparisons aren’t realistic but an individual can forget, envy the competition and change strategy in order to compete. Good returns bring about ego rewards, which feels good, but it doesn’t actually imply that the investor achieved good risk-adjusted returns. A good investor can toil in obscurity without having their egos stroked by periods of sublime outperformance but could steadily outperform with much lower absolute risk. Capitulation is a regular feature of investor behaviour during every cycle, even amongst intelligent investors. When the psychological pressures become irresistible, we surrender and jump on the bandwagon.

Weapons to increase our odds against the psychological pressures:

• Strong sense of intrinsic value
• Insistence on acting as you should when the price diverges from value
• Engagement with past cycles creates understanding the market excesses are ultimately punished, not rewarded
• A thorough understanding of the insidious effect of psychology at market extremes
• A promise to remember that when things seem “too good to be true” they usually are.
• A willingness to “be wrong” when markets go from overvalued to more overvalued
• Like-minded friends and colleagues who can provide support

On contrarianism by Sir John Templeton, “to buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage but provides the greatest profit.” Most investors are trend followers. Superior investors are the exact opposite. Once in a life-time extremes are very profitable. While it is impossible to pick these extremes perfectly, the discipline of attempting to do so should be an important element of the process. Scepticism calls for pessimism when optimism is excessive but it also calls for optimism when pessimism is excessive. A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

There aren’t always great assets to invest in. Sometimes patient opportunism is required where we allow the investments to find us. Using a baseball analogy, “wait for the right pitch” or cycle in which to invest. Acting without assessing conditions, ignoring the conditions or believing you can change the conditions is unwise.

“There are two types of forecasters, those who don’t know and those who don’t know what they don’t know” - JK Galbraith. Forecasters can be correct but they are rarely consistently correct. Most extrapolate the recent past in order to be reasonably close to correct a large majority of the time. This implies that they will be vastly incorrect when the cycle turns, which is when the forecasts matter the most. Failure of imagination is another major psychological trap where investors fail to imagine the full range of potential outcomes. Most investors belong to the “I know school”:

• Think that knowledge of the future direction of economic variables is essential for success
• Confident they can achieve this knowledge
• Aware of others doing the same thing but either think everyone can be successful together or that they will be one of the successful few
• Comfortable investing based on opinions of the future
• Happy to share views with others even though these should be protected if they have any value

Investors who think they know the future act differently to those who don’t hold this hubris. “I know investors” make directional bets, concentrate positions, lever holdings and rely on future growth. By contrast, those investors who are uncertain about the future diversify, hedge, lever less and emphasise value today over growth tomorrow.”

Just because we cannot predict the future doesn’t mean we mustn’t try and understand the present. Understanding current conditions allows us to stay alert, discover periods of market extremes, adjust behaviour and refuse to fall into the herd. Understanding current position is difficult though and requires lots of analytical work!

We must appreciate the role of luck; it is often an important determinant of performance. Someone can buy an asset expecting a certain development, the opposite occurs but the asset goes up anyway. The investor looks good and usually accepts the credit. In reality, the true correctness of the decision cannot be judged by the outcome but that is usually how it is assessed.

Act defensively. “there are old investors, and there are bold investors, but there are no old bold investors.” Ellis Short’s Looser Game: Often investment is more similar to an amateur tennis match where we are trying to avoid unforced errors, rather than a professional tennis match where players are attempting to hit winners because unforced errors are so low.

To end, another great quote, which highlights the weakness of a simplistic understanding of mathematical risk measures, “Never forget the 6-foot tall man who drowned crossing the river that was 5-feet deep on average.”