#13: Use a good filter with your search strategy
When Bill Ackman was recently interviewed on Bloomberg Television, he was asked if he was interested in Hewlett Packard given its recent large sell-off. Ackman commented, “One of the things I learned a lot earlier in my career is to do a calculation which I call return on invested brain damage, which is before I make an investment which requires brain damage, or a lot of work and energy, I figure out how much money I can make. The higher the brain damage, the higher the profit has to be to justify it.”
Ackman does not want to spend time on an idea if the payoff isn’t large, particularly if it is a complex idea requiring extensive analysis. Ackman also said, “I have the fairly quaint notion that the value of anything is the present value of the cash you can take out of the business over its life.” So, if a business is not predictable, he will take a pass and look for something that is.
Buffett has similar filters before he will get interested in an idea.
First, he’s looking for “seven footers”. Making an analogy to putting together a basketball team, Buffett wants ideas with obvious big upside potential. Only after finding a seven footer would he invest the time to check his skills, character, grades, etc. He also wants ideas where, if he could, he would put his entire net worth in the idea. He is not interested in taking a flyer on something.
The lesson here is obvious. Time is short. Don’t squander it on ideas that don’t offer large asymmetrical payoffs, especially if its something you could literally spend a year on and end up with a lot of superficial knowledge but no real insights into its future prospects.
#14: Don’t dabble
When an average person goes to an accountant, they expect, and usually receive, value in exchange for payment. Likewise, when hiring a plumber, electrician, attorney or any number of other specialists, the average layperson receives reasonable value in the exchange.
When it comes to money managers, though, this may not be the case. There is a lot of data that shows that, as a group, money managers’ performance equals that of the general market minus the frictional costs they incur in the form of fees, commissions, slippage, and taxes. How could it be otherwise? Many savvy investors such Bogel, Buffett and Greenblatt advise that average investors simply invest in an index fund and pocket these frictional costs. This is certainly a rational approach, and, as long as expectations are kept in check, it is likely to generate a reasonable return over the long term. Also, it has the added benefit of minimizing, if not eliminating, self inflicted wounds.
What about going it alone as an active investor? I think Buffett is correct that a person who spends an hour or two a week on investing has the potential to get a significantly worse result than simply buying and holding an index fund, particularly if he is doing focused value investing. Being able to value a company is sine qua non for successful value investing and this requires time and experience. Without good valuations grounded in independent work, you will lack the necessary conviction to buy meaningful positions and hold them through the inevitable ups and downs of the market. You could also get seriously burned if you buy something that looks “cheap” that really is a lousy, deteriorating business.
So why do many investors – even those who call themselves value investors – continue to dabble?
First, speculating can be very exciting and enticing. People can go to great lengths to speculate, even if it means dressing it up as value investing. Second, because investing outcomes are a result of both luck and skill, it is easy to draw the wrong lessons from one time successes or bull markets that generate good results for everyone, even know-nothings. These misguided lessons can lead to the conclusion that it is easy to make money in the markets. This is closely related to over-confidence bias which continues to draw patsies into the markets even when they bring nothing to the table and can offer no sound reason why they should generate a sound return when trading against well informed, sophisticated counter-parties.
Therefore, if you want to beat the market, don’t dabble. Dedicate yourself to it in a serious fashion or find a professional with the right investing framework and psychological makeup who will. Short of that, you’re better off investing in an index fund.
#15: Become a master Some years ago, George Leonard wrote a wonderful book calledMastery which gives wise advise on how to become highly skilled at something. The book has helped many people in numerous endeavors and continues to be widely read today. I contend that consistently beating the market requires a high level of skill and that one would be well served by paying attention to what Leonard has to say on the subject of mastery.
Leonard teaches that true mastery requires an understanding that learning a new skill comprises brief periods of progress punctuated by long, successively higher plateaus, and even this does not always happen in regular clockwork fashion. During these plateaus further progress seems elusive. Yet, even without being conscious of it, learning continues. Lessons are being assimilated and the mind and body are preparing for the progress necessary for reaching the next plateau.
The key is recognizing and accepting that this is the nature of pursuing mastery. And that learning to love the plateau is an essential requisite for getting where you want to go.
Leonard further explains that there are three opposing and deficient character types which thwart the pursuit of mastery and short-circuit its attainment: the dabbler, the obsessive and the hacker. The dabbler begins the pursuit of mastery and initially makes good progress. However, once the dabbler hits the first inevitable plateau, he loses interest and moves on to something else. The obsessive thrives on getting better and settles for nothing less than continual progress. To fuel this progress, he throws himself into the task at hand and presses hard – too hard. Eventually he becomes burnt out and moves on to something else. Finally, there is the hacker. After some initial progress, the hacker hits a plateau where he is content to stay, never spending the time or effort to grow and move on to greater levels of skill.
To beat the markets requires mastery. Learn to love the plateau by finding joy in doing the necessary work, confident that real progress will follow and true skill will develop in time.