ValuePickr Forum

Building the right investing temparament

Over the years, I have come to the conclusion that the most critical aspect in investing is to be able to build the right temperament. To me this is the secret sauce that separates the men from the boys and enable some to consistently outperform others, and their benchmarks.

Temperament is something that needs to be learnt through experience. We can augment it by taking a leaf out of the book of the masters. Over the last 15 years, I have tried to read as much as possible about experiences of great investors and fund managers, to try to understand how to improve my temperament.

Let me start this thread with the writings of a great investor who I have followed for the last decade. Not only is he a great investor but he is a fantastic communicator and has that rare gift of making complex subjects appear simple. He also is extremely generous in sharing his knowledge and experience with the general public. He is Howard Marks.

You can read his book “The Most Important Thing Illuminated”

His memos are available at https://www.oaktreecapital.com/insights/howard-marks-memos

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Here are some excerpts from his book and some commentary where it is necessary:

To me, risk is the most interesting, challenging and essential aspect of investing.

The real test of investing is not getting returns but ensuring the downside is always protected. As Buffett has said famously, “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”

You must be aware of what’s taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this - more than anything else - is what dooms most investors to being victimized repeatedly by cycles of boom and bust.

History, of markets and in general, is essential to know. You need to understand the causality of consequences of events. Those who do not know history are condemned to repeat it. Which basically means you need to have some mechanism of capturing your past mistakes for posterity and are able to ensure that they are not repeated again.

ACTIONABLE - A checklist of past mistakes and the reason those occurred is a good starting point.

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Since other investors may be smart, well-informed and highly computerized, you must find and edge they don’t have. You must think of something they haven’t thought of, see things they missed bring insight they don’t possess. You have to react differently and behave differently.

Out of the main four edges that an investor can have, namely i) information, ii) analytical, iii) knowledge and iv) time, here Marks is talking about the analytical or insights edge. With the same set of information, can you have better or different insights which will result in a differentiated result for your portfolio.

To achieve superior investment results, you have to nonconsensus views regarding value, and they have to be accurate.

For your performance to diverge from the the norm, your expectations - and thus your portfolio - have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.

I think this is the simplest yet most overlooked part. You cannot get superior results by doing what everyone around you is doing. Some investors I know of surround themselves only with people who have very similar viewpoints about life and markets. To me, they are living in an echochamber. To really have a nonconsensus view, you have to actively look for disconfirming evidence. That is, an idea which is exactly opposite to the one you hold.

As Charlie Munger has said, " It’s bad to have an opinion that you are proud of if you can’t state the arguments for the other side better than your opponents."

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There are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that belief strongly enough to be able to hang in and buy as price decline suggests you are wrong. Oh yes, there’s a third:you have to be right.

This will only come from experience of being right about your view.

For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are a few assets so bad that they can’t be a good investment when bought cheap enough.

There’s no such thing as a good or bad idea regardless of price!

This is a critical point that people miss in their quest for “quality” stocks!! Quality is not irrespective of price.

Investing is a popularity content, and most dangerous thing is to buy something at the peak of popularity. At that point, all favourable facts and opinions are already factored into its price, and no new buyers are left to emerge.

There is no easy way of identifying when the peak of popularity is reached. But one should have a general sense of when prices have gone up way beyond their worth. And then the trick is to have the emotional fortitude of getting out of the position.

The safest and potentially mist profitable thing to do is to buy something when no one likes it. Given time, it’s popularity, and thus it’s price, can only go one way: up.

This requires a certain mindset of contrarianism and ability to sit through extended period of non-performance of stock price. This may specially be difficult when other stocks are running up consistently.

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I am reading Howard Marks for many years now but never tried to pin down my thoughts in a piece of paper … Here it’s a good opportunity to do so… And if it adds value to others good, else it is basically my own memo to myself :slight_smile:

Courtesy @basumallick I bought TMITL, and it helped in coalesce all ideas in systematic manner in head though I was aware of all the all the learnings for quite a few years now.

I would try to go key pointwise

Howard Marks was quite clear that everyone can’t be an investor just by learning investment … There is no simple, step by step learning process for investment. It needs Second level thinking and insights which is not common, can’t be taught and requires massive mental workload. Success of investing is an anti-thesis of simple … Only three types of people think Investing success is simple… a) Those who teach investing; b) some well intentioned practitioners who over estimate the extent to which they are in control and c) Those who simply don’t fathom the complexity of the subject … Who in HM words are “first level thinkers”.

All investors can’t beat the market as collectively they are the market. To quote HM … “Many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that prevalence of first level thinkers increases the returns available to second level thinkers.” … For me, the task is to continuously seek ways to think different, think alone and think deep. It is a lonely sport, can be best played alone. Some collective information gathering may help, collective decision making can’t, even if it’s done with other second level thinkers.

Second point is on Market efficiency or efficient market theory … I feel, HM covered it in one line somewhere that “Market efficiency” means market is “quick, fast, speedy” to incorporate any new information. But market is not always “RIGHT” or “CORRECT” in its absorption of information. But mentally we associate Market Efficiency as “Right and Correct” not “Speedy and Quick”… It was a major shift in my own thinking when I was really absorbing the thoughts.

Third point is associating Return with Risk and the general hackneyed misconception of Risk Return tradeoff … High return high risk etc. These are ideas drilled in our head and we accepted it because of the rigor with which it was presented before us, not because of the intrinsic merit of the arguments. Risk happens in future and simply it can’t be measured today. Portfolio return never tells the inherent risk the investor took in the first place. If high risk generates high returns then it doesn’t remain risky and when it doesn’t work then it REALLY doesn’t work; and people are reminded of the meaning of the word “RISK”. People overestimate their ability to gauge risk and understand the mechanism.

The succinct point about investing which I quote

“… Investment performance is what happens when a set of developments — geopolitical, macro-economic, company level, technical and psychological — collide with an extant portfolio. Many futures are possible but only one future occurs.” … To me it’s one of the most important philosophy to etch on the head.

Will write more if find time and if people think it’s useful.

Thanks for reading… :slight_smile:

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Howard Marks has written extensively on risk and its management.

The riskiest things: the most dangerous investment conditions generally stem from psychology that’s too positive. For this reason, fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.

The greatest risk doesn’t come from high quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.

Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe.

Risk is inherent in the price you pay for stocks. The higher price you pay, the higher risk there is. Irrespective of the quality of the business.

The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities.

No one knows the future, so deterministic projections make little sense. It is better to think in terms of a range of outcomes that covers the most likely future scenarios.

Invariably things can get worse than people expect. Maybe “worst case” means “the worst we’ve seen in the past”. But that doesn’t mean things can’t be worse in the future.

Careful risk controllers know they don’t know the future. They know it can include some negative outcomes, not how bad they might be, or exactly what their probabilities are.

Case in point, 2008, was much worse that what most investors had expected.

I’m very happy with the phrase “perversity of risk”. When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counter-intuitive.

My core investment assumption is that the market is a complex adaptive system and is auto-correcting in nature. we cannot determine outcomes from a linear thought process.

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.

If you minimize your losers, the winners will take of itself!

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Being attentive to cycles
• Just about everything is cyclical. Cycles always prevail eventually. Nothing goes in one direction forever.
Awareness of the pendulum
• There are a few things of which we can be sure, and this is one: extreme market behaviour will reverse. Those who believe that the pendulum will move in one direction forever - or reside at an extreme forever - will eventually lose huge sums. Those who understand the pendulum’s behaviour can benefit enormously.

This is one of my core beliefs. In sports, we call this by “law of averages” or “rub of the green”. Mean reversion works, but in some cases, you may need to have a suitable long term time frame to judge its impact.

Combating negative influences
• Many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
• From time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price. We must constantly be on the lookout for things that can’t work in real life. In short, the process of investing requires a strong dose of disbelief. Inadequate skepticism contributes to investment losses.

Again, something very very core to my belief system. Temperament is what differentiates the good investor from the bad. And the ability to say “No” to things or stories that don’t make sense regardless of who is saying it.

Contrarianism
• You must do things not just because they are the opposite of what the crowd is doing, but because you know why the crowd is wrong.
• Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortable idiosyncratic portfolios, which frequently appear imprudent in the eyes of conventional wisdom.
• Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

Taking a view that is different from the majority is a psychologically difficult thing to do. But the best results are obtained by people who are able to stand apart from the crowd.

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Finding bargains
• Investment is the discipline of relative selection
• Our goal isn’t to find good assets, but good buys. Thus, it’s not what you buy; it’s what you pay for it.
• The necessary condition for the existence of bargains is that perception has to be considerably worse than reality.

Ultimately, we are all looking to make money from stocks. So, even though HUL is a great business, it is unlikely to make to really wealthy. A good business is not always a good stock and vice versa.

Patient Opportunism
• Sometimes we maximize contribution by being discerning and relatively inactive. Patient opportunism - waiting for bargains - is often your best strategy.

Patience and being emotionally able to sit tight on a position or with cash is critical, although one of the toughest things to do. This is where the right investing temperament is required. As Jesse Livermore said famously and is also oft repeated by Charlie Munger, “Throughout all my years of investing I’ve found that the big money was never made in the buying or the selling. The big money was made in the waiting.”

Having a sense of where we stand
• Most people strive to adjust their portfolios based in what they think lies ahead. At the same time, however, most people would admit forward visibility just isn’t that great. That’s why I make the case for responding to the current realities and their implications, as opposed to expecting the future to be made clear.

Move beyond “hope trades” to discerning what is going on in the markets today and calibrate your actions based on that.

Investing defensively
• If we avoid the losers, the winners will take care of themselves.
• Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t knowand can’t control are hallmarks of the best investors I know.
• Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing goes wrong, surely the winners will take care of themselves.
Avoiding Pitfalls
• The success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead , you must allow for outliers.
• Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery.

Shit happens. Be prepared, atleast mentally to deal with it. Don’t put all your eggs in one basket no matter how good and insulated the basket is!!

Reasonable Expectations
• Investment expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk that is perceived.

Don’t try to overreach. Having an unreal and unjustified return expectation is the beginning to investment mistakes. Don’t pick a return (like 25% or 30% or 40%) out of thin air and hope to make that every year. It will necessarily make you do things which will eventually lead you to losses.

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My notes from Howard Marks’ presentation on 2-Mar-17:

• Definition of “great” companies is dubious. Very difficult to identify great companies over a very long period

• Investing is not a matter of buying good things, but buying things well (buying assets which are out of favour)

• Forecasting is not possible as the future is not knowable. Try to know the knowable. Focus on specific sectors, industries, companies

• The main decision to make at any point in time - whether to play defensive or offensive. You cannot play both at the same time.

• Low purchase price is more important than anything else (including quality of company)

• Have to think differently (variant perception) and better - need to have some knowledge different from everyone else

• Most investors behave pro-cyclically

• You need to have a philosophy and process that you can stick to even in most trying of times

• Most corrosive of emotions is to sit up and watch others make money

• Plan to survive the “worst day” in the market without having to sell. The challenge is we don’t know what the “worst day” will look like, but can get an idea from the past.

• Hubris, ego, over-confidence are enemies of an investor

• Your approach needs to be consistent with your personality

• Turn cycles to your advantage

• Look at E/P and compare with interest rates to get a sense of overall market valuations

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Today I am starting the re-reading of Security Analysis, 6th edition, (also will add on things from the 5th ed). I have been putting it on the backburner for sometime, but since the last time I read this was about 14 years back, decided that I have changed too much not to re-read this once more. Hoping to learn a lot more the second time around.

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From the preface to the 6th edition by Seth Klarman

Value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectable; liabilities are sometimes unrecorded and property values over - or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes.

It is not enough just to number crunch. A business participates in a complex adaptive system, which is continuously in a flux. We need to be able to understand businesses and their operating environments; political, economic and social environments are also important to be understood.

While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided.

Before buying, it is important to ask the question, why is this cheap?

When bargains are scarce, value investors must be patient; compromising standards is a slippery slope to disaster. New opportunities will emerge, even if we don’t know when or where. In the absence of compelling opportunity, holding at least a portion of one’s portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option. – This is a difficult thing to do emotionally, especially in a rising market.

Like Klarman says, this is a very very difficult thing to practice. In a rising market, most value investors get out too early, which in itself is not a bad thing, but tests ones patience and fortitude immensely, to see ones friends keep making money when one is out of the market, sitting on cash.

Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future.

Keep sharpening your saw or as Peter Lynch has said, keep turning over as many rocks as possible. I think it is important to study business in a pattern to get the most benefit. I like to look at a particular industry and multiple stocks within it.

Selling is more difficult because it involves securities that are closer to fully priced. As with buying, investors need a discipline for selling. First, sell targets, once set, should be regularly adjusted to reflect all currently available information. Second, individual investors must consider tax consequences. Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller. Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of speculators.

For stocks which are compounding machines, we need to keep updating the intrinsic value, so that we do not get out of them too early. On the other hand, a sense of what a stock is worth is a must at all times for all stocks in one’s portfolio.

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