Chapter 11 Contrarianism
There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite. Superior investing, as it requires second-level thinking a way of thinking that’s different from that of others, more complex and more insightful. By definition, most of the crowd can’t share it. Thus, the judgments of the crowd can’t hold the key to success.
This is the core of Warren Buffett’s oft-quoted advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He is urging us
to do the opposite of what others do: to be contrarians.
The logic of crowd error is clear and almost mathematical:
• Markets swing dramatically, from bullish to bearish and from overpriced to under priced.
• Their movements are driven by the actions of “the crowd,” “the herd” or “most people.” Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers. The market rises as people switch from being sellers to being buyers, and as buyers become even more motivated and the sellers less so. (If buyers didn’t predominate, the market wouldn’t be rising.)
Market extremes represent inflection points. These occur when bullishness or bearishness reaches a maximum. Figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further and the market is as high as it can go.
Buying or holding is dangerous.
• Since there’s no one left to turn bullish, the market stops going up.
And if on the next day one person switches from buyer to seller, it will start to go down.
• So at the extremes, which are created by what “most people” believe, most people are wrong.
• Therefore, the key to investment success has to lie in doing them opposite: in diverging from the crowd. Those who recognize the errors that others make can profit enormously through contrarianism.
Accepting the broad concept of contrarianism is one thing; putting it into practice is another. On one hand, we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction.
On the other hand, we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond). Investors who believed that the pendulum would move in one direction forever or, having reached an extreme, would stay there are inevitably disappointed.
On the third hand, however, because of the variability of the many factors that influence markets, no tool not even contrarianism can be relied on completely.
The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).
Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling and if our view turns out to be right that’s the route to the greatest
rewards earned with the least risk.
Chapter 12 Finding Bargains
The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of :
(a) a list of potential investments,
(b) estimates of their intrinsic value,
(c) a sense for how their prices compare with their intrinsic value, and
(d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
The first step is usually to make sure that the things being considered satisfy some absolute standards. Even sophisticated investors may not say, “I’ll buy anything if it’s cheap enough.” More often they create a list of investment candidates meeting their minimum criteria, and from those
they choose the best bargains. That’s what this chapter is all about.
A high-quality asset can constitute a good or bad buy, and a low- quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.
We’re active investors because we believe we can beat the market by identifying superior opportunities. On the other hand, many of the “special deals” we’re offered are too good to be true, and avoiding them is essential for investment success. Thus, as with so many things, the optimism that drives one to be an active investor and the skepticism that emerges from the presumption of market efficiency must be balanced.
It’s obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.
Fairly priced assets are never our objective, since it’s reasonable to conclude they’ll deliver just fair returns for the risk involved. And, of course, overpriced assets don’t do us any good.
Our goal is to find under-priced assets. Where should we look for them? A good place to start is among things that are:
• little known and not fully understood
• fundamentally questionable on the surface
• controversial, unseemly or scary
• deemed inappropriate for “respectable” portfolios
• unappreciated, unpopular and unloved
• trailing a record of poor returns; and
• recently the subject of disinvestment, not accumulation.
Chapter 13 Patient Opportunism
The boom-bust cycle associated with the global financial crisis gave us the chance to sell at highly elevated levels in the period 2005 through early 2007 and then to buy at panic prices in late 2007 and 2008. This was in many ways the chance of a lifetime. Cycle-fighting contrarians had a golden opportunity to distinguish themselves.Patient opportunism waiting for bargains is often your best strategy.
Rather than initiating transactions, we prefer to react opportunistically.
At any particular point in time, the investment environment is a given, and we have no alternative other than to accept it and invest within it.
There isn’t always a pendulum or cycle extreme to bet against. Sometimes greed and fear, optimism and pessimism, and credulousness and skepticism are balanced, and thus clear mistakes aren’t being made. Rather than obviously overpriced or under-priced, most things may seem roughly fairly priced. In that case, there may not be great bargains to buy or compelling sales to make.
It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly.
The other possibilities are :
(a) acting without recognizing the market’s status
(b) acting with indifference to its status and
(c) believing we can somehow change its status. These are most unwise. It makes perfect sense that we must invest appropriately for the circumstances with which we’re presented. In fact, nothing else makes sense at all.
One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few winners, the penalty is bearable. The absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers.
From time to time, holders become forced sellers for reasons like these:
• The funds they manage experience withdrawals.
• Their portfolio holdings violate investment guidelines such as minimum credit ratings or position
• They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders.
Chapter 14 The Most Important Thing Is … Knowing What You Don’t Know
This discussion of forecasts suggests that we have a dilemma: investment results will be determined entirely by what happens in the future, and while we may know what will happen much of the time, when things are “normal,” we can’t know much about what will happen at those moments when knowing would make the biggest difference.
• Most of the time, people predict a future that is a lot like the recent past.
• They’re not necessarily wrong: most of the time the future largely is a rerun of the recent past.
• On the basis of these two points, it’s possible to conclude that forecasts will prove accurate much of the time: They’ll usually extrapolate recent experience and be right.
• However, the many forecasts that correctly extrapolate past experience are of little value. Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in ac ontinuation of recent history.
Thus if the future turns out to be like the past, it’s unlikely big money will be made, even by those who foresaw correctly that it would.
• Once in a while, however, the future turns out to be very different from the past.
• It’s at these times that accurate forecasts would be of great value.
• It’s also at these times that forecasts are least likely to be correct.
• Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly forecast key events, but it’s unlikely to be the same people consistently.
• The sum of this discussion suggests that, on balance, forecasts are of very little value.
The biggest problems tend to arise when investors forget about the difference between probability and outcome, that is, when they forget about the limits on foreknowledge:
• when they believe the shape of the probability distribution is knowable with certainty (and that they know it)
• When they assume the most likely outcome is the one that will happen,
• When they assume the expected result accurately represents the actual result, or
• Perhaps most important, when they ignore the possibility of improbable outcomes.
Imprudent investors who overlook these limitations tend to make mistakes in their portfolios and experience occasional large losses. That was the story of 2004–2007: because many people overestimated the extent to which outcomes were knowable and controllable, they underestimated the risk present in the things they were doing.
Chapter 15 The Most Important Thing Is … Having a Sense for Where We Stand
Market cycles present the investor with a daunting challenge, given that:
• Their ups and downs are inevitable.
• They will profoundly influence our performance as investors.
• They are unpredictable as to extent and, especially, timing.
So we have to cope with a force that will have great impact but is largely unknowable. What, then, are we to do about cycles? The question is of vital importance, but the obvious answers—as so often are not the right ones.
The first possibility is that rather than accept that cycles are unpredictable, we should redouble our efforts to predict the future, throwing added resources into the battle and betting increasingly on our
conclusions. But a great deal of data, and all my experience, tell me that the only thing we can predict about cycles is their inevitability. Further, superior results in investing come from knowing more than others, and it hasn’t been demonstrated to my satisfaction that a lot of people know more than the consensus about the timing and extent of future cycles.
The second possibility is to accept that the future isn’t knowable, throw up our hands, and simply ignore cycles. Instead of trying to predict them, we could try to make good investments and hold them throughout.
Since we can’t know when to hold more or less of them, or when our investment posture should become more aggressive or more defensive, we could simply invest with total disregard for cycles and their profound effect. This is the so-called buy-and-hold approach.
There’s a third possibility, however, and in my opinion it’s the right one by a wide margin. Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions?
In the world of investing, … nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. They are the givens.
We cannot know how far a trend will go, when it will turn, what will make it turn or how far things will then go in the opposite direction. But I’m confident that every trend will stop sooner or
later. Nothing goes on forever.
So what can we do about cycles? If we can’t know in advance how and when the turns will occur, how can we cope? On this, I am dogmatic: We may never know where we’re going, but we’d better have a good idea where we are.
That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act
Markets move cyclically, rising and falling. The pendulum oscillates, rarely pausing at the “happy medium,” the midpoint of its arc. Is this a source of danger or of opportunity? And what are investors to do about it? My response is simple: try to figure out what’s going on around us, and use that to guide our actions.
Chapter 16 The Most Important Thing Is … Appreciating the Role of Luck
The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. But it comes down to the same thing: a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.
Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not.
Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted
from skill or simply being lucky.
Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill. The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors.
• Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway;
the investor looks good (and invariably accepts credit).
• The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition
unknown. Thus, correct decisions are often unsuccessful, and vice versa.
• Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).
• For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row.
• Thus, it’s essential to have a large number of observations lots of years of data before judging a given manager’s ability.
Chapter 17 The Most Important Thing Is … Investing Defensively
There are a lot of things I like about investing, and most of them are true of sports as well.
• It’s competitive—some succeed and some fail, and the distinction is clear.
• It’s quantitative—you can see the results in black and white.
• It’s a meritocracy—in the long term, the better returns go to the superior investors.
• It’s team oriented—an effective group can accomplish more than one person.
• It’s satisfying and enjoyable—but much more so when you win.
These positives can make investing a very rewarding activity in which to engage. But as in sports, there are also negatives.
• There can be a premium on aggressiveness, which doesn’t serve well in the long run.
• Unlucky bounces can be frustrating.
• Short-term success can lead to widespread recognition without enough attention being paid to the likely durability and consistency of the record.
Overall, I think investing and sports are quite similar, and so are the decisions they call for. Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mind-set needed for one and the mind-set needed for the other, and a big difference in the tactics to which the two lead.
While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.
There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error (see later in this chapter) and being less willing to bet on continued prosperity, rosy forecasts and developments that may be uncertain.
The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. In addition to the ingredients described previously that help keep individual losing investments from the portfolio, this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.
The prudent lender’s reward comes only in bad times, in the form of reduced credit losses. The lender who insists on margin for error won’t enjoy the highest highs but will also avoid the lowest lows. That’s what happens to those who emphasize defense.
Chapter 18 The Most Important Thing Is … Avoiding Pitfalls
To avoid losses, we need to understand and avoid the pitfalls that create them. In this chapter I bring together some of the key issues discussed in earlier chapters, in the hope that highlighting them under one umbrella will help investors become more alert for trouble spots. The starting point consists of realizing that many kinds of pitfalls exist and learning what they look like.
I think of the sources of error as being primarily analytical/intellectual or psychological/emotional. The former are straightforward: we collect too little information or incorrect information. Or perhaps we apply the wrong analytical processes, make errors in our computations or omit ones we should have performed. There are far too many errors of this sort for me to enumerate, and anyway, this book is more about philosophy and mind-set than it is about analytical processes.
Many of the psychological or emotional sources of error were discussed in previous chapters: greed and fear, willingness to suspend disbelief and skepticism; ego and envy, the drive to pursue high returns through risk bearing, and the tendency to overrate one’s foreknowledge.
These things contribute to booms and busts, in which most investors join together to do exactly the wrong thing.“Failure of imagination” the inability to understand in advance the full breadth of the range of outcomes is particularly interesting, and it takes effect in many ways.
Relying to excess on the fact that something “should happen” can kill you when it doesn’t. Even if you properly understand the underlying probability distribution, you can’t count on things happening as they’re supposed to. And the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing, instead, you must allow for outliers.
Investors often fail to appreciate the common threads that run through portfolios. Everyone knows that if one automaker’s stock falls, factors they have in common could make all auto stocks decline simultaneously.
Fewer people understand the connections that could make all U.S. stocks fall, or all stocks in the developed world, or all stocks worldwide, oral stocks and bonds, etc.
So failure of imagination consists in the first instance of not anticipating the possible extremeness of future events, and in the second instance of failing to understand the knock-on consequences of extreme events.
In many ways, psychological forces are some of the most interesting sources of investment error.
They can greatly influence security prices.
When they cause some investors to take an extreme view that isn’t balanced out by others, these forces can make prices go way too high or way too low. This is the origin of bubbles and crashes.
How are investors harmed by these forces?
• By succumbing to them
• By participating unknowingly in markets that have been distorted by
• By failing to take advantage when those distortions are present
Chapter 19 The Most Important Thing Is … Adding Value
It’s not hard to perform in line with the market in terms of risk and return. The trick is to do better than the market: to add value. This calls for superior investment skill, superior insight. So here, near the end of the book, we come around full circle to the first chapter and second-level thinkers possessing exceptional skill.
Active investors have a number of options available to them. First, they can decide to make their portfolio more aggressive or more defensive than the index, either on a permanent basis or in an attempt at market timing. If investors choose aggressiveness, for example, they can increase their portfolios’ market sensitivity by over weighting those stocks in the index that typically fluctuate more than the rest, or by utilizing leverage.
Second, investors can decide to deviate from the index in order to exploit their stock-picking ability buying more of some stocks in the index, under weighting or excluding others, and adding some stocks that aren’t part of the index. In doing so they will alter the exposure of their portfolios to specific events that occur at individual companies, and thus to price movements that affect only certain stocks, not the whole index.
It’s important to keep these considerations in mind when assessing an investor’s skill and when comparing the record of a defensive investor and an aggressive investor. You might call this process style adjusting.
In a bad year, defensive investors lose less than aggressive investors. Did they add value? Not necessarily. In a good year, aggressive investors make more than defensive investors. Did they do a better job? Few people would say yes without further investigation.
Chapter 20 The Most Important Thing Is … Reasonable Expectations
Every investment effort should begin with a statement of what you’re trying to accomplish. The key questions are what your return goal is, how much risk you can tolerate, and how much liquidity you’re likely to require in the interim.
Return goals must be reasonable. What returns can we aspire to? Most of the time—although not necessarily at any particular point in time (and not necessarily today)—it’s reasonable to aspire to returns in single digits or perhaps low double digits. High teens are something very special, and anything more should be viewed as the province of experienced pros (and only the best of those). The same is true of particularly consistent results. Expecting too much in these regards is likely to lead to disappointment or loss. There’s just one antidote: asking whether the result you’re expecting is too good to be true. This requires the application of skepticism, a quality that’s absolutely essential for investment success.
Higher returns are “unnatural,” and their achievement requires some combination of the following:
• an extremely depressed environment in which to buy (hopefully to be followed by a good environment in which to sell),
• extraordinary investment skill,
• extensive risk bearing,
• heavy leverage, or
• good luck.
Thus, investors should pursue such returns only if they believe some of these elements are present and are willing to stake money on that belief. However, each of these is problematic in some way. Great buying opportunities don’t come along every day. Exceptional skill is rare by definition. Risk bearing works against you when things go amiss. So does leverage, which operates in both directions, magnifying losses as well as gains. And certainly luck can’t be counted on. Skill is the least ephemeral of these elements, but it’s rare (and even skill can’t be counted on to produce high returns in a low-return environment).
Investment expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk than is perceived. Before you swallow the promise of sky-high returns without risk or of steady “absolute returns” at levels much higher than T-bills, you should wonder skeptically whether they’re really achievable and not simply alluring; how an investor with your skill can reasonably expect to achieve them; and why an opportunity so potentially lucrative is available
to you, ostensibly cheaply. In other words, are they too good to be true?
Chapter 21 The Most Important Thing Is … Pulling It All Together
The best foundation for a successful investment—or a successful investment career—is value. You must have a good idea of what the thing you’re considering buying is worth. There are many components to this and many ways to look at it. To oversimplify, there’s cash on the books and the value of the tangible assets; the ability of the company or asset to generate cash; and the potential for these things to increase.
Your view of value has to be based on a solid factual and analytical foundation, and it has to be held firmly. Only then will you know when to buy or sell. Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day. Of course, for your efforts in these regards to be profitable, your estimate of value has to be on target.
The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.
An important part of getting it right consists of avoiding the pitfalls that are frequently presented by economic fluctuations, companies’ travails, the markets’ manic swings, and other investors’ gullibility. There’s no surefire way to accomplish this, but awareness of these potential dangers certainly represents the best starting point for an effort to avoid being victimized by them.
Another essential element is having reasonable expectations. Investors often get into trouble by acting on promises of returns that are unreasonably high or dependable, and by overlooking the fact that, usually, every increase in return pursued is accompanied by an increase in risk borne. The key is to think long and hard about propositions that may be too good to be true.
Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail.
Source: The Most Important Thing Book