|Is it possible to be a better investor?
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- By Bill Bonner
Buenos Aires, Argentina
Stocks were flat yesterday. Gold fell $18...almost back to the $1,200 level.
Noise, noise, and more noise.
When we were in Sao Paulo, we were asked to give a brief speech to Brazilian investors. They wanted to know what we considered the most important things an investor should know.
What follows is more or less what we said. (Long-term Diary sufferers are invited to skip this, since they will find few new ingredients. On the other hand, they may find the new distillation more agreeable.)
What are the most important lessons for an investor?
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Well, let's begin in the beginning. If you're listening to this speech, it suggests you want to improve... that you want to be a better investor. So let's start there. Is it possible to be a better investor?
Believe it or not, there was a time when most serious thinkers believed it was not possible. I thought so myself. Professors of finance and economics won Nobel Prizes based on their research, proving that it didn't make any difference what you did, you'd end up with the same results.
Warren Buffett famously demolished this point of view - known as the Efficient Market Hypothesis, of EMH -- in a debate in 1984.
In effect, he said to his opponents, "If you were right I couldn't be so rich. And if I had believed what you believe I wouldn't be rich either."
The idea behind EMH is that you can just throw darts at a page of the Wall Street Journal and you'll get about the same investment performance as anyone else. In fact, the typical investor would be delighted to do so well. There are a number of studies showing that the typical investor doesn't do nearly as well as the guy who throws darts. The typical investor buys and sells too often... and he tends to listen to TV or read the newspaper. He's trying to keep up with the fads, but his tie is always too narrow or his shoes are too long. He trades too often, always buying too late and selling too early.
In fact, a study by Fidelity Investments found that the clients that did the best were the ones who had left fashion behind. They were account holders who had died. The relatives had forgotten the accounts were there. They had just left them alone.
So, this is probably a good place to introduce the first important thing you should know: Beta
The best you can do...or the best you are likely to do... is by getting in the right place and the right time and staying there. That's what I call "beta." "Alpha" is what you get by choosing good stocks. Beta is what you get from your asset allocation decisions. Most of your gains will come you're your big beta choices -- which market and which asset classes to be in...not which particular stocks or bonds you choose to buy.
In America, for example, if you had just gotten into the stock market in 1982... bought the Dow stocks... and done nothing else for the next 33 years... you would have multiplied your money 17 times.
So, the first lesson is to get into the right market at the right time and then pretend to be dead.
But Warren Buffett proved that you can do much better than either the guy who throws darts or the fashion victim. He showed that if you do your homework, you can even do much better than the dead guy.
What's the secret? Well, it turns out that investing is just like the rest of life. Hard work pays off. Effort is rewarded. So are other virtues, including self-discipline and patience.
The old timers say that 'the market will discover your weakness and turn it against you.' If you are greedy, or lazy, or impatient or arrogant - whatever your weakness is - the market will bring it out and punish you for it.
It's also worth noting that while investing is like everything else - in that virtue pays off - it is also unlike almost everything else too. In the rest of life, action tends to pay off. In your business, your career, and even in your person life, you are usually rewarded for getting busy and taking action. But in the investment world, most often, it's inaction that pays. You think a lot... but you do very little; generally, the fewer decisions the better.
Let's get back to how you can invest like Warren Buffett. In theory, it's very simple. You do a lot of work to figure out what a company is really worth. You add up how much you expect the company will earn in profits over the years ahead. Then, you ask yourself, how much is that stream of anticipated income worth right now? (You discount the expected future income to present value.) If the current stock price is lower than that amount, you should buy it. If it is higher, you should stay away. All the rest is detail and distraction.
Of course, making those calculations is very hard. I've run my own business for the last 35 years. At no time during that whole period could I say with confidence or authority how much money the company would earn in the years ahead. In fact, most of the time I couldn't say for sure if the results would be positive or negative. There are just too many unknowns.
That's why you should never forget the 'margin of safety.' You do your research. You make your calculations. And then, you give yourself some room for error and unexpected events. You could be wrong about so many things. Will the new product line sell? Will management stumble? Will interest rates suddenly go up? Will the economy go into recession?
That's why a margin of safety is so important. And it brings to mind what is probably the Number One secret of successful investing: humility. You're going to be wrong from time to time. Even Warren Buffett, the most successful investor of all time, has made disastrous investments.
Humility helps you remember that you might be wrong. Then, it helps you admit your mistake and correct it before it becomes catastrophic.
There are two devices you can use to help you build humility into your investments. First is a margin of safety. After you've made your analysis, make sure you have a margin of safety that will protect you in case you're wrong. If you think a stock is worth $10, don't buy it until it goes to $6. If you think it is worth $5, wait for it to sink to $3 before making your purchase.
The second device is a 'stop loss.' If you are Warren Buffett... or an extreme value investor...you don't need stop losses. They will just stop your out of good positions. But if you are like most investors, stop losses are a form of automatic humility. They tell you when you are wrong and force you to change your investments.
A stop loss works by pre-determining when you will sell. It allows you to set your maximum risk in advance. If you have an investment in which you have a high level of confidence... with a large margin of safety... you may be happy with a stop loss set at 30% or 40% below the current price. If it is something that you don't feel so confident about, you may want a tighter stop loss... say, at 10%,
Remember too that stop losses should be set in accordance with volatility. A stock that naturally moves up and down deserves a bigger stop loss than one that barely moves at all.
We did a thorough study of stop losses within our company. We found that the stop loss is very useful and not only to protect you from losses. It also helps you get as much profit as possible out of your good stock picks.
Here's what happens. You buy a good stock. It goes up. You are very happy. But you don't want to lose those gains. So you sell the stock to 'lock in' your profits. And then the stock keeps going up!
It is much better to put a trailing stop loss behind your stock. Just decide how of your gains you are willing to leave at risk. Then, put in a trailing stop. If you're lucky, you could get far more profit from your investment. Very often a good stock tends to remain a good stock, sometimes for many, many years. It would be a big shame to get out too early.
So, here are the basic lessons.
- Remember - Being in the right place at the right time is the most important thing. Beta pays. Roughly speaking, one correct big picture is worth 4 or 5 correct little pictures.
- Hard work pays off too. So do the other important virtues - patience, self-discipline, and humility.
- But investing is very different from other parts of life. Usually, it is best to think a lot, but to trade very little. Inaction is more productive than action.
- Always be humble. Have a thick margin of safety. And, unless you are a very confident, long-term deep-value investor, always use stop losses.
Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.
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