• OCTOBER 7, 2009

Investing: Simple or difficult?

Actually that's a trick question. A simple activity can be quite difficult to do. 'Always speak the truth'-that's a simple dictum all of us learn as children. Yet how many can really accomplish it? Not many, really. In contrast, we routinely do many complex activities rather easily. Take driving for example. It involves complex hand-eye coordination, rapid time-distance calculations involving traffic. Yet many of us accomplish it as a matter of fact.

Technique vs. temperament
This distinction is the key to understanding why investing is simple yet difficult. As Warren Buffett put it, "To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."

This is not the kind of statement you would hear from the average investment professional. In fact, the way the investment industry is organised, one is led to believe that one needs to deploy the most expensive brain power, elaborate data bases, complex models and close ties with companies to succeed as investors. Most professional investors tend to come from great academic backgrounds and put in a lot of effort into their investment processes. No wonder then that their solution to most investment problems revolves around 'smarts'. However, try speaking about 'intellectual framework' and 'keeping emotions in check' to them.

While investing certainly requires a degree of skill and intelligence, it is a mistake to think that more and more of these can compensate for the lack of a sound temperament. As is said in Cricket, players can succeed with flawed technique, but no one succeeds without the right temperament. To quote Warren Buffett again, "We don't have to be smarter than the rest; we have to be more disciplined than the rest." And talking about temperament is a simple enough matter, but difficult to put in practice.

Temperament: What exactly?
The key elements of an investment framework were first laid out by Benjamin Graham. They continue to be valid across the boundaries of time and geography.

  1. Owner's perspective: A stock is not a lottery ticket. It is a piece of business. Hence investors should think like businessmen. It has two major implications:

    1. Track operational performance: Think about your neighborhood shopkeeper or restaurateur. He doesn't bother about what his establishment is quoting for in the market. That's because it isn't quoted on an exchange. Stocks are, but that doesn't mean we should let it become a disadvantage. We should be interested in knowing more about the business and its operational performance.

    2. Long term horizon: Businessmen don't keep buying and selling their firms just because they can make a quick buck. They operate under multi-year time horizons.

  2. Mr. Market: Market is there to serve you and not dictate terms. One should check quotes periodically to see if it is offering some good merchandise at a marked down price. It is a mistake to take estimates of values from the markets. It is an even greater mistake to tie your emotional well being to this decidedly manic depressive creature.

  3. Margin of safety: One should be humble about one's estimates of the future and valuations. After all, we are not infallible. Not even close. That means we should buy stocks only when they are selling at a substantial discount to our estimates of value.

    It may be noted that recent advances in a new field called 'behavioral finance' confirms the soundness of this framework. To conclude, investing is a simple art but difficult to master in practice.

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