The market can be an expensive teacher. For a brief moment you think you have everything figured out, then the market shoves that mistake in your face. It happens to everyone. Beginners, veterans, nobody gets a pass from the market’s classroom.

The best investors understand this all too well. They’ve experienced it first-hand…more than once. 

Learning is part of the investment process whether you like it or not. You’re better off, of course, expediting the process by learning on your own. It’s cheaper. But if not, investing forces you to learn, sometimes at the most inopportune times. And the lessons include learning about yourself.

The concept of circle of competence gets tossed around often. It’s a fancy way to say you’re good at some things but not everything. It’s about knowing what you’re good at, where you have an advantage, but, more important, not straying into areas that put you at a disadvantage. 

Studying finance, market history, companies past and present, and outside your discipline, expands your circle of competence, hones the edges, and improves decision making.  That’s the goal, at least. Learning improves your chance of (investment) success.

Quote for the Week

What is that frenzied activity that we see in financial markets all about? Financial markets are the grease in our economy that keeps the wheels of enterprise turning. Financial markets are in the first instance a vehicle for financing governments and enterprises that need money. But why is it that financial markets are so important in this process? Financial markets are a place where owners of outstanding assets can convert those assets into cash, or where owners of cash can find longer-term uses for their money. Financial markets thus give holders of assets with future cash flows the option of realizing the discounted value of those future cash flows in the present. Financial markets are a kind of time machine that allows selling investors to compress the future into the present and buying investors to stretch the present into the future. Without financial markets, all assets would be buy-and-hold and the cost of capital would be orders of magnitude higher than it is today. In panic conditions, as Alan Greenspan so often reminds us (he uses the expression “fear-induced disengagement”), financial markets come to a screeching halt because buyers evaporate and even supposedly liquid assets are transformed into buy-and-hold. — Peter Bernstein (source)

John Kenneth Galbraith, in A Short History of Financial Euphoria, condensed a speculative mania into three parts.

1. New innovation. Something new, financial or technological, captures people’s attention. It’s not new innovation alone. It’s that, gradually, more and more money concentrates into the assets behind that new thing.
2. Debt. The returns on those assets are so good that people want to accelerate their wealth. They turn to leverage, margin loans, derivatives, anything that could enhance returns further.
3. The Crash. Liquidity dries up. Asset prices freefall. Margin calls are made. Forced selling occurs. The new innovation assets are scrutinized too late for many. Painful losses are widespread.

Galbraith’s speculative mania also describes how investors blow up their portfolio. A paper titled, How to Lose Money in Derivatives, studied previous hedge fund blow ups and backs that up.

Quote for the Week

When I shifted my focus from beating gambling games to analyzing the stock market, I naively thought that I was leaving a world where cheating at cards was then problematic and entering an arena where regulation and the rule of law gave investors a fair playing field. Instead, I learned that bigger stakes attracted bigger thieves. Madoff’s Ponzi scheme was only the largest of the many that were exposed in 2008 and 2009, with others ranging from eight billion (a “bank”) through hundreds of millions (including several hedge funds), to multimillion dollar real estate, mortgage and annuity scams. I speculate that the size of swindles likely follows a simple mathematical “power law,” like the distribution of high incomes and top wealth discussed in previous columns, with their number increasing as their economic size decreases…

The flood of almost daily frauds, swindles and hoaxes reported in the financial press has continued during my entire investment career and I expect that when you read this months, years or decades later, you’ll find your own profusion of examples. Hoaxes, frauds, manias and other large scale financial irrationalities have been with us from the beginnings of the markets in the seventeenth century, long before the Internet. — Ed Thorp (source)

Quote for the Week

In a fascinating paper published in 1989, Benjamin Friedman and David Laibson hypothesize that all investors function with two models in mind. The first model approximates the efficient market notion that prices are so close to true value that a movement up is as likely as a movement down and that those movements will be lognormally distributed. The second model is that all hell could break loose at any moment.

Many years ago, an older partner taught me to distinguish between outcomes that are unlikely and outcomes that are catastrophic. The latter are to be avoided even if the odds on them are tiny. Rational investors respond to this type of problem by operating with anchors to windward. They diversify and avoid total commitment to any one bet. But the fear we all share — that what looks like a market today just might not be there for us tomorrow — makes today’s market less than perfect and less than totally liquid. — Peter Bernstein (source)