Investing can be simply defined as using money to make more money. How does one go about doing that? That’s where things can get overly complicated but the answer is simpler than you might think.
One person who distilled it wonderfully was Bill Miller. He offered a simple three-part answer:
When I first got into the business, I met Bill Ruane, Warren Buffett’s friend who ran Ruane Cunniff. Somebody asked him, “If you could give some advice about investing, what would it be?” And as Ruane related this story to me, he said, “I told the guy that if he reads Security Analysis and The Intelligent Investor and then reads all of Warren Buffett’s annual reports, and if he really understands what they were saying, he will know everything there is to know about investing.”
I thought about that advice for a number of years and agree with it, and then I heard this comment from two-time World Series of Poker champion Puggy Pearson: “Ain’t but three things to gambling. Number one: knowing the 60/40 end of a proposition. Number two: money management. And number three: knowing yourself.” This advice is succinct and encompasses all you really need to know about how to approach investing.
Here’s why: Knowing the 60/40 end of a proposition means knowing when you invest that the odds are in your favor. However you compute the odds, the odds have to be in your favor.
Money management involves knowing how much you commit to that position. Will you commit 1 percent, 5 percent, 10 percent? I recommend the book Fortune’s Formula… It is a far better way of thinking about asset allocation than mean-variance analysis.
Finally, knowing yourself means knowing your personal psychology and how you react to adverse circumstances.
Of course, knowing when the odds are in your favor and how much money to commit to it is one of the more difficult parts of investing. First, you need a good understanding of probabilities in an open-ended world. Second, you need a competitive advantage over others.
The competitive edge comes in three forms. Bill Miller broke it down as informational, analytical, and behavioral.
Most people don’t have an informational edge. At least, not legally. You can have better information than everyone else but it usually disappears quickly because it tends to be extremely short term in nature. So you’re either making trades faster than the fastest high-speed trading algorithms or you’re trading on insider information which is illegal.
An analytical edge allows you to see the same information everyone else sees but in a different light. Maybe you have more experience with a company or a certain type of business. Maybe you see the risks differently. The edge allows you to weigh the information differently, which leads you to a different probability of the investment’s outcome.
The behavioral edge has two parts. The first is knowing that behavioral biases exist and can be exploited in markets. So you need to know how different biases affect asset prices, where they can be easily found, and when they can be best exploited.
The second part is knowing that you are just as susceptible to these biases as everyone else. That includes overconfidence. Humans tend to overestimate their own abilities. Some people reading this will believe they have at least one of the edges above when they don’t.
Charley Ellis did something similar with his three sources of superior results. Those are intellectual, physical, and behavioral. You can outsmart, outwork, or out-behave everyone else.
Unfortunately, most people don’t have a significant competitive advantage at all. And that’s okay because the argument can be made that knowing you don’t have an edge is an advantage in itself. It automatically makes knowing yourself the most important of the three.
Most people take the wrong approach when it comes to investing. They spend all their time trying to find the best returns possible. It’s an endless search for the best stock, the perfect strategy, or the precise weighting for every fund in a portfolio.
You are far better off spending your time getting to know yourself.
How comfortable are you with market drawdowns? Where’s the cutoff before you get sick to your stomach? 20%? 40%? More?
Do you get excited when your portfolio rises? Do you feel sad, mad, or queasy when it falls?
Do you feel a strong desire to sell an investment that’s gone up or one sitting at a loss? What about buying? Are you more comfortable buying an investment that recently rose in price or recently fell?
How often do you need to check in on your portfolio? How quickly does impatience kick in if an investment underperforms your expectations?
Knowing how you react to asset price changes and extreme market swings is more important than chasing a holy grail strategy that doesn’t exist. Answers to those questions can help build a portfolio with a specific set of rules that exploit your behavioral strengths and weaknesses.
Conversation with a Money Master
How to Stop Being Your Own Worst Enemy (in Investing)
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