Novel Investor

Compounding investing wisdom...

Joel Greenblatt on the Opportunity in Misbehavior

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Joel Greenblatt is one of the rare few who can claim 40% returns over two decades. He also has a knack for explaining things simply.

He did that in his first book, You Can Be a Stock Market Genius, which explained how he earned some of that 40% return. And it showed again in his second book, The Little Book that Beats the Market.

And he did it again in his third book, The Big Secret for the Small Investor, though it’s a little different than the first two. It’s written for people new to the game, but there’s something in it for everyone.

His message is simple: the small investor has built-in advantages over the pros and there is more than one right way to invest. You can try to value stocks, evaluate fund managers, or settle for index funds. And if the typical index fund is too average for you, maybe spice things up with equal- or value-weighted funds instead. Continue Reading…

A Study in the Psychology of Gambling

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Why is that some people treat the dumbest bet in the world as genius when it hits? It’s not genius, obviously, but confusing skill and luck is a common mistake made by gamblers and investors alike. It’s one of many that arise when human nature and gambling collide.

When the House has the advantage, like in most games of chance, winning has nothing to do with brilliance. It’s almost always a bad decision saved by dumb luck. Yet, hindsight bias spares us from being honest with ourselves.

Picture the person who hits on 17 at blackjack and catches a 4. Or another who goes on an amazing run picking numbers playing roulette. It’s not some uncanny ability. It’s not infinite wisdom. It’s not foresight. It’s dumb luck. But the story is sold as skill.

The mistake is not only denying luck after hitting the improbable 4 on a 17 but embracing bad luck after busting from a hit on 17. The failure to account for stupidity is probably worse than being falsely endowed with unnatural gifts. Who learns from bad luck?

Of course, this problem is as old as gambling itself. Case in point is a letter to the editor of The Spectator in 1873. An insightful English gentleman shared a scathing assessment, of himself and his fellow gamblers, after his first experience in a casino. Continue Reading…

Ed Thorp on Learning from Gambling

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Ed Thorp has a skeptical mind. That’s what got him to question the belief that you couldn’t beat the casino. That same skepticism eventually drove him to question financial markets. During an interview, Thorp explained that journey and what he learned.

The big difference between gambling and investing is in the probabilities. Most gambling games have fixed probabilities. Precise accuracy is possible.

In the game of blackjack, if you know the number of decks, then you know how many of each card exists (assuming the House plays fair), and you can work out the odds from there.

Not so with investing. The complexity of markets, the number of factors involved, make precision impossible. Here’s Thorp: Continue Reading…

Steven Crist: Second Level Thinking at the Racetrack

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What does horse racing have to do with investing? Everything. The key is to think of “horses” as “stocks.”

Most gambling, like blackjack, roulette, or craps, involves betting against the House. Not so at the horse track. Instead, you bet against other bettors and your, and everyone else’s, bets on different horses (stocks) change the odds.

Not surprising, how people approach betting on horses is fairly similar to how people bet on stocks.

Steven Crist says as much in a chapter he wrote for Bet with the Best, as he explains how to bet on horses. But as I said at the top, swap out “horse” with “stock” and you’ll see the similarities with investing: Continue Reading…

Where Less is More

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Compounding works because somebody started something decades ago and never stopped. When you combine consistency with a simple investment plan some wonderful things happen.

Unfortunately, simplicity is often overlooked.

And I’m not just talking about investment plans. Yes, the finance industry is notorious for coming up with complex strategies to warrant the high fees they’re charging. Can a simpler strategy produce similar results? Most likely. But who would pay a similar high fee for it?

I may be going out on a limb here, but it seems to me that if the industry spent more energy on getting clients/customers to maintain consistency and less energy on creating elaborate strategies, both the industry and their clients would be better off in the long run. Conveniently, consistent compounding benefits both investors and those who charge low fees too. Continue Reading…

The Downside of Chasing Huge Wins

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I briefly touched on John Maynard Keynes’s track record on investments in his personal account in the last post. I wanted to take a deeper dive into the impact margin loans had on his results.

For those not aware, a margin loan is borrowed money used to buy securities in an attempt to juice returns. The results can be exceptional if things go right or horrendous when things go wrong.

When you borrow money against an asset, and the value of the asset falls, bad things can happen. The same is true when borrowed money is used to buy an asset like a stock, that then declines in value.

The main reason is due to minimum margin requirements. Lenders don’t like to lose money any more than we do, so minimum margin requirements help to safeguard lenders from losses.

But they don’t protect you from losses. In fact, it does the opposite whenever the minimum gets triggered. At that point, you’re hit with a margin call and forced to cover the difference. So you either scramble to come up with more money or are forced to sell. Forced selling is the typical outcome, at what is likely a (big) loss. Continue Reading…

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