Novel Investor

Compounding investing wisdom...

Daniel Kahneman: Loss Tolerance

by Jon

What’s your risk tolerance? How do you indentify it? Both are important questions that investors spend little time thinking about at first. They’re also abstract questions thanks to the convoluted definitions of risk.

Daniel Kahneman suggests a better way to frame the question. Rather than risk tolerance, you should ask: what’s your loss tolerance? It makes you think about protecting your money. How much loss can you endure before you reach the point where emotions push you to change your mind and change your portfolio?

That breaking point is important because it’s usually where mistakes are made like buying high and selling low. Changing your portfolio every time emotions surface leads to worse results.

By reframing the question, Kahneman forces you to think in terms of actual dollars. Lost dollars can be quickly equated to missed goals and dreams — less money for college, a canceled vacation, a postponed retirement — that make you nauseous.

So how much of your net worth do you want to keep safe versus how much are you willing to lose outright? The goal is to find that breaking point so you can build a portfolio that minimizes regret, limits how often you change your portfolio, and keeps you invested for the long run.

Kahneman went on to explain the importance of minimizing regret and how it translates to portfolio construction. Here’s what he said: Continue Reading…

Jelly Beans and the Importance of Independent Thinking

by Jon

Have you ever entered a jelly bean contest, where you try to guess the number of jelly beans in a jar? An interesting thing happens when you take the average of all the guesses.

Jack Traynor did exactly that. He brought a jar of beans (not the jelly kind) into two classes and asked the students to guess the number of beans inside. So the students crowded around the jar. They tried to count the beans or estimate the beans per volume or other such things to come up with their best guess. Then they wrote down their guesses and turned them in.

Traynor found that in both classes the average of the guesses came very close to the actual number of beans. But what really stood out was that the average of the guesses beat all but one or two guesses. In other words, only one or two students actually did better than the average of the whole group.

This effect is known as the wisdom of crowds, but it requires a key ingredient: Continue Reading…

Wise Words from Robert Wilson

by Jon

Robert Wilson is a lesser-known legend on Wall Street. He turned a small inheritance into $800 million, then gave away the bulk of it to charities before his death.

Wilson began his career in 1949. He spent the first two decades as an analyst, bouncing between several firms, including a hiatus while serving in the Korean War.

In 1968, he set out on his own. He set up a hedge fund, Wilson & Associates, with about $3 million in capital from friends and family. The timing could not have been worse. That same year, the market topped and by the lows of 1969, his fund was down 35%.

Withdrawals came next — reducing the fund to about $350,000. His clients bailed out at the lows. Within the next three months, his fund bounced back to break even. Then he ditched the last of his clients and truly went solo. He only managed his own money going forward.

Wilson ran a true hedge fund. His portfolio was a diversified group of both long and short positions. And he wasn’t afraid to use leverage. He looked for growth companies but used short positions to protect his capital. The ancillary benefit of short positions gave Wilson more money to bet on the long side. Continue Reading…

Don’t Overemphasize Volatility

by Jon

Markets go through points in the cycle where it’s as if investors forget we don’t know what happens next. They’re sure of the outcome.

Unfortunately for investors, those points are at the worst possible times. When they’re certain things will stay better forever and certain things will only get worse.

Then the market teaches them a lesson. Heightened volatility is the wake-up call that uncertainty abounds.

Volatile markets like today are normal but occur just far enough apart that investors forget what it felt like the last time it happened. Each time it’s accompanied by a worrying event and gives us an excuse to try to avoid it.

But when you overemphasize volatility, you miss out on the good it offers. Nobody understands this better than Peter Bernstein: Continue Reading…

Closer to the Bottom Than the Top

by Jon

The irony of investing is that it typically works out best when markets look their worst. Currently, things don’t look good.

So with that in mind, let’s find out where we are in the market cycle. To paraphrase Howard Marks, if we know where we are in the cycle, we can better prepare for what comes next.

I thought I’d approach this from a different angle. Rather than guess what the Fed might do or where inflation and interest rates are going based on past history and how it might affect the market today, let’s look at “irrational” stock prices.

The best way to track irrationally priced stocks is with an old Ben Graham strategy that has largely gone out of style. He looked for companies trading below their liquidation value. In rational markets, that shouldn’t happen. Yet, it does.

Graham’s “Net-Net” strategy looks for companies with a market cap below its net current asset value. Current assets are typically the most liquid assets a company has: cash, money owed to the company (accounts receivable), and finished products not yet sold (inventory). And the net current asset value is found by subtracting total debt from current assets. Continue Reading…

Peter Lynch’s Rule for Dealing with Mistakes

by Jon

Investing mistakes are unavoidable. Everyone makes them. So it’s not a matter of if, but when. The question is what will do once you realized you’ve made a mistake?

Peter Lynch has the answer. In a 1980 appearance on Wall Street Week, Lynch highlights mistakes he’s had first-hand experience with like not knowing what you own or trying to catch a falling knife while ignoring fundamentals.

But Lynch has a rule for dealing with his mistakes. The instant he realizes he’s made a mistake, he gets out.

Unfortunately, many investors turn one mistake into many. They compound the problem.

Our first reaction toward losses is to make the money back. So the next mistake starts with wanting to get back to even. Which rarely goes as planned. Instead, we turn a small loss into a bigger loss. But that’s compounded by the opportunity cost of putting those dollars to work somewhere else. Continue Reading…

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