Novel Investor

Compounding investing wisdom...

Howard Marks: The “Negative Art” of Investing

by Jon

Howard Marks once describes his investment philosophy like this:

My philosophy of investing was built primarily on experiences but also on things I read: John Kenneth Galbraith’s ideas about cycles, the importance of contrarianism and being a countercyclical, and the importance of not being a forecaster, and Charlie Ellis’s article on “The Loser’s Game” — the desirability of just keeping the ball in play rather than trying to hit home runs.

Strategies that swing for the fences can experience random catastrophic strikeouts that ruin a game. Marks wants to stay in the game as long as possible, so he’ll forgo home runs for singles, doubles, and even walks. It’s like a small ball approach to investing, to continue the baseball analogy.

The point is, Marks wants to avoid as many mistakes as possible and not lose. To do that, he follows a process he learned from Ben Graham called the negative art. Here’s how he described it: Continue Reading…

Daniel Kahneman: Loss Tolerance

by Jon

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

During an interview, Daniel Kahneman was asked his thoughts about identifying risk tolerance. He suggested a better way to frame the question: what’s your loss tolerance? How much loss can you endure before hitting the breakpoint where emotions push you to change your portfolio?

By reframing it, Kahneman forces you to think in terms of dollars, not percentages. That may not seem like a big difference, but emotions trigger in dollar terms.

Lost dollars can be quickly equated to missed goals and dreams — less money to spend, a canceled vacation, a postponed retirement — that make you nauseous in ways that a percentage won’t.

Kahneman went on to explain its importance in minimizing regret and how to fit it into portfolio construction. Here’s what he said: Continue Reading…

Benchmarks and the Relative Return Bias

by Jon

Absolute returns get a lot of lip service, but we have a relative return bias. Peter Bernstein weighed in on the bias and suggest benchmarks don’t help.

The downsides are fairly obvious. Relative returns feel great during bull markets. But when a year like 2008 comes around, you beat the benchmark but still lose big.

To add to it, fund managers (and advisors) also have career risk that feeds the relative return bias. All of it leads to more opportunities for short term thinking and poor behavior.

Seth Klarman simplified the problem perfectly: “You can’t think straight with a gun to your head. If you have a relative performance gun to your head, on the way down and on the way up, you’ll do the wrong thing every time. You’ll be liking them when they’re up, and hating them when they’re down – when you should be doing the opposite.”

Absolute returns should be the answer but investors contend with a powerful force: return envy. You have to be comfortable with “losing” to the Jones or an arbitrary index in any given year. What matters is “Are you earning a good return?”

Here’s what Bernstein had to say: Continue Reading…

Daniel Kahneman: The Most Important Bias

by Jon

Casinos thrive because people are wrong about the odds. The same can be said about investing. The reason why is what Daniel Kahneman calls the “single most important bias.”

The odds of most gambling games can figured out using grade school math. In a totally rational world, where everyone was out to maximize their money, nobody would play any game that favored the House. But not everyone plays for maximum wealth.

So there must be something else going on. Entertainment plays a part. The bells and flashing lights and the quick play bring thrills.

Really, some people think they’re the exception the odds. Ed Thorp calls gambling a tax on ignorance: “People often gamble because they think they can win, they’re lucky, they have hunches, that sort of thing, whereas, in fact, they’re going to be remorselessly ground down over time.”

Kahneman chalks it up to optimism combined with confidence. He explained how it fits in the context of investing during a 2005 interview: Continue Reading…

The Elusive “Wonderful Company”

by Jon

Probably the largest aggregate losses are suffered by people who invest overenthusiastically in a basically sound company. — Ben Graham

I was reminded of Graham’s quote after hearing something Joel Greenblatt said at a recent conference:

I’d like to own a great growth company that’s gonna continue to grow forever and there are some extraordinary companies out there that will continue to do well. I would say…people think there are a lot more companies that rhyme with those few companies that can do that, then there are, in reality. There probably are a few great businesses like that, and I’m not gonna argue that they’re great — I have to figure out which one’s they are first — but there will be some winners. And you’ll know their names because they won.

Sometimes the market views stocks through rose-colored glasses. It prices companies as if they’ve built an impregnable moat around them and they already won. Really, it’s an illusion. Continue Reading…

Bernstein and Montier Discuss “Risk”

by Jon

Risk has a long list of definitions that make it unnecessarily confusing. Peter Bernstein sees risk as “the consequences of being wrong.” That’s a version I can get behind.

He contributed it to a great discussion with James Montier on how the different definitions of risks fit together, mainly whether volatility fits in and what it means for investing.

Ironically, Bernstein can see volatility as risk from a behavioral standpoint (hardly mathematical) because of the queasy feeling it creates. Montier sees volatility as opportunity.

In a sense, they’re both right. Volatility is the catalyst to a good or bad decision. The decision introduces the potential for risk — learned only in hindsight from the outcome.

Their discussion offers some food for thought: Continue Reading…

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