Quote for the Week

I divide investors into two schools: The “I know” school and the “I don’t know” school. For my first 20 years in business in what I would call the institutional establishment, I ran into the “I know” school most of the time. These are people who will tell you exactly what is going to go on one, three, five, or 10 years from now in the economy, in the markets, in interest rates, which economies will do best, which industries, and which stocks. They tend to invest on the assumption that they are right. Then when they turn out to be wrong, they try to correct their mistakes and invest on the next set of scenarios rather than acknowledging that perhaps rightly there are limitations on their foreknowledge.

The “I know” school invests for one outcome, economy, market, interest rates, industry, and company. They concentrate their portfolios given that they know what the future holds. They lever heavily, and they target maximum price gains.

Most of the outstanding investors that I have known over the years belong to the “I don’t know” school with regard to the macro environment. They may know companies and securities better than anybody else in the world, but with regard to the macro they assume that they don’t know what the future holds. So they hedge against uncertainty. They diversify. They avoid or limit leverage, and they emphasize the avoidance of losses rather than – or I would say as least as important as – the acquisition of gains.

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Quote for the Week

Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.

In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios…

There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded. — Charlie Munger (source)

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Casinos operate on the simple principle that gambling, over time, is a losing endeavor. They ensure it. Your loss is the casinos gain.

Why is that? They design the games to favor the house, not the player. Anyone can place a bet, beat the odds, and win. The casino expects to lose on some bets in the short term.

But over thousands of spins of the wheel or rolls of the dice, your bankroll gets ground down to nothing and the casino comes out ahead.

That fact doesn’t stop people from gambling though. Some combination of entertainment, ignorance, overconfidence, optimism, and dumb luck keep people gambling and casinos in business.

The same reasons explain why people speculate in markets. Unfortunately, the outcome is same. Which is why the analogy comparing investors to casinos is so apt:

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Quote for the Week

To put the matter in another, perhaps more puzzling, framework, we can say that today’s stock prices do not really forecast what investors think business conditions will be like some six months or so hence, but rather what investors think stock prices will be some six months or so hence! If investors as a group think business conditions and therefore stock prices will be higher six months in the future, they will buy stocks now and refrain from selling them until the level of stock prices reaches a point where they agree with what that price level is predicting, and vice versa on the downside. But the problem is really much more complicated than that, because stock prices six months ahead will not only be reflecting business conditions at that moment but will also be reflecting what investors expect one year from now, or six months beyond six months from now, which is even more difficult to predict.

Thus described, and greatly magnified and elaborated in the process of selecting individual issues rather than in making a general market forecast, any type of reliable prediction of stock prices seems like a total impossibility. It is difficult enough to know what we should think on our own about what is going to happen, but that is simple compared with the difficulty of knowing what other people are thinking and will think about a future that never holds still, even for an instant. — Peter Bernstein (source)

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It’s May 28, 1962 and the stock market is spiraling. It was the biggest one day drop since 1929. And it happened fast.

The flash crash that day left the Dow down 5.7% at the close, 26% below the 1962 high near the start of the year, and below 600 for the first time in two years. Many stocks ended the day 30% to 80% below their highs for the year.

A rebound the next day offered respite from the panic. Two days later J. Paul Getty offered encouraging words when pressed for comment, “I’d be foolish not to buy… Most seasoned investors are doubtless doing much the same thing. They’re snapping up the fine stock bargains available as a result of the emotionally inspired selling wave.”

However, the volatility persisted until late in the year. And J. Paul Getty expanded further in an article published that September.

He blamed herd behavior and emotional investors on the irrational prices and crash. He criticized the speculation that drove stocks with little to no assets to trade at over 100 times earnings.

He relayed the message that get-rich-quick schemes don’t work. His “not-so-secret secrets” of investment success: sound companies, bought at low prices, and held for the long run is the way to wealth.

His real secret: not be panicked by market moves. While it’s hard to remove emotion from investing, its necessary for long-term success because emotional buying at ever higher prices leads to emotional selling when markets turn and panic sets in.

Finally, Getty reminded readers of his investing rules which he laid out nine months prior:

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