The last post of 2014 would be to learn from one of the investment classics, “The most important thing” by Howard Marks.

The book has a clear disclaimer in its introduction and I love, it reproducing for you below

You won’t find a how-to book here. There’s no sure fire recipe for investment success. No step- by- step instructions. No valuation formulas containing mathematical constants or fixed ratios— in fact, very few numbers. Just a way to think that might help you make good decisions and, perhaps more important, avoid the pitfalls that ensnare so many.

Now coming to understand what is the most important thing in investing, the Most Important Thing is not a single thing but a of host things . . first up is second- level thinking , in words of author

First- level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first- level thinker needs is an opinion about the future, as in “The outlook for the company is favourable, meaning the stock will go up.” Second- level thinking is deep, complex and convoluted. The second level thinker takes a great many things into account The difference in workload between first- level and second- level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former.

 

Not be discouraged but investing is indeed not easy, and it would takes years to develop such insights with deliberate practice. Thinking of decision as range of outcomes is very complicated given that we are programmed to think of outcomes as black and white

Moving on all of us aspire to beat markets, But is it easy to beat markets ?

it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences— to consistently hold views that are different from the consensus and closer to being correct. That’s what makes the mainstream markets awfully hard to beat— even if they aren’t always right

But there are few investors (Lynch, Munger, Buffet, R K Damani etc) who have done the impossible, they have beaten market and that too for years. How ?

Some investors can consistently outperform others. Because of the existence of (a) significant mis-valuations and (b) differences among participants in terms of skill, insight and information access, it is possible for mis-valuations to be identified and profited from with regularity.

Additionally to generate superior market beating returns one needs to value companies properly

An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse. This one statement shows how hard it is to get it all right.

As claimed in disclaimer the author has no superfluous excel or formulas to value companies instead what you get are below wise words

Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship— and the outlook for it— lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

Investing is assuming risk and there is where the book has some excellent insights first one is the way risk should be perceived

The incorrect way

The Correct way

The traditional risk/return graph is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money. I hope my version of the graph is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.

But how does one measure risk ?

Risk simply defined is the permanent loss of capital

Given the difficulty of quantifying the probability of loss, investors who want some objective measure of risk- adjusted return— and they are many— can only look to the so- called Sharpe ratio.

Price interestingly is the chief sources of risk

Investment risk comes primarily from too- high prices, and too- high prices often come from excessive optimism and inadequate scepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. The key lies in understanding what impact things like these are having

Apart from understanding and controlling risk the other key factor to succeed is to understand business cycles

The reason for cyclicality in stock markets is human involvement

Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical.

I could go on about how beautifully the book explains the business cycle and human behaviour linkage but the bottom line is buy in pessimism and sell in optimism

Quick recap before we move to what I call difficult part of the book. Till now we have understood in simple terms the most important thing in investing is

• Ability to develop second level of thinking
• Spotting mis valuations by having better insights
• Importance of putting a long term value to the company
• Understanding and controlling risks emancipating from price of security
• Understanding business and market cyclicality

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I call this half of the book difficult as it is a breeze to read but very difficult to implement

Profiting from other’s people mistakes might seem crude in real life but it is highly advocated by author in dealing with investment

Inefficiencies—mispricing, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes.

What makes people and markets in general to commit mistakes ?

• Greed – An extremely power full force that overcomes common sense
• Fear – Prevents investors from taking constructive action when they should
• Herd behaviour – Thinking and behaving like crowd
• Dismissal of historical pattern – reason for so many bubbles and burst

All of the above come naturally to any investor and this is the reason they are very difficult to let go only few individuals develop habits to negate above

Now how does one combat above – Are there any tools ?

Yes

The first one is Contrarianism

The author quotes Buffet

This is the core of Warren Buffett’s oft – quoted advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He is urging us to do the opposite of what others do: to be contrarians

Again extremely difficult to do, Who doesn’t want to ride trend or cut using falling knife ?

Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong- enough stomach to defy conventional wisdom (one of the greatest oxymoron) and resist the myth that the market’s always efficient and thus right

The second one is to hunt bargains

And how to find asset priced at bargain ?

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality

Again an investor has to go in an uncharted territory to find such bargains, again analytical error mistakes create bargains for second- level thinkers capable of seeing the errors of others.

The third is knowing what we don’t know

It is extremely important to know our limitation on what Buffet calls concentrating on circle of competence

One of the essential requirements for investment success— and thus part of most great investors’ psychological equipment— is the realization that we don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding “the knowable”: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t

 

I will stop here !! hope you are with me 🙂 This book is to develop what I call the other side of investing coin the emotional quotient

Give it a slow read, took me 5 months in first attempt 😉

Have a wonderful 2014, I will see in you 2015 at Tankrich with much more

Take Care