Noise, noise and more noise.
When we were in São Paulo, we were asked to give a brief speech to Brazilian investors. They wanted to know what we considered to be the most important things an investor should know.
What follows is more or less what we said. (Long-suffering readers are invited to skip this, since they will find few new ingredients. On the other hand, you may find the new distillation more agreeable.)
What are the most important lessons for an investor?
Well, let’s begin at the beginning. If you’re listening to this speech, it suggests you want to improve…that you want to be a better investor.
So let’s start there. Is it possible to be a better investor?
Believe it or not, there was a time when most serious thinkers believed it was not possible. I thought so myself. Professors of finance and economics won Nobel Prizes based on research ‘proving’ that you could earn higher than average returns without taking on higher than average risk.
Warren Buffett famously demolished this point of view — known as the Efficient Market Hypothesis (EMH) — in a debate in 1984.
In effect, he said to his opponent, Harvard’s Michael Jensen, ‘If you were right I couldn’t be so rich. And if I had believed what you believe I wouldn’t be rich.’
The idea behind EMH is that a dart-throwing chimpanzee is just as likely to beat the market as you are. In fact, the average investor would be delighted to even keep up with the chimps.
That’s because the average investor tends to listen to TV or read the newspaper too much. He’s trying to keep up with the fads. But his tie is always too narrow or his shoes are too long. And therefore he buys and sells too often.
In fact, a study by Fidelity Investments found that the clients that did the best were the ones who had left fashion behind. They were account holders who had forgotten they had accounts with Fidelity. So they had just left them alone.
Right place, right time
So, this is probably a good place to introduce the first important thing you should know: ‘Beta’ is what really counts.
The best you can do…or the best you are likely to do…is by getting into the right place at the right time and staying there.
That’s your market returns. That’s your ‘beta’. It’s what you get from your asset allocation decisions.
Your ‘alpha’ is what you get above and beyond the market returns by choosing the right stocks. Most of your gains will come from your big beta choices — which market and which asset classes to be in…not which particular stocks or bonds you buy.
In the US, for example, if you had just gotten into the stock market in 1982…bought the Dow Industrials…and did nothing else for the next 33 years…you would have multiplied your money 17 times.
So, the first lesson is to get into the right market at the right time and then forget about your portfolio.
Do your homework
But Warren Buffett proved that you can do much better than either the dart-throwing chimp or the fashion victim. And he showed that if you do your homework, you can even do much better than the guy who forgets about his portfolio altogether.
What’s the secret?
Well, it turns out that investing is just like the rest of life: Hard work pays off. Effort is rewarded. So are other virtues, such as self-discipline and patience.
In theory, it’s simple. You do a lot of work to figure out what a company is really worth if it were sold to a private buyer. If the current stock price is lower than that amount, you should buy it. If it is higher, you should stay away.
All the rest is detail and distraction.
But making those calculations is hard. I’ve run my own company for the last 35 years. At no time could I say with confidence or authority how much it was really worth. There are just too many unknowns.
That’s why you should never forget what Ben Graham called your ‘margin of safety’. You do your research. You make your calculations. And then you give yourself some room for error and unexpected events.
This brings to mind the No. 1 secret of successful investing: humility. You’re going to be wrong a lot of the time.
There are two ways for you to build humility into your investments.
The first is a margin of safety.
The second is a stop loss — an order you place with your broker to sell your stock when it reaches a certain price.
If you are Warren Buffett…or an extreme value investor…you probably won’t use stop losses. They will just stop you out of good positions. But if you are like most investors, stop losses are a form of automatic humility. They tell you when you are wrong and force you to change your investments.
We did a thorough study of stop losses within our company. We found that a stop-loss strategy not only helps you cut your losers short, but also it helps you let your winners run.
Here’s what happens. You buy a good stock. It goes up. You are happy. But you don’t want to lose those gains. So you sell the stock to ‘lock in’ your profits. And then your stock keeps going up!
Four lessons to remember
So, here are the basic lessons.
Basic Lesson No. 1 – Being in the right place at the right time is the most important thing. Beta pays. Roughly speaking, one correct big picture is worth four or five correct little pictures.
Basic Lesson No. 2 – Hard work pays off. So remember the other important virtues: patience, self-discipline and humility.
Basic Lesson No. 3 – Investing is different from other parts of life. Think a lot, but do very little. Inaction is more productive than action.
Basic Lesson No. 4 – Always be humble. Always have a margin of safety. And unless you are a very confident, long-term deep-value investor with deep pockets, always use stop losses.
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