Sunday, June 11, 2017

What is The Point of All This?

I own several brokerage accounts with different discount financial companies. And I occasionally get calls from them seeking to build a relationship with me so that they can sell me some service. The first step in the conversation is to ask me about my financial goals. And I have trouble articulating it. I say something to the effect of trying to make as much money as possible. I don't mention the goal is to spend it to achieve some lifestyle. I instead say the money is the goal in and of itself.

For those who think this may seem like a strange answer, to me it is very similar to a person working towards a master title in chess. I do admit that unlike chess, building a nest egg does have the added benefit of providing retirement security. But considering that I live frugally and my savings are performing at or better than the market, I will probably have more than what I need in retirement. So working hard at investments at this stage for me must have more purpose than simply retirement security. So I say making money is the end in itself.

So working hard towards financial success over a lifetime should produce more money than one needs, if that person is frugal. Today I am going to describe how I think it can be done relatively easily. And what are the risks that can derail that.

Survival = Success

In this endeavor, the first thing to keep in mind is that it is a long road and to survive is to succeed. The one thing that can derail success is to have a loss and a lesson that one does not recover from. Even if one can theoretically recover a big loss over a lifetime, the psychological damage may discourage and/or prevent one from doing so. This is what others often call looking after the downside. And to me that means first and foremost, diversification. Diversification means spreading the risk across industries across asset classes and across geographies. A second useful thing is to have reasonable expectations. I have read the writings of various young investors in the blogsphere and I often sense an implied goal of 20% returns.

But in a lifetime achieving such returns on average would make that person one in a million! To get an idea how awesome 20% is, consider a 30 year old who has studied valued investing and who has some kind of a lasting edge. If that person has USD$100K and can save around $18 K per year (that's the limit for 401k retirement contributions) then that person will have $20M by age 60. That is very unlikely. I have never heard of a person who is worth $20M who didn't start out with a large capital base and who didn't work in finance or run a business but simply saved and had phenomenal returns. Instead the goal should be to simply match the market and possibly add one or two percent. So if the market does 8% for the next 30 years, then the target should be 10%. In the above scenario that 30 year old will have $1.8M at age 60. That's a huge difference, but it is also much more realistic.

Think Different

To get above average returns, I think it is necessary to have a different world-view than the greater investing community. That may seem so obvious that it needn't be said. But the actions and mood of the retail investment community seems to indicate people don't know it or forget it.

To make above average return in the market one must think differently from most people because the money made that is above average must come from others. And it is concentrated in a few; think of all the rich like the top 1%. They own a disproportionate amount of the wealth. So the rich minority make above average returns from the majority.

And surprisingly it is not hard to see errors in thought that many people make. It just takes work and practice to think differently. I can point out a few example off the top of my head.

A persistent theme in American politics is that life is getting no better or worse for the current generation than the previous. But that just flies in the face of facts. People think crime is up in this generation compared to the last. In fact, once on TV, the former House speaker Newt Gingrich did not dispute the fact that crime is down but said that it is a problem that people think US crime rate is up. I thought the job of a government entity or company is to achieve something for an end, not make you think that it is achieving something without actually doing it. Here thinking differently is echoing what Warren Buffett has been preaching: that the opportunities and life in the US has never been better.

The last US election dramatically demonstrated common faulty thinking in many ways. One reason people voted for Trump despite so much of his nonsense is that the voters simply wanted change. But society is a fragile institution, change for the sake of change will almost certainly be negative. Just look at history. Many decent societies were made a wreck by flashy orators without substance. I can think of Nassar of Egypt, the Perons of Argentina, Castro of Cuba, and on and on. These people can initially create a sense of euphoria in the general population. But their people's lot hardly gets better. And eventually that fact becomes obvious because the new leaders have taken whatever is right in their society and replaced it with something that is not well thought out and clearly worse.

So far my examples have been about politics, but it is just as applicable in investing. Take Japan for example. The common narrative is that Japan is a greying xenophobic country that restricts immigration. But it is a culture that has been very successful in the past, and they just have a labour shortage because of a low domestic reproductive rate. But I have never heard anyone mention any other way to describe the Japanese mentality. In twenty or thirty years, I believe it is possible that Japan will be forced into allowing some limited forms of immigration to replenish the population. The countries wealth and success can easily bring in as much cheap labour as needed. For example, Japan can allow a few million Chinese or Koreans legal immigration status for periods of five to then years. That can easily revive the economy when they find they have no choice. I am not saying this scenario is a certainty. But I am saying that I have not heard anyone even contemplating such a thing. The uniformity of thought in the investing community towards Japan is palpable. In my opinion, that creates a mispricing of Japanese equities in general and that is why I invest in Japan.

Be Objective

For most of us who are part of mainstream society, we are conditioned to interact harmoniously with others. That is a necessary condition to be successful in our communities and organizations. The way we are taught as children illustrates this point. Many of us have heard the saying, "it's not what you say that matters, but how you say it". I believe, in the business world, the best way to get success requires the following mix. The soft skills are personal attributes that allow someone to interact effectively and harmoniously with other people.

I do not espouse the correctness of efficiency of the way the world works; it just is what it is. But I do know that I am relatively poor in the soft skills department. And I know I can get more reward for my effort by utilizing my skills a pure technical setting, like personal investing. To invest in one stock in one's personal portfolio requires the following mix. Note there is no use for soft skills.

However, this pie chart is hardly encouraging because it shows that a large component of success in picking one stock is still out of our control. It is luck. But if we buy a basket of relatively uncorrelated stocks and waiting long enough, say five years. Then the odds of success in the whole will have the following mix.

This is so because of the law of large numbers in probability theory. As the number of samples increases, the actual ratio of outcomes will converge on the theoretical, or expected, ratio of outcomes. Take a coin toss as an example. The theoretical number of heads and tails should be 50%. However, one toss, or sample, will result in either 100% heads or 0% heads. That is hardly the theoretical result. However, in the total of 100 tosses, the result will be something like 46 out of 100. The 46% result is very close to the theoretical 50% theoretical result. In simple terms, the more the samples taken, the less luck plays in the experiment.

But using one's technical skills to make investing decisions is not so simple. It requires constant vigilance. This is hard because it is very difficult to think objectively in our world. So much of what we perceive is based on subjective biases. Suppose an employee is given a point of view that he feels is wrong, but which is the view of his boss. Does the employee oppose his boss? Many times an employee doesn't because what he wants is not the success of the task or the company at hand, but it is his own personal success within the company. To do that requires being a "yes man". And when a person thinks like this often enough, I believe that person begins to believe that the expedient view is the truth. This kind of subjective mindset can corrupt our minds and has no place in personal investing. This is one of the reason's why the many people have trouble getting good returns picking his own stocks. Because they are not used to thinking this way.

I can think of many examples in the investing world where a lack of objectivity has been costly. Theranos is/was a thirteen year old private company claiming to be on the cusp of revolutionizing the blood testing world. The house of cards came tumbling down last year amidst revelations by the Wall Street Journals that the company did not do anything close to what they were claiming. Then came the soul searching. The medical and investment community were scratching their heads wondering how did they let such a scandal happen. In this video , Harvard Professor Bill George was asked if the "golden-girl" CEO Elizabeth Holmes got a pass on the scrutiny because she was a woman, and he said "..... I would like to see a lot more women successful women..... we all drank the kool-aid......". My opinion is yes, she definitely got a pass because she was a young attractive white woman in a world dominated by middle aged white men. You can see her photo below and judge for yourself.

Theranos CEO Elizabeth Holmes

As a result of this scandal reputations were destroyed, tens thousands of blood tests were recalled, and millions in investors money were flushed down the toilet. Theranos is a very poignant reminder to be very vigilant, skeptical and objective when it comes to one's own investment dollars!

Successful investing of course requires understanding of businesses, economic cycles and value/growth principles. These are technical skills described throughout this blog, in the media, in business schools and in books. But the knowledge I have pointed out here are those that I found extremely useful but which are not so well emphasized elsewhere. This knowledge is difficult to grasp, easy to forget, and can make a huge different in one's investment results.

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