Despite the picture above, intelligent investing is not gambling. When you get interested in investing, an all too common thing people will tell you is: “Don’t put in money you’re not willing to loose”. This is because most people don’t pick individual stocks, and thus they see market movements as completely random and a gamble. In order to do reasonably well in investing, you need to always be thinking in probabilities. And pay special attention to confirmation bias!
Typical Behavior Leads to Typical Results
Sometimes I browse legit “mainstream” as well as “meme stock” investing forums for entertainment, and it’s like the wild west. Unregulatable, coupled with a mix of snake oil, charlatans, good advice, bad advice, different timeframes and motives all mixed in one big geggamoja (mess) of a soup. How on earth is someone to find anything remotely intelligent on these forums? The answer: You won’t!
The internet perhaps laid a blessing and a curse at the same time. The democratization of information has been in full swing for over two decades, but people will get duped anyway. The blessing is that good information is out there, you just have to dig deeper than surface level to find it.
“Is This a Good Stock??”
A common theme on these types of forums is people asking for stock ideas. As well as people stating they are a beginner and wonder where to put some savings. The replies to these posts can be numerous. More information does not always mean better decisions. I don’t think there is a cure to this either. In his excellent book, “The Psychology of Money”, Morgan Housel writes:
“Everyone has their own unique experience with how the world works. People from different generations, raised by different parents, who earned different incomes and held different values, in different parts of the world, born into different economies, experiencing different job markets with different incentives and different degrees of luck, learn very different lessons. So all of us -you, me, everyone- go through life anchored to a set of views about how money works that vary wildly from person to person. What seems crazy to you might make sense to me”
As I wrote in my previous post on Buffett’s early days, you cannot outsource your thinking. If you pick a stock based on what someone else tells you, without looking into the company on a deeper level, you are gambling. There will be two outcomes, and you have no way of honestly knowing the probabilities; you gain or loose.
The outcome of this gamble will predict your future behavior to a high degree. If you win, you will think you are smarter than average, and possibly start following the person who gave you the idea in the first place. This sets the stage for an inevitable loss at some point, as early success based on luck usually leads to overconfidence and an irrational decision in the future. If you loose, the psychology of a loss will have you feeling miserable. If you’re smart, you’ll learn from your mistake and look towards investing that is less of a gamble, i.e. “intelligent investing”. If you’re someone who’s pride has been hurt, and are unwilling to admit a mistake and learn, you’ll be discouraged from investing again.
The Mental Model: Thinking In Probabilities
In order to come to an intelligent conclusion on any given company, you need to think in terms of outcome probabilities. Through constant learning and improvement, you’ll find situations where you almost “know what will happen”. You just don’t know when. This is usually a good sign, but remember to start the decision making process through reversion: What can go wrong, what can cause this, and what are the probabilities for this scenario?
Equity Bonds
Warren Buffett has coined the term “Equity Bonds”. Here’s what it means.
When you buy a bond, you know the payments you’ll receive and the timeframe. With stocks, you need to think of them as “Equity Bonds”. The facts you receive are the price, and business figures. The only thing not printed is the future payments the business will produce. If you can figure out what the payments are likely to be, and the number is high in relation to the price you’re paying, you probably have a good deal. The most simple way to think of the above is estimate what the company’s future free cash flow will look like.
Conclusion: Your Reasoning May Be Right, But The Outcome Unfavorable
Valuation is not an exact science. You may have actually made exceptional analysis on a company, and rationally invested in a scenario with an 80% favorable outcome, and 20% unfavorable. There is still that 20% chance you have an unfavorable outcome. This is why having a margin of safety is so crucially important. It protects you from a negative outcome, and minimizes the possibility of permanent loss of capital (not short-term quotational loss).
Great investment opportunities are rare, but when they do appear, you need to act decisively. So how do you know if what you’re looking at is worth further research? Here are some quick mental criteria:
- The company is within your circle of competence.
- You have a timeframe of at least 3 years.
- You’re willing to punch a hole in your punch card.
- You’re highly certain, that there is indeed, a margin of safety.
When you’re unsure of the outcome, there’s a simple remedy: Don’t invest. Remember, it’s much better to remain patient, to wait for the perfect pitch. And then, swing mightily!
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Sir John Templeton – Wisdom From Global Value Investing Legend
The Emotional Stages of a Value Investor
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