Lessons from Buffett: Investing

Buffett’s actions draw a strong distinction between a speculator and an investor ? the former trying to cash in on short-term fluctuations and emotional movements of stock price, the latter interested in the underlying quality and long-term prospects of a company.  These observations are drawn from the book Buffett, by Roger Lowenstein.

Stick to what you know

Buffett stuck to industries he knew well.  When the investment environment presented him with new challenges he didn’t understand, he got out until he felt comfortable again.

“Diversification had become an article of faith; fund managers were commonly stuffing their portfolios with hundreds of different stocks.  Paraphrasing Billy Rose, Buffett doubted that they could intelligently select so many securities any more than a sheik could get to ‘know’ a harem of one hundred girls.”

However, Buffett’s objections are largely targeted at professional investors.  Lowenstein doesn’t go into detail, but if your specialization is outside of investing, diversification may be a decent strategy.

Counter-trending

Even with his great success, Buffett was always cautious and didn’t presume he had better information than others. Perhaps he only excelled at using that information more wisely.

Buffett said: “I have never met a man who could forecast the market,” and “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

But his secrets were simple: “You try to be greedy when others are fearful and you try to be very fearful when others are greedy.”

Operating in this counter-cyclical manner allowed Buffet to get solid assets while they were cheap and, most likely, unload less impressive assets while other investors were willing to pay more for them.

This principle extends to borrowing.  “If you wait until you need a loan, it is likely to be when others are also borrowing, when?per force?rates will be higher.”

Focus on Long-term Value

Lowenstein explains this concept as Buffett did to the manager at Berkshire when he purchased it as a textile firm.

“He didn’t particularly care how much yarn Chace produced, or even how much he sold.  Nor was Buffett interested in the total profit as an isolated number.  What counted was the profit as a percentage of the capital invested.” 

“He told Chace not to bother with quarterly projections and other time-wasters.  He merely wanted Chace to send him a monthly financial report and to warn him of any unpleasant surprises.”

“Buffett did not think of Berkshire necessarily as a textile company, but as a corporation whose capital ought to be deployed in the greenest possible pastures.”

Buffett developed many of his investing principles from Graham and Dodd who argued, “The market… was not a ‘weighing machine’ that determined value precisely.  Rather, it was a ‘voting machine,’ in which countless people registered choices that were the product partly of reason and partly of emotion.”

He was also influenced by Charlie Munger and Philip Fisher, “each of whom stressed good, well-managed companies as distinct from statistically cheap ones.”

“...one’s house is not quoted day-by-day, and most people do not lose sleep over it’s value.”

Don’t let emotions drive your tax decisions

“Ultimately… there were only three ways to avoid a tax: 1) to give the asset away, 2) to lose back the gain, and 3) to die with the asset…”  Buffet believes “...people’s emotional distaste for paying taxes blind[s] them to acting rationally…”

He also comments on how the disconnect between political preferences and those of the taxpayers may be similar to the disconnect between a corporate manager and that of their shareholders: “Many corporate managers deplore governmental allocation of the taxpayer’s dollar but embrace enthusiastically their own allocation of the shareholder’s dollar.”

Book Review: Fooled by Randomness

“Reality is far more vicious than Russian roulette.  First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six.  After a few dozen tries, one forgets about the existence of a bullet, under numbing false sense of security,” says Nassim Nicholas Taleb.  He refers to this as the black swan problem.

Mistaking Luck For Skill

Fooled by Randomness is a book about mistaking luck for skill, a mistake Taleb sees most prevalent in journalism and the world of markets.  At the root, “risk detection and risk-avoidance are not mediated in the ‘thinking’ part of the brain but largely in the emotional one.”  “The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance.  Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.”

Yet, “[p]eople fail to learn that their emotional reactions to past experiences (positive or negative) were short-lived.”  “[T]hey continuously retain the bias of thinking that the purchase of an object will bring long-lasting, possibly permanent, happiness or that a setback will cause severe and prolonged distress (when in the past similar setbacks did not affect them for very long and the joy of the purchase was short-lived).”

He paraphrases a remark by Einstein: “[C]ommon sense is nothing but a collection of misperceptions acquired by the age eighteen.”

Other Common Misperceptions

Taleb also redefines a common misperception of the word ‘mistake’:  “A mistake is not something to be determined after the fact, but in the light of the information until that point.”

This point ties succinctly with the concept of creative destruction which embraces the role of failure in development.  Mistakes need not be avoided, but learned from.  But, many environments are not conducive to such a framework.  Many of these frameworks have been engrained in society and social relationships for years.  Taleb explores why “bad traders have a short- and medium-term survival advantage over good traders,”  by tying the world of markets to naive evolutionary theories.

“[M]any amateurs believe that plants and animals reproduce on a one-way route toward perfection. Translating the idea to social terms, they believe that companies and organizations are, thanks to competition… irreversibly heading toward betterment.”  This is simply not true.

Taleb offers multiple reasons.  I will follow each with a few of my own thoughts.

1) Organizations do not reproduce like living members of nature.  Competition is never between buyers and sellers.  It is always between buyers and buyers or sellers and sellers.  While finding the perfect mate could fall in the same category as competition between businesses, reproduction is different in many ways.  Perhaps a more valid metric to compare the social environment of organizations to reproduction would be one of accessibility.  That is, to what level do companies, or mates, have the opportunity to enter or exit the marketplace?

2) Randomeness.  Some mutations are for the better, others for the worse.  “Negative mutations (Gould) are traits that survive in spite of being worse, from the reproductive fitness standpoint, than the ones they replaced.”  Again, this acquires a level of complexity when translated into social terms.  While market trends may be surprising on their own, subsidies, labor protection laws, and a variety of other market distorting policies add another level of randomness to the mix, often allowing unprofitable enterprises (negative mutations) to survive.

In Taleb’s mathematical verse: “Just as an animal could have survived because its sample path was lucky, the “best” operators in a given business can come from a subset of operators who survived because of over-fitness to a sample path—a sample path that was free of the evolutionary rare event.” “[E]volution means fitness to one and only one time series, not the average of all possible environments.”

The Dive Bar that is Journalism

Distinguishing between signal and noise is widespread, though, journalism receives the largest swath of Taleb’s relentless skepticism: “[J]ournalism may be the greatest plague we face today—as the world becomes more and more complicated and our minds are trained for more and more simplification.”

This effect of this large-scale compression—going from the particular to the general—“is the reduction in the degree of detected randomness.”  Journalism, through induction, favors the palatable over the counter-intuitive.  In sum: “[M]ost poetic sounding adages are plain wrong.”

From journalism to winning streaks, “if someone performed better than the crowd in the past, there is a presumption of his ability to do better in the future.”  But this is a weak presumption.  It depends on two factors: “The randomness content of his profession and the number of monkeys in operation.”

While Taleb doesn’t offer any advice on which particular profession to choose, he does offer a suggestion.  Don’t shoot for a profession where you only like the way people live at the top. Consider the lifestyle of the average person, there are many more of them.

Escaping Randomness (Kind of)

The idea of alternative histories across several disciplines all seem to converge on the same concept of risk and uncertainty: “certainty is something that is likely to take place across the highest number of different alternative histories;  uncertainty concerns events that should take place in the lowest number of them.”  Taleb mentions examples in philosophy, physics and economics.

However certain this convergence may appear, one still has to stay alert.  Profits and losses are never guaranteed.  “The frequency or probability of [a] loss, in and by itself, is totally irrelevant; it needs to be judged in connection with the magnitude of the outcome.”

A Bundle of Instincts

"It was (and is) common to think that other animals are ruled by "instinct" whereas humans lost their instincts and are ruled by "reason", and that this is why we are so much more flexibly intelligent than other animals. William James took the opposite view. He argued that human behavior is more flexibly intelligent than that of other animals because we have more instincts than they do, not fewer."

Leda Cosmides & John Tooby offer more here: Evolutionary Psychology: A Primer.