Wednesday, January 15, 2014

How to become a better investor

I love to run.  I enjoy being outside, and pushing myself both physically and mentally.  Running fills both of those needs.  I'd like to become a better runner by increasing my endurance, and decreasing my times.  The only way for me to achieve these goals is to go out and run.  I sometimes read about running, and think about it, but the only way to improve is to actually run.

When taking up a new activity reading isn't the same as doing.  You can read all you want about the activity, read others' experiences, but you need to do it yourself.  I had a co-worker who was much more passionate about running than myself.  He would spend hours reading about the body mechanics of running and knew everything about various running gizmos.  Unfortunately all this knowledge didn't make him a better runner, it just made him a more informed runner.

Knowledge alone doesn't make anyone faster; to become faster requires practice.  Ultimately speed is determined by a mix of practice and genetics.  I'm a fairly average runner, I can run three or four miles at a seven minute mile pace comfortably.  I'm not fast though, the fastest mile I've ever ran was 6:09, and that was in high school.  On my high school cross country team I was one of the slowest kids, not something I'm proud of, but a reality.  I ran the same workouts as everyone else on the team, its just my body wouldn't move as fast as them.  No matter what I tried I could never get it to move beyond a certain limit.  Fortunately I haven't degraded much over time, in my 30s I can run at almost the same speeds that I did in high school.  If I continue to degrade gracefully I'm looking forward to my 40s and 50s where I'll finally be able to win a race in my age bracket.

I think the parallels to running and investing are very similar.  A lot of what applies to becoming a better athlete applies to becoming a better investor as well.

I receive emails from readers asking me the best way to learn how to invest, and become a better investor.  The best way to learn how to invest is to get started and invest money.  Just like with running, you can read a lot, and think a lot, but until the shoes hit the road, or the money hits the brokerage it's all just theory.  There is an emotional component to investing that you will never experience until you see your money, the money you worked hard to save move up and down with the market.

Becoming a better investor isn't a matter of building a better process, or from practice researching companies.  Becoming a better investor is done through the practice of actually investing.  There is a feeling investors experience when they see their money drop 10% that you will never experience if you just follow a company.  Yes, a market loss isn't realized until you sell, but it's an emotional gut check to see a loss and contemplate the things you could have purchased.  It's also euphoric to take action on a stock and see the stock react the way you expected.  The idea that money was invested and almost out of nothing new money appeared.  No products were sold, no services offered, just a purchase, a period of waiting and voila, more money.

Getting started in a new activity is difficult.  I remember the first time I ever ran, it was in 8th grade in the spring.  I made it maybe a mile and thought I was going to die right there on the sidewalk.  It was a terrible experience, I went home and told my parents I was going to quit the track team after my first day.  They encouraged me to stick with it and give it a try.  About a week later I remember running three miles, the feeling of accomplishment was incredible.  What was impossible a week before was now possible.

The beginning of anything is difficult, you're starting from a standing still position, there is no momentum.  Once you've started you build momentum, it's easier to keep moving with momentum.  Researching and investing in your first company is difficult, it's not as difficult to invest in your 200th company.

Once you've begun and have started to gain some experience flaws will start to appear almost immediately.  You'll notice things you missed, or things you're not good at.  Continue to practice, but with each new investment work on fixing those flaws.    Continually iterate, learn what went wrong, fix it and try again.  From the continual iteration you'll start to build a repeatable process.  An investing process is never finished, it's always a work in progress.

Another way to get started is by starting small and simple.  Just like a beginning runner wouldn't run a marathon as their first practice, an investor shouldn't be tackling AIG warrants as their first investment.  Start with simple companies where the accounting is easy to understand.  Once you understand the easy accounting slowly start to invest in companies with more complex accounting that stretches your skills.

This method of learning and extending could be applied to investing in new industries as well.  A common complaint I hear is that banks are too hard to understand and they're black boxes.  Often the complaint will mention a money center bank such as Bank of America or Wells Fargo.  Instead of trying to run a marathon first why not start with a very small and simple bank?  Small banks have simple accounting and are easy to understand.  I'm singling out banks because I'm familiar with the industry, but the same thing could be said for oil and gas, or biotech, or really anything.

Just like people naturally run at different speeds, people invest at different speeds as well.  Just because Warren Buffett reads, thinks, and invests doesn't mean that if I replicate his steps the result will be the same.  No matter how hard I try I will never break five minutes on a mile, my body is not built for it.  I'm too old and slow, but I'm aware of my ability.  We as investors need to be aware of our abilities and limitations as well.  Some investors, the Superinvestors perhaps, are naturally more gifted.  I can never match their ability, but that doesn't mean I can't enjoy investing, or work to maximize my own ability.

The best way to get better at anything is to do it.  Do you want to improve at sales?  Then sell.  Looking to improve at marketing?  Start marketing.  Want to improve as an investor?  Invest.

The formula is simple, almost too simple.  Yes we can learn from the mistakes of others, and the experience of others is valuable.  But the best experience is your own.  You will remember your own mistakes and experiences better than you'll remember someone else's.

20 comments:

  1. Some great guidance here, as per usual. Thanks, Nate.

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  2. The road to wisdom? -- Well, it's plain and simple to express: Err and err and err again, but less and less and less.

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    1. I like this statement, very simple, and very true.

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  3. Much appreciated Nate, especially for someone like me, who is at the starting line getting ready to invest but who is also afraid what it will be like once the starting gun goes off

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  4. I think you miss a point that without significant knowledge and training in Corporate Finance, most small time investors (and many large ones too) are just glorified gamblers. Without the ability to dissect financials and understand how to truly value a company, shouldn't they get that first? And/or just stick it in SPY and call it a day (and also never sell and thus never pay taxes).

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    1. I disagree, a baseline of knowledge is required for sure, but not a background or training in Corporate Finance. If that requirement were true I'm merely just a gambler. Some of the greats like Walter Schloss were just gamblers as well.

      Clearly understanding accounting is of utmost importance. But not just accounting alone, if a mastery of accounting were all one needed a computer could be programed to be the best investors, just follow the accounting rules. There is a lot of thought and consideration that moves beyond raw accounting. I would say on average 30-40% of my time spent on an investment is thinking about the financials, the rest is on soft issues like risk, or whether the CEO is going to short change shareholders.

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  5. Great post! I would add, before you start investing learn playing poker and understand it. Thats was a key eye opener for me that changed my way.

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    1. Thanks, interesting perspective regarding poker. I think it's interesting how there are many different backgrounds that can be conducive to investing, not just the formal route many believe.

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  6. Nate,
    Consider yourself lucky in the running department. I ran 4:20s in high school and suffered knee problems throughout my later years. Keep up the good work. I totally agree with this.

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    1. Thanks, I'm enjoying it while it lasts. I have knee problems, but they're from biking, a supposedly zero impact activity. Running doesn't bother them at all, nor does skiing.

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  7. One difference to investing is that running has adverse training effects if you run too much.
    Aditionally more knowledge about running can make your training more efficient (e.g. combine interval training with longer runs, instead of "just" running. Knowledge is required to get better results.

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    1. Yes, it works the same in investing, too much investing (trading) can lead to bad results as well.

      I agree with you on the workouts, but I'd argue that you need to start investing before the knowledge can really pay off. Yes a base level of knowledge is required to get started, but maybe not as much as many people think.

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  8. Few things I learn once I started investing is:

    1. How to handle conflict indicators.

    For most decent potential investments, I always have conflict indicators. A firm might have decent cash flow,
    strong balance sheet, and consistent earning, but the inside ownership is low and executives' pay is high. What should I do in this situation? Another example is sometimes I find a company with a little bit more reputation and growth, as compared to the second company with less known products and lower growth. If the first company trades at 12 X TEV/E and the second company trades at 8 X TEV/E, which one should I invest? Or should I take a chance in making a very good investment as compares to waiting for an excellent one? Does the wait justify the reward?

    I spent a large portion of my time thinking about questions in the nature and determine what should I do. And I realize the perfect pitch analogy - firms that tick all the boxes (valuation, earning, balance sheet, cash flow, moat, low executive pay, high insider ownership, growth, large buybacks or dividends, low capex...etc) are indeed extremely rare, especially in a bull market. If I see one, I absolutely take a large position.

    2. Simple ideas are so much better than an intellectually elegant ones.

    I have came across a company, Insyde Software ( http://goo.gl/7lnhFN). It is a BIOS firmware developer. It seemed to be the perfect company in early 2012 - Growth in revenue, net profit, net margin, good niche and low capex. Intel was its major stockholder and collaborated heavily with Insyde to set standards in many platforms(notebooks, PC, servers) . It seemed like Insyde's moat was unbeatable.

    However, in 2012, Insyde's competitor Phoenix lowered its price and Insyde had to cut as well. At the same time, Intel also made investment in Phoenix to build a stronger relationship in R&D. Suddenly all of Insyde's moat crumbled and stock price plunged.

    I didn't invest in Insyde. During the time I was invest in simple ideas and loosely followed Insyde. Still, the downturn of Insyde shocked me and it shows how a moat(or at least my perception of it) can be undermined so fast.

    I think books are sometimes a little withdrawn and irrelevant. An investor definitely needs to step in to get a feel of the real game.

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    1. You make some great points. A moat can disappear quickly, although a moat investor might argue that Insyde never had a moat. If they had one then they would have been immune to competition. I disagree with that, I think any business has a weak point and is vulnerable at certain times.

      There are no perfect stocks, and sometimes perfect is the enemy of good. It can be a fools errand to search for the perfect stock, I'd rather buy a lot of good cheap stocks. When I was first looking for Japanese net-nets I had trouble because I'd be debating with myself on whether I'd rather buy one stock at 50% of NCAV and 5x earnings or another at 53% of NCAV and 6x earnings. Why decide, just buy both?

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  9. Good article Nate. Just as a runner needs callus himself by training at race pace, the investor needs to become inured to scalding losses. But I think the novice can achieve this via index funds. After reading some of the basic texts (e.g., Graham) he can advance to stockpicking.

    As an avid runner myself, soon to hit the 50-59 age group, I have some disheartening news for you. You still have to run some sick times to medal in most races, particularly in the 40-49 age group. Even 50+ may require a sub-20 5K to medal. Sometimes half the field is M40+, and a lot of them run every day and do speed work. Your best bet even before you become a master may be to enter a local race that is way off the radar, such as the Conduril 5K.

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    1. Patrick,

      I have sought out 'oddball' races in the past, I ran one last summer, pulled a rabbit out of the hat and came in fifth place. That was a complete surprise. I live in Western PA which is extremely hilly. On a five mile run it's not uncommon to gain 800-1000ft in elevation. There are no flat routes anywhere. What I try to do is run good times on routes like that, then enter races in Ohio (we have family that lives there) where it's flat and I have an advantage.

      Just like in investing I'm looking for an advantage running as well!

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  10. Simple yet effective.....I do enjoy the stuff you publish in your blog...Thanks a ton and do keep it up!

    Regards--Surender

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  11. Nice article. The nice thing about investing is that success can come from being opportunistic and opportunity typically comes in small packages (unless you get a panic like 2008) where you can focus on analyzing only a few situations versus many. This allows you to jump in with a few stocks at a time. I have found being selective (only swinging when the ball is just right) improves performance over time. However all stocks have faults and you just need to determine which one you can live with and which ones you cannot.

    Packer

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