Mindmap-Book SummaryWarrentBuffetWay

Mindmap-Book SummaryWarrentBuffetWay

• About The Warrent Buffet Way
  • Date Read: December 2014
  • Author: Robert Hagstrom
  • ISBN: 978-1-118-79399-2
  • 322 pages
  • MyRating: 5 Stars
• Chapter 01 : A Five Sigma Event: The World’s Greatest Investor
  • Personal History and Investment Beginnings
  • The Buffett Partnership Ltd
  • Berkshire Hathaway
  • Insurance Operations
  • The Man and His Company
  • Five Sigma Event
• Chapter 02 : The Education of Warren Buffett
  • Benjamin Graham
    • Graham insists that for a security to be considered aninvestment two conditions must be present: some degree of safetyof principal and a satisfactory rate of return

      “An investmentoperation is one which upon thorough analysis promises safety ofprincipal and a satisfactory return Operations not meeting theserequirements are speculative ”

      “thorough analysis”

      “the careful study of available facts with theattempt to draw conclusions therefrom based on established principlesand sound logic

      three step process

      ( ) descriptive

      ( ) critical

      ( ) selective

      examining the merits ofthe standards used to communicate information

      Have the facts beenrepresented fairly?

      to pass judgmenton the attractiveness of the security in question

      Graham ’s second contribution—after establishing a clear andlasting distinction between investment and speculation—was amethodology for buying common stocks that would qualify themas an investment rather than speculation

      The danger of was not that speculation tried to masqueradeas investing but rather that investing fashioned itselfinto speculation

      Graham noted that optimism based on historywas rampant—and dangerous Encouraged by the past investorsprojected forward an era of continued growth and prosperity andbegan to lose their sense of proportion about price

      people were paying prices for stocks without any sense of mathematicalexpectation; stocks were worth any price that the optimisticmarket quoted

      wayof selecting stocks

      ( ) purchase shares when the overall market istrading at low prices (generally this occurs during a bear marketor a similar type of correction)

      ( ) purchase the stock whenit trades below its intrinsic value even though the overall market isnot substantially cheap

      identifying undervalued securities

      a margin of safety existed for a commonstock if its price was below its intrinsic value

      How does one determine intrinsic value?

      intrinsic value

      intrinsic value is “that valuewhich is determined by the facts ”

      facts include

      a company ’sassets its earnings and dividends

      future defi nite prospect

      Acompany ’s intrinsic value can be determined by estimating thefuture earnings of the company and multiplying those earningsby an appropriate capitalization factor

      margin of safetycould work successfully in three areas:

      ( ) in stable securities suchas bonds and preferred stocks;

      ( ) in comparative analysis

      ( ) in selecting stocks provided the spread between price and intrinsicvalue is large enough

      Graham proposed that it was not essentialto determine a company ’s exact intrinsic value; even an approximatevalue compared against the selling price would be suffi cientto gauge the margin of safety

      Don ’t lose

      Don ’t forget the fi rst rule

      ( ) buy a companyfor less than two thirds of its net asset value

      analyzing the fi nancial results of stocks

      a year low price to earningsmultiple

      a stock price that was equal to half its previous markethigh

      a net asset value

      John Burr Williams ’s classic defi nition of value

      The value of any investment is the discounted present valueof its future cash fl ow

      Graham ’s methods—buyinga stock for less than two thirds of net asset value and buying stockswith low price to earnings multiples

      Graham ’s conviction rested on certain assumptions

      First hebelieved that the market frequently mispriced stocks usually becauseof the human emotions of fear and greed

      second assumption wasbased on the statistical phenomenon known as reversion to the mean

      “Many shall be restored that now have fallen andmany shall fall that now are in honor ”

      Graham believed that an investor could profi t from thecorrective forces of an ineffi cient market

  • Philip Fisher
    • investment counseling fi rm

      Fisher fi gured he had two advantages

      First any investor who had any money left after the crash was probablyvery unhappy with his or her existing broker

      Second in themidst of the Depression businesspeople had plenty of time to sitand talk with Fisher

      superiorprofi ts could be made by

      ( ) investing in companies with aboveaveragepotential

      ( ) aligning oneself with the most capable management

  • Charlie Munger
    • To achieve “worldly wisdom

      you must build a latticework of mental models that unites all thebig ideas in the world

      Poor Charlie ’s Almanack: The Wit and Wisdom of CharlesT Munger

      A Blending of Intellectual Influences

      The key lessonthat Buffett took from Graham was

      Successful investing involvesThe Education of Warren Buffett purchasing stocks when their market price is at a signifi cant discountto their underlying business value

      margin of safety

      do not be dissuaded just because others disagree

      “You are neither right or wrong because the crowd disagreeswith you ”

      “You are right because your data and reasoningare right

      Phil Fisher was in many ways the exact opposite of Ben Graham Fisher believed that to make sound decisions investors needed tobecome fully informed about a business

      That meant

      investigatingall aspects of the company

      look beyond the numbers

      learn about the business itself

      study the attributes ofthe company ’s management

      Fisher taught Buffett not to overstress diversifi cation

      Hebelieved that it was a mistake to teach investors that putting their eggsin several different baskets reduces risk

      The danger in purchasing too many stocks he felt is that it becomes impossible to watch all theeggs in all the baskets

      Investors run the risk of putting too much in acompany they are unfamiliar with

      buying shares in a companywithout taking time to develop a thorough understanding of thebusiness is far riskier than having a limited diversifi cation

      The differences between Graham and Fisher are apparent

      Graham the quantitative analyst emphasized those factors thatcould be measured: fi xed assets current earnings and dividends His investigative research was limited to corporate fi lings andannual reports He spent no time interviewing customers competitors or managers

      Fisher ’s approach was the antithesis of Graham ’s Fisher thequalitative analyst emphasized factors that he believed increasedthe value of a company: principally future prospects and managementcapability

      Whereas Graham was interested in purchasingonly cheap stocks

      Fisher was interested in purchasing companiesthat had the potential to increase their intrinsic value over the longterm

      Fisher was

      unassuming

      generous in spirit

      extraordinaryteacher

      “It is not enough to have good intelligence ”

      “the principal thing is to apply it well ”

• Chapter 03 : Buying a Business: The Twelve Immutable Tenets
  • There is no fundamental difference according to WarrenBuffett between buying a business outright and buying a pieceof that business in the form of shares of stock

    Of the two he hasalways preferred to directly own a company for it permits him toinfl uence the business ’s most critical issue: capital allocation Buying its common stock instead has one big disadvantage: Youcan ’t control the business

    offset Buffett explains by twodistinct advantages:

    First the arena for selecting noncontrolledbusinesses—the stock market—is signifi cantly larger

    Second thestock market provides more opportunities for fi nding bargains

    looks for companies he understands

    with favorable long term prospects

    are operated by honest and competent people

    available at attractive prices

    “When investing ” he says “we view ourselves as business analysts not as market analysts not as macroeconomic analysts andnot even as security analysts ”

    THE TWELVE IMMUTABLE TENETS

    • Business tenets
      • Business tenets —three basic characteristics of the businessitself
    • Management tenets
      • Management tenets —three important qualities that seniormanagers must display
    • Financial tenets
      • Financial tenets —four critical financial decisions that thecompany must maintain
    • Market tenets
      • Market tenets —two interrelated cost guidelines
    • Stocks are an abstraction
      • He doesn ’t think in termsof market theories macroeconomic concepts or sector trends

        Hemakes investment decisions based only on how a business operates

        He believes that if people are drawn to an investment because ofsuperfi cial notions rather than business fundamentals

        they aremore likely to be scared away at the fi rst sign of trouble and in alllikelihood will lose money in the process

        Instead Buffett concentrateson learning all he can about the business under consideration

    • He focuses on three main areas
      • A business must be simple and understandable
      • A business must have a consistent operating history
      • A business must have favorable long term prospects
      • Tenets of the Warren Buffett Way
    • A Business Tenets
      • Is the business simple and understandable?
      • Does the business have a consistent operating history?
      • Does the business have favorable long term prospects?
    • B Management Tenets
      • Is management rational?
      • Is management candid with its shareholders?
      • Does management resist the institutional imperative?
    • C Financial Tenets
      • Focus on return on equity not earnings per share
      • Calculate “owner earnings ”
      • Look for companies with high profi t margins
        • For every dollar retained make sure the company has createdat least one dollar of market value
    • D Market Tenets
      • What is the value of the business?
      • Can the business be purchased at a signifi cant discount toits value?
    • Simple and Understandable
      • investors ’ fi nancial success is correlated to howwell they understand their investment

        This is a distinguishing traitthat separates investors with a business orientation from most hitand run types—people who are constantly buying and selling

        acutelyaware of how all these businesses operate

        • revenues
        • expenses
        • cash fl ows
        • labor relations
        • pricing fl exibility
        • capital allocation

        Investment success is not a matter of how much you know buthow realistically you defi ne what you don ’t know

        “Invest in your circleof competence ”

        “It ’s not how big the circle isthat counts; it ’s how well you defi ne the parameters

    • Consistent Operating History
      • Buffett not only avoids the complex but he also avoids purchasingcompanies that are either solving diffi cult business problems or fundamentallychanging direction because their previous plans wereunsuccessful

        It has been his experience that the best returns areachieved by companies that have been producing the same productor service for several years

        Undergoing major business changesincreases the likelihood of committing major business errors

        “Severe change and exceptional returns usually don ’t mix ”

        Investors tend to be attracted to fast changing industries or companiesthat are in the midst of a corporate reorganization

        investors are so infatuated with whattomorrow may bring that they ignore today ’s business reality

        Buffett cares very little for stocks that are hot at any givenmoment

        He is far more interested in buying into companies thathe believes will be successful and profi table for the long term

        And while predicting the future success is certainly not foolproof a steady track record is a relatively reliable track record

        When acompany has demonstrated consistent results with the same type ofproducts year after year it is not unreasonable to assume that thoseresults will continue

        Buffett also tends to avoid businesses that are solving diffi cultproblems

        Experience has taught him that turnarounds seldom turn

        “Charlie and I havenot learned how to solve diffi cult business problems ” Buffett admits “What we have learned to do is to avoid them To the extent thatwe have been successful it is because we concentrated on identifyingone foot hurdles that we could step over rather than because weacquired any ability to clear seven footers

    • Favorable Long Term Prospects
      • Franchise as a company providing a productor service
        • ( ) needed or desired
        • ( ) has no close substitute
        • ( ) is not regulated

        moat

        • something that gives the company aclear advantage over others and protects it against incursion fromcompetition

          The bigger the moat and the more sustainable

          The key to investing ” he explains “is determiningthe competitive advantage of any given company and above all the durability of the advantage The products or servicesthat have wide sustainable moats around them are the ones thatdeliver rewards to investors

        a bad business

        a bad business offers a product that is virtually indistinguishablefrom the products of its competitors—a commodity

        basic commodities

        • oil
        • gas
        • chemicals
        • copper
        • lumber
        • wheat
        • orange juice
        • computers
        • automobiles
        • airline service
        • banking
        • insurance

        Despite mammoth advertising budgets they areunable to achieve meaningful product differentiation

        Commodity businesses

        Commodity businesses generally are low returning businessesand “prime candidates for profi t trouble

        Their product is basicallyno different from anyone else ’s so they can compete only onthe basis of price—which of course cuts into profi t margins

        Themost dependable way to make a commodity business profi table isto become the low cost provider

        The only other time commoditybusinesses turn a healthy profi t is during periods of tight supply—afactor that can be extremely diffi cult to predict

        A key to determiningthe long term profi t of a commodity business Buffett notes isthe ratio of “supply tight to supply ample years ”

    • Management Tenets
      • When considering a new investment or a business acquisition Buffettlooks very hard at the quality of management

        He tells us that thecompanies or stocks Berkshire purchases must be operated by honestand competent managers whom he can admire and trust

        “Wedo not wish to join with managers who lack admirable qualities ”he says “no matter how attractive the prospects of their business

        We ’ve never succeeded in making good deals with a bad person ”

        three traits:

        • Is management rational?
        • Is management candid with shareholders?
        • Does management resist the institutional imperative?

        The highest compliment Buffett can pay a manager is that heor she unfailingly behaves and thinks like an owner of the company

        Managers who behave like owners tend not to lose sight ofthe company ’s prime objective—increasing shareholder value—andthey tend to make rational decisions that further that goal

        also greatly admires managers who take seriously their responsibilityto report candidly and fully to shareholders and who have thecourage to resist what he has termed the institutional imperative—blindly following industry peers

    • Rationality
      • Deciding what to dowith the company ’s earnings—reinvest in the business or returnmoney to shareholders—is in Buffett ’s mind an exercise in logicand rationality

        “Rationality is the quality that Buffett thinks distinguishesthe style with which he runs Berkshire—and the quality heoften fi nds lacking in other corporations ”

    • Candor
      • Buffett holds in high regard managers who report their company ’sfi nancial performance fully and genuinely who admit mistakes aswell as share successes and are in all ways candid with shareholders

        What needs to be reported

        ( ) Approximately howmuch is the company worth?

        ( ) What is the likelihood that it canmeet its future obligations?

        ( ) How good a job are its managersdoing given the hand they have been dealt?”

        Mistakes of the First Twenty Five Years

        Mistake DuJour

        The CEO who misleads others in public ” he says “may eventuallymislead himself in private

        The Institutional Imperative

        If management stands to gain wisdom and credibility by facing mistakes why do so many annual reports trumpet only success? If allocationof capital is so simple and logical why is capital so poorlyallocated?

        The answer Buffett has learned is an unseen force hecalls “the institutional imperative”—

        “the institutional imperative”—

        the lemming like tendency ofcorporate managers to imitate the behavior of others no matterhow silly or irrational it may be

        institutional imperative is responsiblefor several serious but distressingly common conditions

        “( ) [Theorganization] resists any change in its current direction;

        ( ) just aswork expands to fi ll available time corporate projects or acquisitionswill materialize to soak up available funds;

        ( ) any businesscraving of the leader however foolish will quickly be supported bydetailed rate of return and strategic studies prepared by his troops

        ( ) the behavior of peer companies whether they are expanding acquiring setting executive compensation or whatever will bemindlessly imitated

        Just because everyone else isdoing something that doesn ’t make it right

        Human nature

        What is behind the institutional imperative that drives so manybusinesses?

        Most managers are unwilling to lookfoolish with for example an embarrassing quarterly loss whenothers in their industry are still producing quarterly gains eventhough they assuredly are heading like lemmings into the sea

        three factors as beingmost infl uential in management ’s behavior

        • Most managers cannot control their lust for activity Suchhyperactivity often fi nds its outlet in business takeovers

          Most managers are constantly comparing their business ’ssales earnings and executive compensation to other companieswithin and beyond their industry These comparisonsinvariably invite corporate hyperactivity

          Most managers have an exaggerated sense of their owncapabilities

        poor allocationskills

        The fi nal justifi cation for the institutional imperative ismindless imitation

        The CEO of Company D says to himself “IfCompanies A B and C are all doing the same thing it must be allright for us to behave the same way ”

        They are positioned to fail—not Buffett believes because ofvenality or stupidity but because the institutional dynamics of theimperative make it diffi cult to resist doomed behavior

        Speakingbefore a group of Notre Dame students Buffett displayed a list of investment banking fi rms Every single one he explained hadfailed even though the odds for success were in their favor Heticked off the positives: The volume of the New York Stock Exchangehad multiplied fold and the fi rms were headed by hardworkingpeople with very high IQs all of whom had an intense desire to succeed Yet all failed Buffett paused “You think about that ” he saidsternly his eyes scanning the room “

        “How could they get a result likethat? I ’ll tell you how—mindless imitation of their peers

    • Taking the Measure of Management
      • Review annual reports from a few years back paying special attentionto what management said then about the strategies for the future

        Then compare those plans to today ’s results; how fully were the plansrealized?

        Also compare the strategies of a few years ago to this year ’sstrategies and ideas; how has the thinking changed?

        “If youput these same guys to work in a buggy whip company it wouldn ’thave made much difference ” He adds “When a managementwith a reputation for brilliance tackles a business with a reputationfor poor fundamental economics it is the reputation of the businessthat stays intact ”

    • Financial Tenets
      • The fi nancial tenets by which Buffett values both managerial excellenceand economic performance are all grounded in some typicallyBuffett like principles

        he does not take yearlyresults too seriously

        Instead he focuses on fi ve year averages

        Profi table returns he wryly notes don ’t always coincide with thetime it takes the planet to circle the sun He also has little patiencewith accounting sleight of hand that produces impressive year endnumbers but little real value

        he is guided by these fourprinciples:

        • Focus on return on equity not earnings per share
        • Calculate “owner earnings” to get a true reflection of value
        • Look for companies with high profit margins
        • For every dollar retained make sure the company has createdat least one dollar of market value

        Return on Equity

        • Customarily

          analysts measure annual company performance bylooking at earnings per share (EPS)

          Did EPS increase over theprior year?

          Did the company beat expectations?

          Are the earningshigh enough to brag about?

          Buffett considers earnings per share a smoke screen

          Buffett considers earnings per share a smoke screen Sincemost companies retain a portion of their previous year ’s earnings asa way to increase their equity base he sees no reason to get excitedabout record EPS

          There is nothing spectacular about a companythat increases EPS by percent if at the same time it is growingits earning base by percent

        Owner Earnings

        Profit Margins

        Buffett is aware that great businesses makelousy investments if management cannot convert sales into profi ts

        There ’s no big secret to profi tability

        The One Dollar Premise

        • The increase in valueshould at the very least match the amount of retained earningsdollar for dollar
    • Market Tenets
      • All the principles embodied in the tenets described thus far leadto one decision point
      • buying or not buying shares in a company Anyone at that point must weigh two factors
      • Is this company agood value
      • is this a good time to buy it—that is is the pricefavorable?
      • rational investing has two components
        • What is the value of the business?
        • Can the business be purchased at a significant discount toits value?
      • Determine the Value
      • The Theory of Investment Value
        • the value of a business isdetermined by the net cash fl ow expected to occur over the life ofthe business discounted at an appropriate interest rate
      • Buy at Attractive Prices
      • Anatomy of a Long Term Stock Price
    • The Intelligent Investor
      • The most distinguishing trait of Buffett ’s investment philosophy is theclear understanding that by owning shares of stock he owns businesses not pieces of paper

        The idea of buying stock without understandingthe company ’s operating functions—including its productsand services inventories working capital needs capital reinvestmentneeds (e g plant and equipment) raw material expenses and laborrelations—is unconscionable

        “Investing is most intelligentwhen it is most businesslike ”

        “the nine most important words ever written about investing ”

        “I am a better investor because I am a businessman ” confessesBuffett “and a better businessman because I am an investor

        what types of companies he will purchasein the future

        he will avoid commodity businesses andmanagers in whom he has little confi dence

        What he will purchaseis the type of company that he understands one that possessesgood economics and is run by trustworthy managers

        “A good businessis not always a good purchase ” says Buffett “although it is agood place to look for one ”

    Business Tenets

    • Simple and Understandable
    • Consistent Operating History
    • Favorable Long Term Prospects

    Management Tenets

    • Rationality
    • Candor
    • The Institutional Imperative
    • Taking the Measure of Management

    Financial Tenets

    • Return on Equity
    • Owner Earnings
    • Profit Margins
    • The One Dollar Premise

    Market Tenets

    • Determine the Value
    • Buy at Attractive Prices

    Anatomy of a Long Term Stock Price

    • The Intelligent Investor
• Chapter 04 : Common Stock Purchases: Nine Case Studies
  • The Washington Post Company
    • Tenet: Simple and Understandable
    • Tenet: Consistent Operating History
    • Tenet: Favorable Long Term Prospects
    • Tenet: Determine the Value
    • Tenet: Buy at Attractive Prices
    • Tenet: Return on Equity
    • Tenet: Profit Margins
    • Tenet: Rationality
    • Tenet: The One Dollar Premise
  • GEICO Corporation
    • Tenet: Simple and Understandable
    • Tenet: Consistent Operating History
    • Tenet: Favorable Long Term Prospects
    • Tenet: Candor
    • Tenet: Rationality
    • Tenet: Return on Equity
    • Tenet: Profit Margins
    • Tenet: Determine the Value
    • Tenet: The One Dollar Premise
  • Capital Cities ABC
    • Tenet: Simple and Understandable
    • Tenet: Consistent Operating History
    • Tenet: Favorable Long Term Prospects
    • Tenet: Determine the Value
    • Tenet: The Institutional Imperative
    • Tenet: The One Dollar Premise
    • Tenet: Rationality
  • The Coca Cola Company
    • Tenet: Simple and Understandable
    • Tenet: Consistent Operating History
    • Tenet: Favorable Long Term Prospects
    • Tenet: High Profit Margins
    • Tenet: Return on Equity
    • Tenet: Candor
    • Tenet: Rational Management
    • Tenet: Owner Earnings
    • Tenet: The Institutional Imperative
    • Tenet: Determine the Value
    • Tenet: Buy at Attractive Prices
  • General Dynamics
    • Tenet: The Institutional Imperative
    • Tenet: Rationality
  • Wells Fargo & Company
    • Tenet: Favorable Long Term Prospects
    • Tenet: Rationality
    • Tenet: Determine the Value
  • American Express Company
    • Tenet: Consistent Operating History
    • Tenet: Rationality
    • Tenet: Determine the Value
  • International Business Machines
    • Tenet: Rationality
    • Tenet: Favorable Long Term Prospects
    • Tenets: Profit Margins; Return on Equity; One Dollar Premise
    • Tenet: Determine the Value
  • H J Heinz Company
    • Tenet: Consistent Operating History
    • Tenet: Favorable Long Term Prospects
    • Tenet: Determine the Value
    • Tenet: Buy at Attractive Prices
    • Tenet: Rationality
  • A Common Theme
• Chapter 05 : Portfolio Management: The Mathematics of Investing
  • What is the probability of a cat giving birth to a bird? Zero

    What is the probability the sun will rise tomorrow?

    That event which is considered certain is given a probability of All eventsthat are neither completely certain nor completely impossible havea probability somewhere between and expressed as a fraction Determining the fraction is what probability theory is all about

    Decision theory

    • Decision theory is the process of decidingwhat to do when you are uncertain what will happen
    • “Making thatdecision ” wrote Bernstein “is the essential fi rst step in any effort tomanage risk ”

    Bayesian analysis

    • How does this work? Let ’s imagine that you and a friend havespent the afternoon playing your favorite board game and now atthe end of the game you are chatting about this or that Somethingyour friend says leads you to make a friendly wager: that with oneroll of a die from the game you will get a Straight odds areone in six a percent probability But then suppose your friendrolls the die quickly covers it with his hand and takes a peek “I can tell you this much ” he says; “it ’s an even number ” Now youhave new information and your odds change dramatically to one inthree a percent probability While you are considering whetherto change your bet your friend teasingly adds: “And it is not a ”With this additional bit of information your odds have changedagain to one in two a percent probability

    decisiontree theory

    • But to put probability theory to practical usein investing we need to look a bit deeper at how the numbers arecalculated

      In particular we need to pay attention to the notion offrequency

    Probability Theory and the Market

    Kelly Optimization

    Each time you step foot inside a casino the probability of comingout a winner is pretty low You shouldn ’t be surprised; after all weall know the house has the best odds

    Munger on Betting Odds

    • art of achieving worldly wisdom

      “The model I like—to sort of simplify the notion of what goeson in a market for common stocks—is the pari mutuel system at theracetrack ” he said “If you stop and think about it a pari mutuelsystem is a market Everybody goes there and bets and the oddsare changed based on what ’s bet That ’s what happens in the stockmarket ”

    The Element of Psychology

    strategy

    • Prime bets
      • Prime bets are reserved forserious players when two conditions occur
      • ( ) confi dence in thehorse ’s ability to win is high
      • ( ) payoff odds are greater thanthey should be
      • Prime bets call for serious money
    • Action bets
      • Action bets as the name implies are reserved for the long shots and hunchesthat satisfy the psychological need to play

        They are smaller bets andnever are allowed to become a large part of the player ’s betting pool

    From Theory to Reality

    • Calculate probabilities
      • This is the probability you are concernedwith: What are the chances that this stock I am consideringwill over time achieve an economic return greater than thestock market?
    • Wait for the best odds
      • The odds of success tip in your favorwhen you have a margin of safety; the more uncertain thesituation the greater the margin you need In the stock market the margin of safety is provided by a discounted price When the company you like is selling at a price that is belowits intrinsic value that is your signal to act
    • Adjust for new information
      • Knowing that you are going to waituntil the odds turn in your favor pay scrupulous attentionin the meantime to whatever the company does Has managementbegun to act irresponsibly? Have the financial decisionsbegun to change? Has something happened to alterthe competitive landscape in which the business operates? Ifso the probabilities will likely change
    • Decide how much to invest
      • Of all the money you have availablefor investing in the market what proportion should go into aparticular purchase? Start with the Kelly formula then adjustdownward perhaps to a half Kelly bet or a fractional Kelly bet

    “The wise [investors] bet heavily when the worldoffers them that opportunity They bet big when they have the odds And the rest of the time they don ’t It ’s just that simple ”

    Focus Investors in Graham and Doddsville

    John Maynard Keynes

    Keynes Fund Principles

    • A careful selection of a few investments having regard totheir cheapness in relation to their probable actual andpotential intrinsic [emphasis his] value over a period of yearsahead and in relation to alternative investments at the time;

      A steadfast holding of these fairly large units through thick andthin perhaps several years until either they have fulfilled theirpromise or it is evident that they were purchased on a mistake;

      A balanced [emphasis his] investment position i e a varietyof risks in spite of individual holdings being large and if possibleopposed risks

    Charles Munger Partnership

    Sequoia Fund

    Lou Simpson

    • Lou developed a reputation as a voracious reader who ignoredWall Street research reports and pored over annual reports instead

      His common stock selection process was similar to Buffett ’s

      Hepurchased only high return businesses that were run by able managementand that were available at reasonable prices

      He focused hisportfolio on only a few stocks

    four portfolio groups

    • Three thousand portfolios containing stocks

      Three thousand portfolios containing stocks

      Three thousand portfolios containing stocks

      Three thousand portfolios containing stocks—the focusportfolio group

      Among the portfolios containing stocks the standarddeviation was percent; the best portfolio returned percent annually and the worst was percent

      Among the stock portfolios the standard deviation was percent— percent best percent worst

      Among the stock portfolios the standard deviation was percent— percent best percent worst

      Among the stock portfolios the standard deviation was percent— percent best percent worst

      one key fi nding emerged

      When we reduced thenumber of stocks in a portfolio we began to increase the probabilityof generating returns that were higher than the market ’s rate return But not surprisingly at the same time we also increased theprobability of generating lower returns

      remarkablestatistics

      Out of stock portfolios beat the market

      Out of stock portfolios beat the market

      Out of stock portfolios beat the market

      Out of stock portfolios beat the market

    With a stock portfolio you have a one in chance of beatingthe market With a stock portfolio your chances increase dramatically to one in four

    it simply reinforces the criticalimportance of intelligent stock selection

    It is no coincidence that thesuperinvestors of Buffettville are also superior stock pickers If yourun a focus portfolio and do not have good stock picking skills theunderperformance could be striking However if you developthe skill set to pick the right companies then outsized returns canbe achieved by focusing your portfolio on your best ideas

    Because investors habitually take money away from underperformingmutual funds portfolio managers have increasingly madetheir portfolios more similar to indexes thereby reducing thechance they will signifi cantly underperform the index

    Of course aswe learned the more your portfolio resembles the index the lesslikely you are to outperform it It is important to remember thatany portfolio manager who has a portfolio that is different from thebenchmark however small a difference is an active portfolio manager

    The Real Measure of Worth

    price myopic

    • Making this shift will not be easy Our entire industry—moneymanagers institutional investors and all manner of individualinvestors—is price myopic If the price of a particular stock isgoing up we assume good things are happening; if the price startsto go down we assume something bad is happening and we actaccordingly

      It ’s a poor mental habit and it is exacerbated by another: evaluatingprice performance over very short periods of time Not onlyare we depending solely on the wrong thing (price)

      but we ’re looking at it too often and we ’re too quick to jumpwhen we don ’t like what we see

    double barreled foolishness

    • price based
    • short termmentality

    how it works in mutual funds

    fi nd a better way tomeasure performance

    • We have to drop our insistence onprice as the only measuring stick and we have to break ourselves ofthe counterproductive habit of making short term judgments

      But if price is not the measuring stick what are we to useinstead?

      Warren Buffett once said he “wouldn ’t care if the stock market for a year or two After all it closes on Saturday and Sundayand that hasn ’t bothered me yet ” It is true that “an actively tradingmarket is useful since it periodically presents us with mouthwateringopportunities ” said Buffett “But by no means is itessential ”

      To fully appreciate this statement you need to think carefullyabout what Buffett said next “A prolonged suspension of tradingin securities we hold would not bother us any more than does thelack of daily quotations for [Berkshire ’s wholly owned subsidiaries] Eventually our economic fate will be determined by the economicfate of the business we own whether our ownership is partial [inthe form of shares of stock] or total ”

    Buffett ’s thesis

    • Buffett ’s thesis that given enough time the priceof a business will align with the company ’s economics He cautions though that translation of earnings into share price is both“uneven” and “unpredictable ”
      • “In the shortrun the market is a voting machine but in the long run it is a weighingmachine ”

    A Variety of Measuring Sticks

    look through earnings

    Berkshire ’s look through earnings aremade up of the operating earnings of its consolidated businesses(its subsidiaries) the retained earnings of its large common stockinvestments and allowance for the tax that Berkshire would have topay if the retained earnings were actually paid out

    “An approach of this kind ”counsels Buffett “will force the investor to think about long termbusiness prospects rather than short term market prospects a perspectivethat will likely improve results

    When Buffett considers adding an investment

    he fi rst looks atwhat he already owns to see whether the new purchase is any better

    “For an ordinary individual the best thing you already have shouldbe your measuring stick ”

    What happens next is one of the mostcritical but widely overlooked secrets to increasing the value of aportfolio “

    “If the new thing you are considering purchasing is notbetter than what you already know is available ” says Charlie “thenit hasn ’t met your threshold This screens out percent of whatyou see ”

    defi ne yourown personal economic benchmark in several different ways

    lookthroughearnings

    • return on equity
    • margin of safety

    the Standard & Poor ’s index is a measuring stick

    It is made up of companies andeach has its own economic return

    If at fi rst you dosucceed quit trying

    ideal holding period

    • “Forever”—so long as the company continues togenerate above average economics and management allocates theearnings of the company in a rational manner

    Morningstar theChicago based researcher of mutual funds discovered that fundswith low turnover ratios generated superior returns compared tofunds with higher turnover ratios

    Journal of Portfolio Management

    • the key strategy involves another of those commonsensenotions that is often underappreciated: the enormous

      value of the unrealized gain When a stock appreciates in pricebut is not sold the increase in value is an unrealized gain No capitalgains tax is owed until the stock is sold If you leave the gain inplace your money compounds more forcefully

    The Jeffrey Arnott study concluded that to achieve high aftertaxreturns investors need to keep their average annual portfolioratio somewhere between and percent

    focus investing approach entails

    • Do not approach the market unless you are willing to thinkabout stocks fi rst and always as part ownership interests inbusinesses

      Be prepared to diligently study the businesses you own aswell as the companies you compete against with the idea thatno one will know more about your business than you do

      Do not even start a focus portfolio unless you are willingto invest a minimum of fi ve years ( years would even bebetter)

      Never leverage your focus portfolio An unleveragedfocus portfolio will help you reach your goals fast enough Remember an unexpected margin call on our capital willlikely wreck a well tuned portfolio

      Accept the need to acquire the right temperament and personalityto become a focus investor

      There is nothing scientifi c about valuinga business and then paying a price that is below this business value

      “You don ’t need to be a rocket scientist ” confesses Buffett “Investing is not a game where the IQ guy beats the guy withthe IQ

      The size of an investor ’s brain is less important thanhis ability to detach the brain from the emotions ” Changingthe way you approach investing including how you will going forward interact with the stock market will involve some emotionalPortfolio Management and psychological adjustments

    When we think about managing our portfolios we often believeit is a simple process of deciding what to buy sell or hold

    You buy great businesseswhen the price is far below that value hold them when the price ismodestly below and sell them when the price is signifi cantly higher

    margin of safety approach

    • His way of building a portfolio for long term growth

      His alternative measuring stick for judging the progress of aportfolio

      His techniques for coping with the emotional roller coasterthat inevitably accompanies portfolio management

    Hollywood has given us a visual cliché of what money managerslook like: talking into two phones at once frantically taking noteswhile trying to keep an eye on a bank of computer screens thatblink and blip endlessly and showing pained expressions wheneverone of those computer blinks shows a minuscule drop in a stockprice

    Warren Buffett is far from that kind of frenzy

    He moves withthe calm that comes with great confi dence

    He has no need towatch a dozen computer screens at once;

    the minute by minutechanges in the market are of no interest to him

    Warren Buffettdoes not think in seconds minutes days months or quarters butin years

    He doesn ’t need to keep up with hundreds of companies

    his common stock investments are focused in a select few

    He refers to himself as a “focus investor”—“We just focus on a fewoutstanding companies ”

    This approach called focus investing greatly simplifi es the task of portfolio management

    Focus investing

    Focus investing is a remarkably simple idea and yet like mostsimple ideas it rests on a complex foundation of interlocking concepts

    we look more closely at the effects focusinvesting produces

    The goal here is to give you a new way of thinkingabout portfolio management

    current state of portfolio management

    ( ) active portfoliomanagement

    Active portfolio managers are constantly at work buying andselling a great number of common stocks

    Their job is to try tokeep their clients satisfi ed or risk losing clients and ultimately theirjobs To stay on top active managers try to predict what will happenwith stocks in the coming months so at the end of the quarter theportfolio is in good relative shape and the client is happy

    Index investing

    Index investing in contrast is a buy and hold approach

    Itinvolves assembling and then holding a broadly diversifi ed portfolioof common stocks deliberately designed to mimic the behaviorof a specifi c benchmark index such as the Standard & Poor ’s

    Active portfolio managers argue that by virtue of their superiorstock picking skills they can do better than any index

    Index strategists for their part have history on their side

    “By periodically investing in an indexfund ” Buffett says in his inimitable style “the know nothing investorscan actually outperform most investment professionals

    third alternative

    a very different kind of active portfolio strategythat signifi cantly increases the odds of beating the index

    Thatalternative is focus investing

    focus investing

    Choose a few stocks that are likely to produce aboveaveragereturns over the long haul concentrate the bulk of yourinvestments in those stocks and have the fortitude to hold steadyduring any short term market gyrations

    concentrating your investmentsin companies with the highest probability of above averageperformance

    the ideal portfolio should containno more than stocks

    The Mathematics of Focus Investing

    The Mathematics of Focus Investing

    • Probability Theory and the Market
    • Kelly Optimization
    • Munger on Betting Odds
    • The Element of Psychology
    • From Theory to Reality

    Focus Investors in Graham and Doddsville

    • John Maynard Keynes
    • Charles Munger Partnership
    • Sequoia Fund
    • Lou Simpson
    • The Real Measure of Worth
    • A Variety of Measuring Sticks
• Chapter 06 : The Psychology of Investing
  • learn two very importantlessons
    • First was the value of patience

      second although shorttermchanges in stock prices may have little to do with value theycan have a lot do with emotional discomfort

  • The Intersection of Psychology and Economics
    • The study of what makes us all tick is endlessly fascinating It is particularlyintriguing to me that it plays such a strong role in investing a world that is generally presumed to be dominated by coldnumbers and soulless data When it comes to investment decisions our behavior is sometimes erratic often contradictory and occasionallygoofy

      What is particularly alarming and what all investors need tograsp is that they are often unaware of their bad decisions

      Tofully understand the markets and investing we now know we haveto understand our own irrationalities

      The study of the psychology ofmisjudgment is every bit as valuable to an investor as the analysisof a balance sheet and an income statement

      Meet Mr Market

      The Intelligent Investor

      Graham devoted considerable space toexplaining how investor emotions trigger stock market fl uctuations

      Graham fi gured that an investor ’s worst enemy was not thestock market but oneself

      They might have superior abilities inmathematics fi nance and accounting but people who could notmaster their emotions were ill suited to profi t from the investmentprocess

      • important principles to Graham ’s approach
        • simply looking at stocks as businesses
          • gives you an entirelydifferent view than most people who are in the market
        • margin of safety concept
          • which “gives you the competitiveedge
        • having a true investor ’s attitude towardthe stock market
          • If you have that attitude “you startout ahead of percent of all the people who are operating in thestock market—it is an enormous advantage

      behavioral fi nance

      • place wherefi nance intersects with psychology

      Behavioral Finance

      Behavioral fi nance is an investigative study that seeks to explain marketineffi ciencies by using psychological theories

      Observing thatpeople often make foolish mistakes and illogical assumptions whendealing with their own fi nancial affairs academics began to digdeeper into psychological concepts to explain the irrationalities inpeople ’s thinking It is a relatively new fi eld of study but what we arelearning is fascinating as well as eminently useful to smart investors

  • Behavioral Finance
    • Overconfidence
      • Several psychological studies have pointed out that errors in judgmentoccur because people in general are overconfi dent

        Ask alarge sample of people to describe their skills at driving a car

        overwhelming majority will say they are above average

        Doctors believe they can diagnose pneumonia with percent confi dence when in fact they are right only percentof the time

        “One of the hardest things to imagine is that you arenot smarter than average ”

        the sobering reality is that noteveryone can be better than average

        Confi dence per se is not a bad thing But overconfi dence isanother matter and it can be particularly damaging when we aredealing with our fi nancial affairs

        Overconfi dent investors not onlymake silly decisions for themselves but also have a powerful effecton the market as a whole

        Investors as a rule are highly confi dent they are smarter thaneveryone else

        They have a tendency to overestimate their skills andtheir knowledge

        They typically rely on information that confi rmswhat they believe and disregard contrary information

        the mind works to assess whatever information is readily availablerather than to seek out information that is little known

        Too often investors and money managers are endowed with a belief that theyhave better information and therefore can profi t by outsmartingother investors

        Overconfi dence explains why so many money managers makewrong calls

        They take too much confi dence from the informationthey gather and think they are more right than they actually are

    • Overreaction Bias
      • One of the most important names in the fi eld of behavioral fi nanceis Richard Thaler professor of behavioral science and economics who moved from Cornell to the University of Chicago with thesole purpose of questioning the rational behavior of investors

        Hepoints to several recent studies that demonstrate that people pu too much emphasis on a few chance events thinking that theyspot a trend

        investors tend to fi x on the most recentinformation they received and extrapolate from it; the last earningsreport thus becomes in their mind a signal of future earnings

        believing that they see what others do not they make quickdecisions based on superfi cial reasoning

        Overconfi dence is at work here of course; people believe theyunderstand the data more clearly than others and interpret it better

        Overconfi dence is exacerbated byoverreaction The behaviorists have learned that people tend tooverreact to bad news and react slowly to good news

        Psychologistscall this overreaction bias

        To illustrate his ideas about overreaction Thaler developeda simple analysis He took all the stocks on the New York StockExchange and ranked them by performance over the precedingfi ve years He isolated the best performers (those that went upin price the most) and the worst performers (those that wentdown the most) and created hypothetical portfolios of those stocks Then he held those portfolios for a subsequent fi ve years and watched as “losers” outperformed “winners” percent ofthe time In the real world Thaler believes few investors wouldhave had the fortitude to resist overreacting at the fi rst sign of aprice downturn and would have missed the benefi ts when the losersbegan to move in the other direction

        Is this constant fi xation on stock prices healthy for investors?

        “Invest in equities and then don ’t the mail ”

        “And don ’t check your computer or your phone orany other device every minute ”

    • Loss Aversion
      • This psychological condition was discovered years ago by twogiants in the fi eld Nobel laureate Daniel Kahneman whom we metearlier in the chapter and Amos Tversky professor of psychologyat Stanford University The two men longtime collaborators wereinterested in the theory of decision making

        “ProspectTheory: An Analysis of Decision under Risk

        value is assigned individually to gains and losses

        Kahneman and Tversky were able to prove that people do not lookat fi nal wealth as dictated by utility theory but rather they focuson the incremental gains and losses that contribute to their fi nalwealth

        The most important discovery in prospect theory was therealization that people are loss averse

        were able to prove mathematically that people regret lossesmore than they welcome gains of the same size—two to two andone half times more

        peopleneed twice as much positive to overcome a negative

        asymmetric loss aversion

        peopleneed twice as much positive to overcome a negative On a bet with precisely even odds most people will not risk anythingunless the potential gain is twice as high as the potential loss

        The downsidehas a greater impact than the upside

        investors feel twice as bad about losing money as they feel goodabout picking a winner

        This aversion to loss makes investors unduly conservative Participants in (k) plans whose time horizons are decades stillkeep large amounts of their money invested in the bond market

        Mental Accounting

        Why would anyone with a long term horizon want to own bonds overstocks when they know that stocks have consistently outperformed?

        The answer they believed rested on two central concepts

        • loss aversion
        • mental accounting behavioral concept
          • which describes the methods people use to codefi nancial outcomes

            It refers to our habit of shifting our perspectiveon money as surrounding circumstances change

            We tend to mentallyput money into different “accounts ” and that determines howwe think about using it

            A simple situation

            A simple situation will illustrate Let us imagine that you havejust returned home from an evening out with your spouse Youreach for your wallet to pay the babysitter but discover that the$ bill you thought was there is not So when you drive the sitterhome you stop by an ATM machine and get another $ Then thenext day you discover the original $ bill in your jacket pocket If you ’re like most people you react with something like glee The $ in the jacket is found money Even though the fi rst $ and the second $ both came from your checking account andboth represent money you worked hard for the $ bill you hold inyour hand is money you didn ’t expect to have and you feel free tospend it frivolously

            Once again Richard Thaler provides an interesting academicexperiment to demonstrate this concept In his study he startedwith two groups of people People in the fi rst group were given $ in cash and told they had two choices: ( ) pocket the money andwalk away or ( ) gamble on a coin fl ip in which if they won theywould get $ extra and if they lost they would have $ deducted Most ( percent) took the gamble because they fi gured theywould at the very least end up with $ of found money Those inthe second group were offered a different choice: ( ) try a gambleon a coin toss: if they win they ’d get $ and if they lost they ’dget $ or ( ) get an even $ with no coin toss More than half( percent) decided to take the sure money Both groups of peoplestood to win the exact same amount of money with the exactsame odds but the situation was perceived differently

            The implications are clear: how we decide to invest and howwe choose to manage those investments has a great deal to do withhow we think about money

            been suggested as one further reason why people don ’t sell stocksthat are doing badly: In their minds the loss doesn ’t become realuntil it is acted on It also helps us understand our risk tolerance:We are far more likely to take risks with found money

    • Myopic Loss Aversion
      • would be willing toaccept the following bet: a percent chance of winning $ ora percent chance of losing $

        According to Samuelson thecolleague turned down the initial offer but then reconsidered Hewould happily play the game he said if he could play timesand did not have to watch each individual outcome The willingnessto play the game under a new set of rules sparked an idea

        Samuelson ’s colleague was willing to accept the wager with twoqualifi ers

        • lengthen the time horizon for the game
        • reduce thefrequency in which he was forced to watch the outcomes

        Movingthat observation into investing Thaler and Benartzi reasoned thatthe longer the investor holds an asset the more attractive the assetbecomes but only if the investment is not evaluated frequently

        When analyzing historical investment returns we fi nd that thevast majority of long term returns are a result of just percent of alltrading months The return of the remaining percent averagesout to approximately zero

        What is clear then is that evaluatingperformance over shorter periods of time increases the chances thatyou will see a loss in your portfolio If you check your portfolio daily there is a chance you will experience a loss The odds don ’timprove much if you extend the evaluation period to a month

        myopic loss aversion

        • to refl ect a combination of loss aversion and frequency

          frequent evaluation period

          How long would investorsneed to hold stocks without checking their performance to reachthe point of being indifferent to the myopic loss aversions of stocksversus bonds?

          The answer: one year

          Thaler and Bernatzi examined the return standard deviation and positive return probability for stocks with time horizons ofone hour one day one week one month one year years and years

          Next they employed a simple utility function based onKahneman and Tversky ’s loss aversion factor of (utility = probabilityof price increase ? probability of decline × )

          Based on themath an investor ’s emotional utility factor did not cross over to apositive number until it reached a one year observable time period

          Thaler and Bernatzi argue that any time we talk about loss aversionwe must also consider the frequency with which returns arecalculated If investors evaluate their portfolios over shorter andshorter time periods then it is clear that they will be less attractedto volatile stocks “Loss aversion is a fact of life ” explain Thalerand Benartzi “In contrast the frequency of evaluations is a policychoice that presumably could be altered at least in principle

    • The Lemming Factor
      • One other psychological trap that beckons investors is the temptationto follow what everyone else is doing whether or not it makessense We might call it the lemming fallacy

        Soon this bold group begins to move in daylight When confrontedby barriers the number of lemmings in the pack increases until apanic like reaction drives them through or over the obstacle As thisbehavior intensifi es lemmings begin to challenge other animalsthey normally would avoid Although many lemmings die from starvation predators and accidents most reach the sea There theyplunge in and swim until they die from exhaustion

        The behavior of lemmings is not fully understood Zoologiststheorize that the mass migration occurs because of changes in theirfood supply and or stressful conditions The crowding and competitionamong lemmings possibly evoke a hormonal change thatinduces an alteration in behavior

        Why do so many investors behave like lemmings?

        An oil prospector

        An oil prospector moving to his heavenly reward was met bySt Peter with bad news “You ’re qualifi ed for residence ” said St Peter “but as you can see the compound for oilmen is packed There ’s no way to squeeze you in ” After thinking for a moment the prospector asked if he might say just four words to the presentoccupants That seemed harmless to St Peter so he gave hisokay The prospector cupped his hand and yelled “Oil discoveredin hell ” Immediately the gates to the compound ed and allthe oilmen rushed out

        Impressed St Peter invited the prospectorto move in and make himself comfortable The prospector paused “No ” he said “I think I ’ll go along with the rest of the boys Theremight be some truth to that rumor after all ”

        “Most managers ”Buffett has said “have very little incentive to make the intelligentbut with some chance of looking like an idiot decision Their personalgain loss ratio is all too obvious; if an unconventional decision worksout well they get a pat on the back and if it works out poorly theyget a pink slip Failing conventionally is the route to go; as a group lemmings may have a rotten image but no individual lemming hasever received bad press ”

    • Managing the Emotional Traps
      • He does not need to look at stock prices every day because he does not need the market ’s affi rmation to convince himhe has made the right investment

        “I don ’t need astock price to tell me what I already know about value ”

        Ben Graham reminded us that “most of the time commonstocks are subject to irrational and excessive price fl uctuations inboth directions as the consequence of the ingrained tendencyof most people to speculate or gamble—i e to give way to hope fear and greed ” Investors must be prepared he cautioned forups and downs in the market And he meant prepared psychologicallyas well as fi nancially—not merely knowing intellectually that adownturn will happen but having the emotional wherewithal to actappropriately when it does

        “The investor who permits himself to be stampeded or undulyworried by unjustifi ed market declines in his holdings is perverselytransforming his basic advantage into a basic disadvantage ” said

  • And on the Other Side Warren Buffett
    • Harry Markowitz—Covariance
      • Journal of Finance

        Markowitz explained what hebelieved was a rather simple notion that return and risk are inextricablylinked and presented the calculations that supported his conclusionthat no investor can achieve above average gains withoutassuming above average risk

        PortfolioSelection: Effi cient Diversifi cation of Investments

        In what many believe was his greatest contribution he nowturned his attention to measuring the riskiness of an entire portfolio

        covariance

        • a method for measuring the direction ofa group of stocks

          The more they move in the same direction thegreater is the chance that economic shifts will drive them down at thesame time

          a portfolio composed of risky stocks might actually be a conservative selection if the individual stockprices move differently

          Markowitz said diversifi cationis the key

          The smart course for investors he concluded is fi rst toidentify the level of risk they are comfortable handling and thento construct an effi cient diversifi ed portfolio of low covariance stocks

    • Eugene Fama—The Efficient Market
      • Predictionsabout future stock prices are pointless because the market is tooeffi cient

        In an effi cient market as information becomes available a great many smart people aggressively apply that information in away that causes prices to adjust instantaneously before anyone canprofi t

        At any given point prices refl ect all available informationand hence we say the market is effi cient

    • Bill Sharpe—Capital Asset Pricing Model
      • A Simplifi edModel of Portfolio Analysis

        Sharpe suggested a simpler method Sharpe believed that all securities bore a common relationship withsome underlying base factor and therefore analysis was simply amatter of measuring the volatility of an individual security to its basefactor He gave his volatility measure a name: beta factor

        beta factor

        • volatility measure

        CAPM

        capital asset pricing model

        a direct extension of hissingle factor model for composing effi cient portfolios

        CAPM saysthat stocks carry two distinct risks

        One risk is simply the risk ofbeing in the market

        systemic risk

        Systemic riskis “beta” and it cannot be diversifi ed away

        unsystemic risk

        is the risk specifi c to a company ’s economic position

        Unlike systemic risk unsystemic risk can be diversifi ed away by simplyadding different stocks to the portfolio

        modern portfolio theory

        • Markowitz with his idea that the proper reward risk balancedepends on diversifi cation
        • Fama with his theory of the effi cientmarket
        • Sharpe with his defi nition of risk
    • Buffett on Risk and Diversification
      • Buffett has a different defi nition of risk

        the possibility of harmor injury

        that is a factor of the “intrinsic value risk” of a business not the price behavior of the stock

        The real risk Buffett says is whether after tax returns from an investment “will give him [aninvestor] at least as much purchasing power as he had to beginwith plus a modest rate of interest on that initial stake

        Risk for Buffett is inextricably linked to an investor ’s time horizon

        If you buy a stock today with the intention of selling it tomorrow Buffett explains then you have entered into a risky transaction

        Theodds are no better than the toss of a coin—you will lose about halfthe time

        if you extend your time horizon outto several years the probability of its being a risky transaction declinesmeaningfully assuming of course that you have made a sensible purchase

        “If you ask me to assess the risk of buying Coca Cola this morningand selling it tomorrow morning ” Buffett says “I ’d say that that ’sa very risky transaction ” But in Buffett ’s way of thinking buyingCoca Cola this morning and holding it for years that ’s zero risk

        Buffett ’s unique view on risk also drives his portfolio diversification strategy

        here too his thinking is the polar opposite ofmodern portfolio theory

        According to the theory remember theprimary benefi t of a broadly diversifi ed portfolio is to mitigatethe price volatility of the individual stocks

        But if you are unconcernedwith short term price volatility as Buffett is then you willalso see portfolio diversifi cation in a different light

        Diversifi cation serves as a protection against ignorance

        “If you want to make sure that nothing bad happensto you relative to the market you should own everything

        modern portfolio theory protects investors who havelimited knowledge and understanding of how to value a business

        modernportfolio theory “will tell you how to do average

        almost anybody can fi gure out how to do average by fi fth grade

        if the effi cient market theory (EMT) is correct there isno possibility except a random chance that any person or groupcould outperform the market and certainly no chance that thesame person or group could consistently do so

        Yet Buffett ’s performancerecord for the past years is prima facie evidence thatit is possible especially when combined with the experience ofother bright individuals who also have beaten the market followingBuffett ’s lead

        Buffett ’s problem with the effi cient market theory rests on onecentral point

        It makes no provision for investors who analyze all theavailable information and gain a competitive advantage by doingso

        Observing correctly that the market is frequently effi cient theywent on to conclude incorrectly that it was always effi cient The differencebetween these propositions is night and day ”

        investors are caught at an intellectual and deeply emotionalcrossroads To the left lies the pathway of modern portfoliotheory The theory has a year history full of academic papers neat formulas and Nobel Prize winners It seeks to get investorsfrom point A to point B with as little price volatility as possible thereby minimizing the emotional pain of a bumpy ride Believingthe market is effi cient hence price and intrinsic value are one andthe same adherents to modern portfolio theory focus on price fi rstand asset value later—or sometimes not at all

        To the right lies the pathway that Warren Buffett and other successfulinvestors have taken It is a year history that is full of lifeexperiences simple arithmetic and long term business owners Itseeks to get investors from point A to point B not by providing a

        smooth short term price ride but by orchestrating an investmentapproach that seeks to maximize on an economic risk adjustedbasis the intrinsic value rate of growth Proponents of the Buffettapproach do not believe the market is always effi cient Instead theyfocus on asset values fi rst and prices later—or sometimes not at all

  • Why Psychology Matters
    • In Daniel Kahneman—a psychologist—was awarded theNobel Prize in economics “for having integrated insights fromthe psychological research into economic science especially concerninghuman judgment and decision making under certainty ”

      That signaled the formal arrival of behavioral fi nance as a legitimateforce in how to think about capital markets

      Despite computerprograms and boxes it is still people who make markets

      Because emotions are stronger than reason fear and greedmove stock prices above and below a company ’s intrinsic value

      When people are greedy or scared Buffett says they often willsell stocks at foolish prices

      In the short run investor sentiment—human emotion—has a more pronounced impact on stock pricesthan a company ’s fundamentals

      Long before behavioral fi nance had a name it was understoodand accepted by a few renegades like Warren Buffett andCharlie Munger Charlie points out that when he and Buffett leftgraduate school they “entered the business world to fi nd huge predictablepatterns of extreme irrationality ” He is not talking aboutpredicting the timing but rather the idea that when irrationalitydoes occur it leads to predictable patterns of subsequent behavior

      When it comesto investing emotions are very real in the sense that they affectpeople ’s behavior and thus ultimately affect market prices Youhave already sensed

      two reasons why understandingthe human dynamic is so valuable in your own investing

      ( ) Youwill have guidelines to help you avoid the most common mistakes

      ( ) You will be able to recognize other people ’s mistakes in time toprofi t from them

      All of us are vulnerable to individual errors of judgment whichcan affect our personal success When a thousand or a million peoplemake errors of judgment the collective impact is to push themarket in a destructive direction Then so strong is the temptationto follow the crowd accumulated bad judgment only compoundsitself In a turbulent sea of irrational behavior the few who actrationally may well be the only survivors

      the only antidote to emotion driven misjudgment isrationality especially when applied over the long haul with patientperseverance

• Chapter 07 : The Value of Patience
  • In his epic masterpiece War and Peace Leo Tolstoy made this profoundobservation: “The strongest of all warriors are these two—time and patience ”

    All market activity lies on a time continuum

    Moving from leftto right we observe buy sell decisions that occur in microseconds minutes hours days weeks months years and decades

    (shorter time frame)

    • it is unclear exactly where the demarcation line is located it is generallyagreed that activity on the left side (shorter time frame) ismore likely to be speculation

    (longertimes)

    • activity on the right side (longertimes) is considered investing

    Why are so many people franticallyscrabbling on the far left trying to make as much money as fast aspossible?

    Is it greed?

    Is it a mistaken belief that they can predictchanges in market psychology?

    Or could it be that they have lostfaith in the possibility of achieving positive long term investmentreturns after experiencing two bear markets and a fi nancial crisisover the past decade?

    the answer to all three questionsis yes

    For the Long Term

    • EquilibriumShort Horizons of Investors and Firms

      cost of arbitrage

      risk is the amount of uncertainty over the outcome

      return is the amount of money made on the investment

      in order to generate substantial returnsfrom short term arbitrage the strategy must be employed frequently over and over again

      to increase your investment return beyond what a speculatorwould likely receive you must be willing to increase the cost of theinvestment (the amount of time your money is invested) as wellas take on more risk (uncertainty as to when the outcome will beresolved)

      Speculators work in short horizon periodsand accept smaller returns

      Investors operate over long horizonperiods and expect larger returns

      In long horizon arbitrage do large returns from buying and holding common stocks actuallyexist?

      We calculated the one year return trailing three year return and trailing fi ve year return (price only) between and During this year period the average number of stocks in theS&P index that doubled in any one year averaged percent or about nine stocks out of Over three year rolling periods percent of stocks doubled about stocks out of In rollingfi ve year blocks percent doubled about out of

      Over the long term do largereturns from buying and holding stocks actually exist?

      The answeris indisputably yes And unless you think a double over fi ve years istrivial this equates to a percent average annual compoundedreturn

    Rationality: The Critical Difference

    • Rationalism according to the Oxford American Dictionary is a beliefthat one ’s opinions or actions should be based on reason andknowledge rather than emotional responses

      A rational person thinks clearly sensibly and logically

      rationality is not the same as intelligence

      Smart people can do dumb things

      dysrationalia

      • —the inability to think andbehave rationally despite high intelligence

      two principal causes of dysrationalia

      • first is a processing problem
      • second is a content problem

      we humans process poorly

      When solving aproblem he says people have different cognitive mechanisms tochoose from

      At one end of the thinking spectrum are mechanismsthat have great computational power

      It is a slower process of thinking andrequires a great deal of concentration

      At the opposite end of thethinking spectrum are mechanisms with very little computationalpower

      they require very little concentration and permit quick decisions

      Humans are cognitive misers

      becauseour basic tendency is to default to the processing mechanisms thatrequire less computational effort even if they are less accurate

      Ina word humans are lazy thinkers

      They take the easy way out whensolving problems; as a result their solutions are often illogical

    Slow Moving Ideas

    • The slowmovingidea is not intellectually diffi cult to grasp but it is morelaborious than relying on the “straightforward and obvious ”

      Treynor on Institutional Investing

      “two kinds of investment ideas

      • (a) those whoseimplications are straightforward and obvious take relatively littlespecial expertise to evaluate and consequently travel quickly

        (b) those that require refl ection judgment and special expertisefor their evaluation and consequently travel slowly

    System and System

    two modes of thinking

    intuition

    • which produces “quick and associative” cognition

    reason

    • slow and rule governed

    System thinking

    • where simple and straightforwardideas travel quickly

      takes little time and not much intellectualwork to calculate a price earnings ratio or a dividend yield

    System thinking

    refl ective part of our cognition process

    It operates in a controlled manner slowly and with effort

    Our“slow moving ideas” that require “refl ection judgment and specialexpertise” are housed in System thinking

    The Mindware Gap

    • Psychologists who studydecision making refer to content defi ciency as a mindware gap

      mindwareis all the rules strategies procedures and knowledge peoplehave at their mental disposal to help solve a problem

      “Just as kitchenwareconsists of tools for working in the kitchen and softwareconsists in tools with your computer mindware consists in the toolsfor the mind ”

      A piece of mindware is anything aperson can learn that extends the person ’s general powers to thinkcritically and creatively

    Time and Patience

• Chapter 08 : The World’s Greatest Investor
  • The Private Buffett
  • The Buffett Advantage
    • Behavioral Advantage
    • Analytical Advantage
    • Organizational Advantage
  • Learning to Think Like Buffett
    • Business Tenets
    • Management Tenets
    • Financial Tenets
    • Market Tenets
  • Finding Your Own Way
• What do you think about the book?
• Conclusions:
• Recommendations:
• Compiled By:
  • blindcaveman.wordpress.com
  • Rigel Arcayan