ELIMINATION AS A STRATEGY FOR INVESTING … AND FOR LIFE
Richer, Wiser, Happier (Scribner, 2021), a book by Wall Street columnist William Green, is a wonderful collection of interviews of highly successful investors that also have developed valuable lessons for life in general. Mr. Green does not approach these interviews as a traditional “groupie” only impressed by investment performances and dollars earned but elaborates on the character and life disciplines of his subjects.
Many of these interviews and analyses have reminded me how, with an increasingly complex investment universe and confusing world in general, it has become more important to simplify and concentrate on what we know and understand and also on what we really desire. One of the observations that came into clearer focus was that some of the most successful investors in the long term expend more effort on avoiding major mistakes than on selecting the most promising investments.
As Warren Buffet’s long-time partner Charlie Munger, known for not mincing his words, has said many times in similar fashion: “It is remarkable how much long-term advantage people like us [at Berkshire Hathaway] have gotten by trying to be consistently not stupid, instead of being very intelligent.” Over fifty years of investing, I may not have succeeded in avoiding stupidity completely, but I have increasingly veered toward eliminating potentially costly mistakes in our portfolios instead of trying to discover presumably rare pearls.
There are approximately 41,000 listed companies in the world with a combined market value of more than USD 80 trillion, and the United States alone counts nearly 6,000 public companies. (Wikipedia 8/30, 2021 and OECD report 10/17 2019). I won’t even try to estimate the number of derivatives and manufactured products that piggyback on those corporate equities or the bonds and other credit instruments that are issued by their underlying companies. So, especially with a small but effective investment team, which I prefer, it would be impossible to thoroughly analyze all the opportunities available to us. Proceeding first by elimination is a more effective approach, I believe.
I discovered Carl Jacobi, a nineteenth-century German mathematician who made important contributions to somewhat esoteric (for me) areas of science when reading Nassim Taleb’s Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (2001, Random House). I have since read many papers about Jacobi’s work but, I must confess, I never read his books in the text — or in the math as it were. Nevertheless, I retained perhaps his most famous advice for solving problems: “Invert, always invert”: many hard problems are best solved when they are addressed backward by turning a situation or problem upside down and looking at it backward.
One of the corollaries of that maxim, as it applies to investments, is not to look for the rare outsized winners but rather to eliminate those that we should avoid. These include any businesses that are overindebted, illiquid, or that are spread too thin over very diverse activities, and also, any involvement in activities that we don’t clearly understand, which requires a talent for introspection to acknowledge.
I believe that there are two main types of dangerous investors: those who are poorly educated or insufficiently informed and only invest on gut feelings, and those at the other extreme, who are overeducated and/or excessively intellectual. The latter live under the assumption that there is nothing that they cannot understand and thus are easily seduced by challenging schemes or new products without applying basic cynicism and common sense. Two examples of recent years were the costly lures of energy “innovator” ENRON and the Ponzi investment scheme expertly organized by Bernard Madoff. Both attracted surprising large numbers of supposedly-sophisticated professional investors before eventually collapsing.
We prefer to be ready, after thorough analysis if it is necessary and possible, to admit that we don’t know or don’t understand when honest introspection makes us feel “inadequate”.
There is another shortcoming that affects most kinds of investors when they are looking for outstanding gains: the optimistic bias that makes them overestimate the potential gain from the investment being considered and overlook any potential downside due, for example, to changes in the company’s or industry’s fundamental environment or to the entry into their competitive space by disruptive technologies or new marketing or distribution approaches. These often cannot be precisely anticipated, but a higher level of reflection can create an awareness of possible vulnerabilities.
Most of us realize that, with all the traditional media sources and now the newer access to social network conversation, we are submerged, not only by data but also by unnecessary and unwanted analyses, opinions and other “noise”. There is a growing need to simplify the torrent of information that aggresses us daily. We live in an age of plethora, and this statement does not apply only to investments: in a social context as well, we are constantly adding new “friends” from the Internet. Even if we do not wish to add to our social network, it is often delicate to unfriend people who have invited us to join their hundreds of closest confidantes.
But systematically eliminating new ideas and new acquaintances can be intellectually diminishing, and it is important to keep an open mind – in investments as in social interaction. A few years ago, a stranger in a cocktail party started to ask me about investments. Just as doctors who resent being asked to diagnose and recommend treatments at such social gatherings, I tend to shut out what I perceive as aggressions. I told my wife that I did not want to see that person again. But, as it happens, we did, and I discovered a wonderful man with diversified interests: he had been a prominent doctor, was well-traveled, had an ongoing passion for photography, and, most importantly, had a wonderful sense of humor. He became one of my closest friends and valuable addition to my life.
Similarly, I initially rejected buying the shares of Google and Amazon, for example, on the basis of their excessive valuations, without fully recognizing how search engines would become indispensable to our lives or understanding that Amazon would evolve from an interesting experiment in bookselling to being the logistical master of the global retail business.
My bad, as they say in sports… But, in truth, it is not so important to collect spectacular winners in a portfolio, as long as you keep compounding your clients’ fortunes by avoiding costly mistakes. Furthermore, with true long-term winners, the market usually offers you later occasions to buy into more easily appraised values.
It is challenging to reconcile long-term ambition and short-term humility or lack of greed. But as I look to the future, I am confident that the lessons from history, a sharpened focus on research, and a good dose of unbiased introspection will serve me and my clients well.
François Sicart – December 1, 2021
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