Lessons to Become a Better Investor
Lessons to Become a Better Investor
Welcome to the 91st Pari Passu Newsletter.
Today, I have a lighter writeup for two reasons:
I sincerely hope most of you are not in the office; if you are, I would encourage you to skim this email and try to leave early to enjoy a nice summer Friday evening. We have many cold weeks ahead when we will dive into complex topics!
Over the past few weeks, we have had some complex write-ups. I would read again and truly master the below writeups in order to get the most out of next writeup (will be one of the most exciting writeups of the year):
Let’s go back to today’s edition. In this year’s Norges Bank Investment Management Investment Conference, the world’s top financial professionals shared their ideas and knowledge about a simple topic: how to become a better investor. Today, we will explore some of the key insights and takeaways from the conference.
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What is a good investor?
Here are some ideas, per members of Norges Bank Investment Management’s portfolio teams:
A good investor combines passionate curiosity with the relentless pursuit of truth
A good investor truly understands the market and their portfolio, how to enter and exit positions, and how to effectively manage risk
A good investor is confident enough in their conviction and is able to make contrarian bets that may disagree with the consensus
Each of these perspectives provide valid, broad-level descriptions of what makes a good investor. Being a good investor means a lot of different things, and developing a perfect definition of a “good investor” is quite difficult. However, a two attributes shared among all high performing investors: adherence to a developed philosophy and mastery of risk management.
Philosophy
Every high performing investor has a thorough and developed investment philosophy for which they base their decisions upon. At Bridgewater Associates, per CIO Greg Jensen, this philosophy consists of three main parts: fundamental, systematic, and diversified. ‘Fundamental’ refers to an understanding of the true drivers of the market; ‘systematic’ refers to the application of the fundamental understanding to develop explicit rules to be debated and tested; ‘diversified’ refers to a strategy to hedge against being wrong – in Bridgewater’s case, portfolio diversification is their method of balancing risk.
Developing a sound investment philosophy ensures that investors make rational, consistent decisions on the market. Furthermore, it allows investors to make unbiased decisions that are unaffected by short-term influences such as emotional and mental states. Howard Marks, founder and CEO of Oaktree Capital Management, calls on investors to develop a unique investment creed. Despite the different terminology, his ideology is very much similar to that of Jensen’s. The first step, Howard Marks states, is to decide whether one wants to be average or to be above average, where striving to be above average forces one to take on the risk of being below average. In other words, Howard Marks believes that all investors should develop their own definition of success and outline the risks that they are willing to take to achieve it. Being above average in investing is very difficult, but those who are able to forge a sound investment philosophy, over years of experience and compounded learning, will be the ones that come out on top.
Risk Management
Good investors have accepted that it is difficult to have both superior returns and a high level of safety. Howard Marks defines market risk as the risk of bad outcomes, as opposed to the commonly accepted definition of risk as the variability of outcomes. Naturally, risk and return are positively correlated, and as risk increases, the range of possible outcomes increases, and the unfavorable outcomes become worse. Developing effective strategies to generate high returns while mitigating the adverse effects of risk is what differentiates average from above average performers.
For Jensen, diversification is key to risk management. Jensen defines diversification as aiming for fifteen to twenty uncorrelated return streams. Uncorrelated means that changes within one return stream do not affect the other return streams. Furthermore, Jensen states that real diversification requires thinking in terms of risk rather than capital. For example, an investor could allocate capital equally between public equities and government bonds, but risk has not been allocated equally because public equities are inherently much riskier than bonds are. Risk must be equally allocated across return streams and asset classes to ensure effective diversification.
What makes a good investment organization?
We are often a product of our environment, and high performing investment organizations can foster meaningful growth to transform good investors into great ones. Robert Wallace, CEO of the Stanford Management Company, which manages Stanford University’s ~$40bn endowment, outlined the three pillars of investment success at his organization.
The first pillar is strategy. Famous Norwegian explorer Roald Amundsen said “Victory awaits him who has everything in order – people call it luck.” True success is rarely the product of luck, but the product of thorough preparation and strategy. Therefore, Wallace employs a specific strategy to achieve their two goals: provide reliable support for Stanford University’s operating budget and preserve the purchasing power of the endowment for future generations by offsetting the annual operating budget payout and higher education inflation. The endowment portfolio maintains an equity bias (~70%), due to their higher expected return than bonds and cash. Diversification is a key aspect of the portfolio, with Wallace referring to it as the only “free lunch” in investing. Portfolio equities are diversified across region, industry, public/private, etc., in order to lower the risk of permanent capital loss and volatility. The remainder of capital is invested in fixed income and absolute return for further diversification.
The second pillar is execution. A strategy might look good on paper, but it is useless without proper execution. At the Stanford Management Company, this entails three aspects. Firstly, associates perform rebalancing between asset classes to preserve the desired risk, return, and liquidity characteristics. Next, associates rotate capital within asset classes depending on the opportunity sets available in each asset class. Lastly, the company handpicks partners to manage each of their asset classes. The practice of outsourcing asset managers to third party, usually boutique, firms is common among endowment management companies, and superior manager selection is paramount to portfolio success. The key characteristics that Wallace looks for in a manager are rigorous investment discipline, repeatable and thorough process, superior judgment of risk and return, an appropriate capital base, and a strong economic alignment of interests.
The third and final pillar is governance. Forward-thinking and resilient governance supports strategy and execution. Effective governance is especially important during times of extremes, namely euphoria or panic. An example of a time of euphoria might be when a portfolio asset class experiences rapid short-term growth, while a time of panic might be when a portfolio asset class declines. In each of these situations, steadfast governance is integral to ensure that the company does not act impulsively based on short-term trends in the market.
An additional fourth pillar that should be included is communication. An investment organization’s success depends on its ability to make high quality investments, or bets. A major part of this process is communication, and fostering a welcoming and collaborative work environment is key to any organization’s success. Harvard Business School professor Amy Edmondoson describes a concept known as psychological safety, which refers to how safe or comfortable an individual feels to take interpersonal risks, speak up, and openly disagree with others. All of these actions are important to promote discourse, debate accepted beliefs, and generate new ideas. Productive disagreement is the driver of growth, and if employees are uncomfortable speaking up or disagreeing with the status quo, then an organization becomes stagnant. However, this argument goes both ways – an organization can over prioritize psychological safety, which leads to inefficient and ineffective communication.
Investment Psychology
Grit
Sound preparation, strategy, and execution can only take you so far. The world’s highest performing investors also possess intangible qualities and skills that elevate their ability to the next level. Research has found that one of the most prevalent qualities, not just in high performing investors, but in all high performers, is grit. Angela Duckworth, Professor at the Wharton School of the University of Pennsylvania, famous for her research on grit, defines it as sustained passion and perseverance for especially long-term goals. In fact, grit is so powerful that it can outperform innate talent.
Tobi Cosgrove, a former American heart surgeon, exemplifies grit outworking talent. Growing up, Cosgrove was never the smartest in his class, due to him suffering from the learning condition dyslexia. However, nobody knew what dyslexia was at the time, so Cosgrove was simply deemed to be “slow”. Nevertheless, from a young age, Cosgrove set his sights on becoming a doctor. After managing to get into medical school, Cosgrove would eventually enter residency for heart surgery, one of the most difficult and competitive medical specialties. During his time as a resident, his instructors told him that he was the “least talented individual there was.” Despite his doubters, Cosgrove continued to refine his craft. Cosgrove would fly out to the world’s top heart surgeons, watch and take notes on how they worked, and then spend hours learning from them. His top-level goal of becoming the world’s top heart surgeon was fuel for his unwavering determination, even in the face of his dyslexia. Cosgrove’s grit would eventually pay off. In 2004, Cosgrove would be named CEO of the Cleveland Clinic, one of the world’s top medical centers, and during his lengthy career, he would invent numerous groundbreaking heart procedures. By the time Cosgrove retired, he was widely regarded as the most influential heart surgeon of his time. All of this, impossible without Cosgrove’s grit.
Grit is more than an individual quality – it can influence entire organizations. As Duckworth observes, when you find gritty leaders, you often find gritty organizations, and vice versa. As famous American writer Ralph Waldo Emerson once said, “An institution is the lengthened shadow of its leader.”
Decision-Making
Prudent decision-making is also an important part of succeeding as an investor. Michael Mauboussin, investment strategist at Morgan Stanley, explores the major barriers to good decision-making and how to make better decisions as an investor. Overconfidence is a primary cause of poor decision-making. There are three types of overconfidence:
Overprecision: the tendency to be certain that one’s judgment is correct
Overestimation: the belief that we can perform at a level beyond what is objectively warranted
Overplacement: the belief that we can perform better than others
The most common type of overconfidence that often affects investors is overplacement. People often assume that their own abilities are generally superior to those of others. This kind of arrogant overconfidence can cloud judgment and lead to unwise decisions.
Mauboussin also differentiates how people approach a problem into two distinct categories: the inside vs. outside view. The inside view refers to one’s personal understanding, based on personal experience, background information, and research. The outside view, known as the base rate, refers to viewing one’s problem as an instance of a larger reference class and understanding how other people dealt with the same or a similar issue. The majority of people approach their problems with the inside view because we are biased towards personal experiences. However, this is inherently flawed because making a decision based on unique personal experiences neglects the historical and statistical data that are actually important when making an objective decision. As Mauboussin argues, personal experiences such as stories and anecdotes are often much more persuasive than statistics are.
In order to improve investment decision-making, Mauboussin offers one piece of advice: maintain a journal. Everyday, write down what you expect to happen in the market and why you expect it to happen. Record how you feel physically and emotionally. For each prediction, include a probability, not words, to express your views. This probability should include three key elements: an outcome that can be agreed upon, a specific period of time, and a numeric probability. By using probabilities, it provides an objective rating of one’s confidence in a specific prediction, whereas words lose value over time from being vague and from subjective interpretations. Keeping a journal will enable investors to maintain an organized record of their thoughts and test the validity of their predictions. It fosters both reflection and growth.
Ultimately, making better decisions can be summarized into a two-step process. First, calibrate your mind well, appealing to base rates. This means opting for statistical based assumptions rather than anecdotal ones. Second, appropriately adjust your beliefs and convictions in response to new information.
There is always room for improvement, even for the world’s best. I hope you learned something new today!
Sources: [1]
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