The Most Important Thing

My son Andrew is a budding investor, and he comes up with lots of appealing investment ideas based on today’s facts and the outlook for tomorrow. But he’s been well trained. His first test is always the same: “And who doesn’t know that?”

Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

Successful investing requires thoughtful attention to many separate aspects, all at the same time.

Successful investing requires thoughtful attention to many separate aspects, all at the same time.

The second-level thinker takes a great many things into account:
-What is the range of likely future outcomes?
-Which outcome do I think will occur?
-What’s the probability I’m right?
-What does the consensus think?
-How does my expectation differ from the consensus?
-How does the current price for the asset comport with the consensus view of the future, and with mine?
-Is the consensus psychology that’s incorporated in the price too bullish or bearish?
-What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

All investors can’t beat the market since, collectively, they are the market.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

The Most Important Thing Is Understanding Market Efficiency (and Its Limitations)

The efficient market hypothesis states that:
-There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.
-Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.
-Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.
-Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.

For every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.

Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
Do you really know more about the asset than the seller does?
If it’s such a great proposition, why hasn’t someone else snapped it up?

The Most Important Thing Is Value:
For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.

buy at a price below intrinsic value, and sell at a higher price. Of course, to do that, you’d better have a good idea what intrinsic value is. For me, an accurate estimate of value is the indispensable starting point.

The random walk hypothesis says a stock’s past price movements are of absolutely no help in predicting future movements ;
-we are left with two approaches, both driven by fundamentals: value investing and growth investing.
-value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.
-Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.
-Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.
-Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.
-Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

If you liked it at 60, you should like it more at 50 . . . and much more at 40 and 30;
Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

Buying something for less than its value. In my opinion, this is what it’s all about—the most dependable way to make money.

The Most Important Thing Is Understanding Risk:
-investors have to be bribed with higher prospective returns to take incremental risks.
-riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!
-risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset—a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town—can make for a very successful investment if bought at a low-enough price.

Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world. Quantification often lends excessive authority to statements that should be taken with a grain of salt. That creates significant potential for trouble.

We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away.

Risk cannot be eliminated; it just gets transferred and spread.
Risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

The Most Important Thing Being Attentive to Cycles:
Rule 1: most things will prove to be cyclical.
Rule 2: some of the greatest opportunities for gain and loss come when other people forget rule number one.

The three stages of a bull market:
First, when a few forward-looking people begin to believe things will get better
Second, when most investors realize improvement is actually taking place
Third, when everyone concludes things will get better forever

Flip side, the three stages of a bear market:
First, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy
Second, when most investors recognize things are deteriorating
Third, when everyone’s convinced things can only get worse

The Most Important Thing Is Combating Negative Influences:
-To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.

The Most Important Thing is Contrarianism:
-Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates
-In 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”

The Most Important Thing Is Finding Bargains:
-a list of potential investments, estimates of their intrinsic value, a sense for how their prices compare with their intrinsic value, and an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
-Second, it is by necessity comparative. Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there. Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist.

First-level thinkers tend to view past price weakness as worrisome, not as a sign that the asset has gotten cheaper.

The Most Important Thing Is Patient Opportunism
-there aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism—waiting for bargains—is often your best strategy.
-You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own.