The individual investor
Process, character and risk policies
This post is the second in a series that examines what it takes to achieve superior performance in investing. I’ve noted many times that you can achieve satisfactory results by investing in an S&P 500 index. But we are looking at something different. What we are looking at in this blog and in this post is what it takes to move to the next level i.e. superior performance.
The focus today is the question of whether you need insight that others don’t possess.
I propose to make my point today by disagreeing with a highly successful and high profile investor. Let me explain what I mean by ‘disagreeing’. Our thinking advances by testing each other’s ideas. So, we will look at both sides. Further, what works for one of the lions of Wall Street may not be right for the individual investor.
Do you need insight others don’t possess?
Howard Marks “is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. In 2020, with a net worth of $2.1 billion, Marks was ranked No. 391 on the Forbes 400 rankings of the wealthiest Americans.”(Google). He has written two books: 2013: The Most Important Thing – Illuminated: Uncommon Sense for the Thoughtful Investor, the annotated version of an earlier book (Marks, 2013) and 2018: Mastering the Market Cycle: Getting the Odds on Your Side. I have read the first of these. I note that Mark’s background is in distressed debt where he obviously developed uncommon expertise.
Chapter 1 of the 2013 book is titled: “The Most Important Thing Is … Second-Level Thinking”. In a memo written a couple of years after the 2013 book, Marks writes: “…something I labeled ‘second-level thinking.’ This is a crucial subject that has to be understood by everyone who aspires to be a superior investor. And yet I’ve never covered it explicitly for the readers of my memos. I want to correct that now. In what ended up being the book’s first chapter, I introduced the subject as follows:
“Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different. . . .
For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.”
For a copy of this memo see here.
Investing with an edge
I would agree with Marks that to achieve superior results you need to have an edge. But what is good for the goose is not necessarily good for the gander. I do not have the resources of a money manager with tens of billions under management. As an individual investor I have to recognize that I am unlikely to think of something the brains of Wall Street haven’t thought of, or see things the brains of Wall Street have missed, or have insights they don’t possess. Also, I am focused on investing in the common shares of companies, not distressed debt. So, I disagree with Marks on where the edge is found for the individual investor in equities.
Investment process and behavioral edge
At the end of his career in 1974 in the midst of what may, even in 2022, be the greatest bear market since the 1930s, Benjamin Graham gave a speech to securities analysts. It was styled “Renaissance of Value”, and was reprinted in Barron’s September 23, 1974, and is quoted by Roger Lowenstein in ‘Buffett’. (Lowenstein, Buffett, The Making of an American Capitalist. 1995,2008) p.160. Graham remarked that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.”
What Ben Graham meant by ‘principles of operation’ is simply a sound investment process. What he meant by ‘character’ is personal qualities like long term thinking, resilience, patience and so on, as well as the ability to protect yourself from your own behavioral foibles and take advantage of Mr. Market’s behavioral foibles. I call the latter a behavioral edge. Taken together, a sound investment process and character can lead to superior investment results for the individual investor.
The sound investment process revolves around buying only superb companies and then only with what Ben Graham and Warren Buffett call a Margin of Safety. Good companies generate wealth. Superb companies generate superior wealth. The Margin of Safety reduces risk and also enhances performance.
I suspect that distressed debt investing and investing in the shares of superb companies differs fundamentally. In Mark’s 2013 book, he writes: “And there are few assets so bad that they can’t be a good investment when bought cheap enough.” P.29. I would never touch a bad company no matter how cheap.
Character and a behavioral edge come from reading about things like how to cultivate long term thinking and reading and working to enhance things like resilience and patience. One can also read about our behavioral biases and befuddling cognitive errors and adopt risk policies to counter them, what I call gap-to-edge rules, as recommended by Daniel Kahneman.
I have distinguished between a sound investment process and character. You can’t always compartmentalize things so clearly. So, for example, a sound investment process assists on the mental or psychological side of investing. It’s easier to be resilient if your investment process is sound.
I have tried to make clear that the individual investor does not need to outsmart Wall Street to succeed in investing. We do not need to have thought of something they haven’t thought of, or see things they miss, or bring insight they don’t possess. All that is necessary is firstly: to have a sound investment process and let the wealth generating capability of wonderful companies produce our returns; and secondly, develop and cultivate personal qualities such as calmness in the face of turmoil and recognize and deal with our human foibles.
To read more about developing a sound investment process check out the Motherlode Part 4: Principles of Operation
This Part contains the following Chapters:
24. Business objective
25. Investment Styles
26. Buying with a margin of safety
27. Sound Principles of Operation
To dig deeper into character and the development of personal qualities take a look at the Motherlode Chapter 20. The Right Stuff
Also, take a look at this post and the following appendix from the Motherlode:
Beat the behavioral gap and take advantage of Mr. Market’s foibles
Appendix 3: Gap-to-Edge Rules.
You can reach me by email at firstname.lastname@example.org
I’m also on Twitter @rodneylksmith
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