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Thursday 16 August 2012
Risk versus Reward
Most investors believe that the more risk you take on, the greater the profit you can expect.
The Master Investor, on the contrary, does not believe that risk and reward are related. By investing only when his expectancy of profit is positive, he assumes little or no risk at all.
The Master Investor, on the contrary, does not believe that risk and reward are related. By investing only when his expectancy of profit is positive, he assumes little or no risk at all.
Actuarial Investing. Benjamin Graham's investing was actuarially based.
When Warren Buffett started investing, his approach was very different from the one he follows today. He adopted the method of his mentor, Benjamin Graham, whose system was actuarially based.
Graham's aim was to purchase undervalued common stocks of secondary companies "when they can be bought at two-thirds or less of their indicated value."
He determined value solely by analysing publicly available information, his primary source of information being company financial statements.
A company's book value was his basic measure of intrinsic value. His ideal investment was a company that could be bought at a price significantly below its liquidation or break-up value.
But a stock may be cheap for a good reason.
By just analysing the numbers Graham could not know why the stock was cheap.
So how could he make money? He made sure he bought dozens of such stocks, so the profits on the stocks that went up far outweighed the losses on the others.
This is the actuarial approach to risk management. In the same way that an insurance company is willing to write fire insurance for all member of a particular class of risks, so Graham was willing to buy all members of a particular class of stock.
An insurance company doesn't know, specifically, whose house is going to burn down, but it can be pretty certain how often it's going to have to pay for fire damage. In the same way, Graham didn't know WHICH of his stocks would go up. But he knew that, on average, a predictable percentage of the stocks he bought would go up.
An insurance company can only make money by selling insurance at the right price. Similarly, Graham had to buy at the right price; if he paid too much he would lose, not make money.
The actuarial approach certainly lacks the romantic flavour of the stereotypical Master Investor who somehow magically, only buys stocks that are going to go up. Yet it is probably used by more successful investors than any other method. For success, it depends on identifying a narrow class of investments that, taken together, have a positive average profit expectancy.
Buffet started out this way, and still follows this approach when he engages in arbitrage transactions. it also contributes to Soro's success: and is the basis of most commodity trading systems.
AVERAGE PROFIT EXPECTANCY is the investor's equivalent of the insurer's actuarial tables. Hundreds of successful investment and trading systems are built on the identification of a class of events which, when repeatedly purchased over time, have a POSITIVE AVERAGE EXPECTANCY OF PROFIT.
Ref: The Winning Investment Habits of Warren Buffett and George Soros by Mark Tier
Graham's aim was to purchase undervalued common stocks of secondary companies "when they can be bought at two-thirds or less of their indicated value."
He determined value solely by analysing publicly available information, his primary source of information being company financial statements.
A company's book value was his basic measure of intrinsic value. His ideal investment was a company that could be bought at a price significantly below its liquidation or break-up value.
But a stock may be cheap for a good reason.
- The industry may be in decline,
- the management may be incompetent, or
- a competitor may be selling a superior product that's taking away all the company's customers - to cite just a few possibilities.
By just analysing the numbers Graham could not know why the stock was cheap.
- So some of his purchases went bankrupt:
- some hardly moved from his purchase price; and
- some recovered to their intrinsic value and beyond.
So how could he make money? He made sure he bought dozens of such stocks, so the profits on the stocks that went up far outweighed the losses on the others.
This is the actuarial approach to risk management. In the same way that an insurance company is willing to write fire insurance for all member of a particular class of risks, so Graham was willing to buy all members of a particular class of stock.
An insurance company doesn't know, specifically, whose house is going to burn down, but it can be pretty certain how often it's going to have to pay for fire damage. In the same way, Graham didn't know WHICH of his stocks would go up. But he knew that, on average, a predictable percentage of the stocks he bought would go up.
An insurance company can only make money by selling insurance at the right price. Similarly, Graham had to buy at the right price; if he paid too much he would lose, not make money.
The actuarial approach certainly lacks the romantic flavour of the stereotypical Master Investor who somehow magically, only buys stocks that are going to go up. Yet it is probably used by more successful investors than any other method. For success, it depends on identifying a narrow class of investments that, taken together, have a positive average profit expectancy.
Buffet started out this way, and still follows this approach when he engages in arbitrage transactions. it also contributes to Soro's success: and is the basis of most commodity trading systems.
AVERAGE PROFIT EXPECTANCY is the investor's equivalent of the insurer's actuarial tables. Hundreds of successful investment and trading systems are built on the identification of a class of events which, when repeatedly purchased over time, have a POSITIVE AVERAGE EXPECTANCY OF PROFIT.
Ref: The Winning Investment Habits of Warren Buffett and George Soros by Mark Tier
Risk is Manageable: Manage Risk Actuarially
Risk avoidance strategy: Manage Risk Actuarially
This way is to act, in effect, like an insurance company.
An insurance company will write a life insurance policy without having any idea WHEN it will have to pay out. It might be tomorrow; it might be 100 years from now. It doesn't matter (to the insurance company).
The insurance company controls risk by writing a large number of policies so that it can predict, with a high degree of certainty, the AVERAGE amount of money it will have to pay out each year.
Dealing with averages, not individual events, it will set its premium from the AVERAGE EXPECTANCY of the event. So the premium on your life insurance policy is based on the average life expectancy of a person of your sex and medical condition at the age you were when you took out the policy. The insurance company is making no judgement about YOUR life expectancy.
The person who calculates insurance premiums and risks is called an actuary; thus calling this method of risk control "managing risk actuarially."
This approach is based on averages of what's called "risk expectancy."
The Master Investor using this way of managing risk is actually looking at the AVERAGE PROFIT EXPECTANCY.
This way is to act, in effect, like an insurance company.
An insurance company will write a life insurance policy without having any idea WHEN it will have to pay out. It might be tomorrow; it might be 100 years from now. It doesn't matter (to the insurance company).
The insurance company controls risk by writing a large number of policies so that it can predict, with a high degree of certainty, the AVERAGE amount of money it will have to pay out each year.
Dealing with averages, not individual events, it will set its premium from the AVERAGE EXPECTANCY of the event. So the premium on your life insurance policy is based on the average life expectancy of a person of your sex and medical condition at the age you were when you took out the policy. The insurance company is making no judgement about YOUR life expectancy.
The person who calculates insurance premiums and risks is called an actuary; thus calling this method of risk control "managing risk actuarially."
This approach is based on averages of what's called "risk expectancy."
The Master Investor using this way of managing risk is actually looking at the AVERAGE PROFIT EXPECTANCY.
Risk is Manageable: Actively Managing Risk
Risk avoidance strategy: Actively Managing Risk
This is primarily a trader's approach - and a key to Soros's success.
Managing risk is very different from reducing risk. If you have reduced risk sufficiently, you can go home and go to sleep. Or take a long vacation.
Actively managing risk requires full-focused attention to constantly monitor the market (sometimes minute-by-minute); and the ability to act instantly with total dispassion when it's time to change course (when a mistake is recognised, or when a current strategy is running its course).
Soro's ability to handle risk was "imprinted" on him during the Nazi occupation of Budapest, when the daily risk he faced was death.
His father, being a Master Survivor, taught him the three rules of risk which still guide him today:
1. It's okay to take risks.
2. When taking a risk, never bet the ranch.
3. Always be prepared to beat a hasty retreat.
This is primarily a trader's approach - and a key to Soros's success.
Managing risk is very different from reducing risk. If you have reduced risk sufficiently, you can go home and go to sleep. Or take a long vacation.
Actively managing risk requires full-focused attention to constantly monitor the market (sometimes minute-by-minute); and the ability to act instantly with total dispassion when it's time to change course (when a mistake is recognised, or when a current strategy is running its course).
Soro's ability to handle risk was "imprinted" on him during the Nazi occupation of Budapest, when the daily risk he faced was death.
His father, being a Master Survivor, taught him the three rules of risk which still guide him today:
1. It's okay to take risks.
2. When taking a risk, never bet the ranch.
3. Always be prepared to beat a hasty retreat.
Risk is Manageable: Reduce Risk
Risk avoidance strategy: Reduce Risk
This is the core of Warren Buffett's entire approach to investing.
Buffett invests only in what he understands, where he has conscious and unconscious competence.
But he goes further: his method of avoiding risk is built into his investment criteria. He will only invest when he can buy at a price significantly below his estimate of the business's value (the intrinsic value). He calls this his "Margin of Safety."
Following this approach, almost all the work is done BEFORE an investment is made. (As Buffett puts it: "You make your profit when you buy.")
This process of selection results in what Buffett calls "high probability events": investments that approach (if not exceed) Treasury bills in their certainty of return.
This is the core of Warren Buffett's entire approach to investing.
Buffett invests only in what he understands, where he has conscious and unconscious competence.
But he goes further: his method of avoiding risk is built into his investment criteria. He will only invest when he can buy at a price significantly below his estimate of the business's value (the intrinsic value). He calls this his "Margin of Safety."
Following this approach, almost all the work is done BEFORE an investment is made. (As Buffett puts it: "You make your profit when you buy.")
This process of selection results in what Buffett calls "high probability events": investments that approach (if not exceed) Treasury bills in their certainty of return.
Risk is Manageable: Don't Invest
Risk-avoidance strategy: Don't Invest
This strategy is always an option. Put all your money in Treasury bills - the "risk-free" investment - and forget about it.
It is practised by every successful investor when they can't find an investment that meet their criteria, they don't invest at all.
Even this simple rule is violated by far too many professional fund managers. For example, in a bear market they'll shift their portfolio into "safe" stocks such as utilities, or bonds ... on the theory they'll go down less than the average stock. After all, you can't appear on Wall Street Week and tell the waiting audience that you just don't know what to do at the moment.
This strategy is always an option. Put all your money in Treasury bills - the "risk-free" investment - and forget about it.
It is practised by every successful investor when they can't find an investment that meet their criteria, they don't invest at all.
Even this simple rule is violated by far too many professional fund managers. For example, in a bear market they'll shift their portfolio into "safe" stocks such as utilities, or bonds ... on the theory they'll go down less than the average stock. After all, you can't appear on Wall Street Week and tell the waiting audience that you just don't know what to do at the moment.
Risk is Manageable: Risk-Avoidance Strategies
Master Investors use one of the four-risk avoidance strategies:
1. Don't invest.
2. Reduce risk (the key to Warren Buffett's approach).
3. Actively manage risk (the strategy George Soros uses so astonishingly well).
4. Manage risk actuarially.
There is a fifth risk-avoidance that is highly recommended by the majority of investment advisors: diversification. But to Master Investors, diversification is for the birds.
No successful investor restricts himself to just one of these four risk-avoidance strategies. Some - like Soros - use them all.
1. Don't invest.
2. Reduce risk (the key to Warren Buffett's approach).
3. Actively manage risk (the strategy George Soros uses so astonishingly well).
4. Manage risk actuarially.
There is a fifth risk-avoidance that is highly recommended by the majority of investment advisors: diversification. But to Master Investors, diversification is for the birds.
No successful investor restricts himself to just one of these four risk-avoidance strategies. Some - like Soros - use them all.
High Probability Events
No matter what his personal style, the Master Investor's method is designed to find one thing only: what Buffett calls "high probability events." He invests in nothing else.
When you invest in a "high probability event," you are almost certain to make money. The risk of loss is tiny - and sometimes non-existent.
When capital preservation is built into your system, these are the only kinds of investments you will make. That's the Master Investor's secret.
He KNOWS it is possible to make very big profits with little to even no risk of loss.
When you invest in a "high probability event," you are almost certain to make money. The risk of loss is tiny - and sometimes non-existent.
When capital preservation is built into your system, these are the only kinds of investments you will make. That's the Master Investor's secret.
He KNOWS it is possible to make very big profits with little to even no risk of loss.
The Power of Mental Habit
A habit is a learned response that has become automatic through repetition. Once ingrained, the metnal processes by which a habit operates are primarily subconscious.
Four elements are needed to sustain a mental habit:
1. A belief that drives your behaviour.
2. A mental strategy - a series of internal conscious and subconscious processes.
3. A sustaining emotion.
4. Associated skills.
Four elements are needed to sustain a mental habit:
1. A belief that drives your behaviour.
2. A mental strategy - a series of internal conscious and subconscious processes.
3. A sustaining emotion.
4. Associated skills.
Wednesday 15 August 2012
My Investing Objective
My investing objective:
To grow my whole portfolio by 15% per year over many years, that is, doubling the portfolio value every 5 years.
For every 5 stocks, expect 3 to do averagely, 1 to do exceptionally well and 1 to underperform. Sell the underperformer and keep the winners. By ensuring that you do not lose or lose small (not big), the modest gains from your stocks will translate into good gains for your overall portfolio.
For every 5 years in the stock market, expect 4 bull years and 1 bear year. If you can avoid investing in a bubble market, you will often be safe with your carefully chosen and implemented philosophy and strategy.
There are many variables affecting the returns of your investing.
Choose a long term time horizon (>10 years) for your investing. The reasoning is as below.
You can see here why stocks are considered a good long-term investment, but a horrible short-term investment. This chart shows that for any 25-year period within 1950-2005, the very worst you would have done was +7.9% annually while the best was +17.2%. However, for a 1-year time horizon, the possible returns vary wildly.
To grow my whole portfolio by 15% per year over many years, that is, doubling the portfolio value every 5 years.
For every 5 stocks, expect 3 to do averagely, 1 to do exceptionally well and 1 to underperform. Sell the underperformer and keep the winners. By ensuring that you do not lose or lose small (not big), the modest gains from your stocks will translate into good gains for your overall portfolio.
For every 5 years in the stock market, expect 4 bull years and 1 bear year. If you can avoid investing in a bubble market, you will often be safe with your carefully chosen and implemented philosophy and strategy.
There are many variables affecting the returns of your investing.
Choose a long term time horizon (>10 years) for your investing. The reasoning is as below.
You can see here why stocks are considered a good long-term investment, but a horrible short-term investment. This chart shows that for any 25-year period within 1950-2005, the very worst you would have done was +7.9% annually while the best was +17.2%. However, for a 1-year time horizon, the possible returns vary wildly.
Reward-risk Chart
Everyone will fall on different parts of the below reward-risk graph.
The goal is to get to the fourth quadrant (high reward, low risk; bottom right hand corner).
Of course the ideal quadrant is the Low Risk, High Reward quadrant.
Yet many times, investors end up in the High Risk, Low Reward quadrant.
Always understand the risk-reward relationship in your investments and your work.
QMV approach
QMV approach
Q = Quality of the Business
M = Integrity and Efficiency of the Management
V = Value or Valuation
Q = Quality of the Business
M = Integrity and Efficiency of the Management
V = Value or Valuation
To reach large sums, you only need to save smaller amounts early on.
For selected good quality growth/value stocks, over a 10 years investing horizon, the upside reward/downside risk
= 100% upside gains / 0% downside loss.
The three most important words in the books of Benjamin Graham
Yes, these are the three most important words in the books of Benjamin Graham.
If you have to take home a message from his thick books, it is knowing everything about "Margin of Safety".
Better still, tattoo these three words to your body, so that you can be reminded every minute of the day.
If you have to take home a message from his thick books, it is knowing everything about "Margin of Safety".
Better still, tattoo these three words to your body, so that you can be reminded every minute of the day.
The "Good Investment". Clarify your Investment Goals.
By pinpointing what you think represents value, you can now create your definition of a good investment. You should be able to summarize it in one sentence.
Consider these examples:
Warren Buffett: a good business that can be purchased for less than the discounted value of its future earnings.
George Soros: an investment that can be purchased (or sold) prior to a reflexive shift in market psychology/fundamentals that will change its perceived value substantially.
Benjamin Graham: a company that can be purchased for substantially less than its intrinsic value.
A few more examples:
The Corporate Raider: companies whose parts are worth more than the whole.
The Technical Analyst: an investment where technical indicators have identified a change in the price trend.
The Real Estate Fixer-Upper: run-down properties that can be sold for much more than the investment required to purchase and renovate them.
The Arbitrageur: an asset that can be bough low in one market and sold simultaneously in another at a higher price.
The Crisis Investor: assets that can be bought at fire-sale prices after some panic has hammered a market down.
Coming to your definition of a good investment is easy - if you're clear about the kinds of investments that interest you and have clarified your beliefs about prices and values.
Consider these examples:
Warren Buffett: a good business that can be purchased for less than the discounted value of its future earnings.
George Soros: an investment that can be purchased (or sold) prior to a reflexive shift in market psychology/fundamentals that will change its perceived value substantially.
Benjamin Graham: a company that can be purchased for substantially less than its intrinsic value.
A few more examples:
The Corporate Raider: companies whose parts are worth more than the whole.
The Technical Analyst: an investment where technical indicators have identified a change in the price trend.
The Real Estate Fixer-Upper: run-down properties that can be sold for much more than the investment required to purchase and renovate them.
The Arbitrageur: an asset that can be bough low in one market and sold simultaneously in another at a higher price.
The Crisis Investor: assets that can be bought at fire-sale prices after some panic has hammered a market down.
Coming to your definition of a good investment is easy - if you're clear about the kinds of investments that interest you and have clarified your beliefs about prices and values.
Choose Your Mentor
The fastest way to master anything is to study with a Master of the Art.
If someone has already perfected the method of investing that appeals to you, why reinvent the wheel? Seek him out. If necessary, offer to work for him for nothing (as Buffett offered to Graham).
If that's not possible you can still adopt your mentor by long distance. Read and study everything you can about him and his methods. When you're thinking about making an investment always ask yourself: "What would he do?"
If someone has already perfected the method of investing that appeals to you, why reinvent the wheel? Seek him out. If necessary, offer to work for him for nothing (as Buffett offered to Graham).
If that's not possible you can still adopt your mentor by long distance. Read and study everything you can about him and his methods. When you're thinking about making an investment always ask yourself: "What would he do?"
Spending money is simple - anyone can do it. Making money is not.
Living below your means
Frugality is a natural aspect of Buffett's character. As his wealth increased, he indulged in minor extravagances. He bought an executive jet he named The Indefensible.
But wealth didn't change his natural frugality. It is easy to see how the consequence of living below your means is important when you're starting out. It's the only way you can accumulate capital to invest. What's less obvious is how this mental habit remains crucial to your investment success even after your net worth has soared into the billions.
Very simply, without this attitude to money you won't keep what you have earned. Spending money is simple - anyone can do it. Making money is not. That;s why living below your means is the attitude that underlies the foundation of the Master Investor's success: Preservation of Capital.
Frugality is a natural aspect of Buffett's character. As his wealth increased, he indulged in minor extravagances. He bought an executive jet he named The Indefensible.
But wealth didn't change his natural frugality. It is easy to see how the consequence of living below your means is important when you're starting out. It's the only way you can accumulate capital to invest. What's less obvious is how this mental habit remains crucial to your investment success even after your net worth has soared into the billions.
Very simply, without this attitude to money you won't keep what you have earned. Spending money is simple - anyone can do it. Making money is not. That;s why living below your means is the attitude that underlies the foundation of the Master Investor's success: Preservation of Capital.
Is it working? Always measure and monitor your investments.
You can't tell if something is working unless you measure it.
Set a return on investment for your projects to make a contribution, with a deadline. Monitor the progress towards that at regular (monthly) intervals.
Set a return on investment for your projects to make a contribution, with a deadline. Monitor the progress towards that at regular (monthly) intervals.
"It worked last time?"
How many of your decisions are based on "It worked last time?"
Take another look, and you might see that some of those successful outcomes are random, or - even worse - lucky.
Take another look, and you might see that some of those successful outcomes are random, or - even worse - lucky.
Don't panic more than you have to. Look at the return over years rather than days.
Don't panic more than you have to. Decide measurable standards for what events are a concern, a worry and a big problem, and what you'll do when they happen.
If the value of your pension drops in a stock-market dip, for example, the best advice is often to do nothing, wait for a recovery and look at the return over years rather than days.
If the value of your pension drops in a stock-market dip, for example, the best advice is often to do nothing, wait for a recovery and look at the return over years rather than days.
Always look at facts and the statistical basis first.
We like to hear good news, so sometimes we trust unreliable sources. Don't make decisions based on what fits your preconceptions; look at facts and the statistical basis first.
Seek out and stay with the high probability events.
Seek out and stay with the high probability events.
Make sure the majority of your portfolio is geared to offering long-term returns.
When you are investing, by all means look at the daily price shifts for entertainment and mild speculation, but make sure the majority of your portfolio is geared to offering long-term returns. Over ten or twenty years of conservative investment is far more attractive than a meteoric stock.
Sometimes bad things happen to good people
When you review projects that went wrong, make it a search for the truth - not a search for someone to blame.
The greatest threat to your future financial security
The greatest threat to your future financial security is the loss, over time, in the purchasing power of power currencies. A dollar today buys less than 5% of what a dollar bought 100 years ago.
Study the fascinating history and theory of money and use this knowledge as a basis in formulating and guiding your investment philosophy.
Study the fascinating history and theory of money and use this knowledge as a basis in formulating and guiding your investment philosophy.
The world's investment markets are interconnected.
To be a successful investor it wasn't enough to understand a company's market and competitors on its home turf: you need an appreciation of how foreign companies and economies might affect that company's destiny.
John Templeton
Why I am interested in stocks?
Stock prices fluctuated wildly while the underlying value of the business was far more stable.
To be a successful investor you need to have the time to stop and contemplate what's going on.
To be a successful investor you need to have the time to stop and contemplate what's going on.
MARKET FLUCTUATIONS OF INVESTOR'S PORTFOLIO
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