Preservation of Capital. Not losing money.

#Losing money is worse than not losing money. 

Some math makes clear why value investors act conservatively.

Picture a portfolio that realizes a 50 percent loss in a year. Not one that started the year with stock that just happens to have halved in price 12 months later. One that actually realized a 50 percent loss. One that began on January 1 with cash, bought stock during the year, sold that stock later in the year, and on December 31 had half as much cash as it started with. What would it take for the portfolio to get a fresh start?

It would need a 100 percent return the next year just to get back to zero. That’s hard. 

Consider soccer. If a player takes a shot on goal and misses, nothing happens to the score. The player gets a fresh start with the next ball. But if soccer was investing, the player would get negative points for missing. Goals would be required just to get back to zero.

That’s why value investors behave with such restraint. We put capital preservation first. We do so because the mathematics of our missed shots is punitive.




#When capital preservation is underemphasized

When capital preservation is underemphasized, returns suffer. 

Returns suffer because losses add up like weights. 

This truth isn’t evident to those who believe in the risk-return trade-off. They see the subordination of capital preservation as a step toward outperformance. And those believers constitute the majority. 

Perhaps that’s why the asset management industry has such staggering failure rates. Most actively managed equity funds—those that pick individual stocks—don’t beat basic market indexes.

Most. That’s the output of a blind majority.




#Repel Losses

Two practices help to preserve the value investing model’s ability to repel losses.

A.  The first is to keep it current. 

Think of the model as having three layers (Figure 21.1).

1.  The top layer is the general guidance:

• know what to do, 
• do it, and 
• don’t do anything else. 

2..  The middle layer gets more specific, insisting that investments be

• understood, 
• good, and
• inexpensive.

3.   The bottom layer is more specific still. It’s all of the lower text:

• the six parameters of understanding,
• the historic operating metrics,
• the cognitive biases, and so forth.

FIGURE 21.1: The value investing model


The top layer is permanent.
Knowing what to do, doing it, and not doing anything else is so durably commonsensical that one might even apply it to other endeavors.

But the bottom layer could change.
Both accounting standards and disclosure requirements will evolve.

• For example, the Federal Accounting Standards Board might mandate some new calculation of operating income such that ROCE has to adapt. 
• Or perhaps the SEC will eliminate related-party transaction reporting such that the number of shareholder-friendliness indicators has to be trimmed down to three. 
• The more time that has passed, the more important it is to be aware of such developments.

B.  The second practice is to think in percents. 

One should focus on the total return expressed as a percentage, not on currency amounts.

• A 20 percent realized loss is not okay just because the actual damage was only $1,000. 
• And a $1,000,000 gain is not impressive if it represents just a 2 percent annualized return.

Thinking in percents nurtures habits that perform faithfully over a lifetime.

• Discipline learned in the early years of little capital works just as well in the later years of more capital. New tricks aren’t required just because of more zeroes.

When one thinks in percents, the absolute gains follow. 

• They follow because value investing is remunerative. 
• That provides most practitioners with enough motivation to stay with the strategy. 

#Value Investing has other benefits too

But since I committed to it at the end of the last century, I’ve come to see that value investing has other benefits as well.

• For one, it keeps me engaged with the world. 

Turn on the serendipity spigot, and suddenly everything applies. Shopping, news, traffic—all become inputs just as worth processing as financial statements. The instants and fragments of everyday life become relevant in a vivid way.

• Second, value investing is, at root, truth seeking. 

It takes inherently hazy situations and chases the facts. What’s this thing worth? I see a realness in that.

• Third, it rewards a long-term perspective. 

It compels me to consider how enterprises will develop over time. Part of that drill is picturing civilization years forward. That carries an aspect of foresight that I like.



#Value Investing benefits at personal level 

That long-term perspective applies on a personal level as well.

• I hope to keep value investing long after other lines of work would have become difficult.

Making presentations, attending meetings, and flying overseas all get harder with age. But value investing requires none of that.

• I’ll do it for as long as I have all my marbles. 

My younger loved ones are standing by to let me know when the first one plinks out.

• Above subsistence and below gluttony, there’s little correlation between net worth and happiness. 

Money just doesn’t produce life’s great joys. Those come from those loved ones, from health, and from other sources that don’t care much about geometric means, depreciation schedules, or enterprise values.

• But an absence of money can keep one from the great joys. And therein lies value investing’s promise. 

It gives one the freedom to fully embrace what really matters. To be able to drop everything and lavish attention on such gifts, fearlessly, and at times of one’s choosing—That, I think, is what rich is.




Summary

1. Capital preservation is a value investing priority because of the mathematics of realized losses.
2. The risk-return trade-off blinds most asset managers to the primacy of capital preservation.
3. Most actively managed equity funds fail to beat basic market indexes over time.
4. The bottom layer of the value investing model is the part most likely to change.
5. Thinking in percents encourages habits that work over a lifetime.
6. Value investing has benefits beyond remunerativeness.


Reference:;
Good Stocks Cheap - Value Investing with Confidence for a Lifetime of Stock Market Outperformance.

Portfolios and Selling

#Good company gets inexpensive, how much to buy?

When an understood, good company gets inexpensive, we buy its stock. But how much?

(1)  Enough uninvested cash (CASH)
My rule is simple. Provided that I have enough uninvested cash, I put 10 percent of the portfolio in it. I’ve seen other good investors use infinitely more complicated guidelines, but none that I’ve found to be more practical.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

(2)  Strong conviction (COURAGE)
A strong conviction is important in part because right after a buy the price of a stock is almost certain to drop. That’s the corollary to another near-certainty: that the price paid for a stock is unlikely to be a low. Rock-bottoms don’t send out invitations. So knowing when one will happen is impossible. The astute investor counts on missing them.

Correspondingly, I prefer not to put more than a tenth of the portfolio into a single equity. This reduces the chance that I’ll lack the cash necessary to take advantage of other opportunities that emerge.



#Buying is one aspect of portfolio construction. Another is selling.

There are two problems with selling. 

1.  The first is taxes. 

The profitable sale of stock is taxable in most circumstances. Just how much this eats into long-term returns is best illustrated by example.

Picture two portfolios. Each starts with only cash, buys only non-dividend paying stocks, and liquidates after 30 years. Assume that any stock sales are subject to a total long-term capital gains tax rate of 30 percent.

Portfolio one uses all its cash to buy stock on the first day. It appreciates 15 percent before taxes every year. It doesn’t sell anything until the liquidation date, at which point it immediately pays any taxes due.


Portfolio two also uses all its cash to buy stock on the first day. It too appreciates 15 percent per year before taxes. But it churns its holdings annually. At the end of every year, it sells everything, and uses all the after-tax proceeds to instantly buy different stocks. When it liquidates after 30 years, it too promptly pays any taxes due.

Portfolio one would end the 30-year period with more money. But what’s striking is just how much more. It would wind up with over twice as much cash. That’s because every year when portfolio two paid its capital gains taxes, it whittled down the amount set to grow at 15 percent over the following year. In other words, ongoing tax payments stunted the power of compounding.

By contrast, portfolio one’s capital was never whittled down. It regularly got to multiply its 15 percent by a bigger number:

http://www.goodstockscheap.com/17.1.xlsx

Of course one could never count on an equity portfolio to appreciate at exactly 15 percent annually, and the chance of immediately finding stocks to replace just-sold ones is low. Plus the 30-year period is arbitrary, and a 30 percent tax rate doesn’t apply to everyone. But however simplified, this example
highlights the toll that frequent selling takes.


2.  The second problem with selling is alternatives. 

Companies that are understood and good don’t go on sale every day. They’re hard to find. So absent an acute cash requirement, each stock sale mandates a hunt for the next opportunity.



#When selling makes sense

Even with these problems, selling does makes sense in some instances. I see four.

(a)  The first is when price flies past value. 
If EV/OI is over 25, and there are no mitigating facts, I find it hard to justify holding.

(b) The second instance is when a company that originally registered as good turns out not to be. 
This could be because the original analysis was wrong. Perhaps the threat of new entrants was stronger than it first appeared, or a market thought to be growing really wasn’t. Or it could be because circumstances have changed. Maybe a once-mighty retail chain has come under pressure from online-only sellers, or a company that thrived under regulation has faltered in deregulation.

The cognitive bias of consistency can make it hard to see such instances. We may want to hold just to validate our buys. But analyses really can be wrong, and contexts really can change. Selling in such situations keeps a snag from ripping into both a realized loss and a missed chance to redeploy cash into a better opportunity.

(c)  The third instance is when one is bought out. 
Public companies sometimes get acquired. Such transactions often happen at a premium to the recent trading price. A vote may be put to shareholders on the matter, but for everyone other than major stakeholders, it’s perfunctory. One effectively has no say.

I’ve been bought out several times. I dislike it. It turns a pleasantly appreciating investment into a taxable event. But if profitable, given the absence of practical options, it makes sense to accept such sales.

(d)  The fourth instance is when cash is needed to make an investment that’s clearly better than one already held. 
The problem with this is that fresh ideas often glow with a special promise. They’re new. The hope bias gets a prime shot at causing mischief. As such, I get extremely suspicious of my reasoning when I think that I’m spotting such a circumstance. I’ve never actually sold one company for the specific purpose of buying another.



#When selling makes no sense

Two commonly cited reasons for selling puzzle me.

1.  One is rebalancing. 
It’s selling part of a stock holding because appreciation has caused it to represent a disproportionately large percentage of the portfolio.

Rebalancing makes sense to those who equate risk with total portfolio volatility. I don’t. So on the sell side, I’ve never seen the merits of this practice.

It makes more sense to me on the buy side, since unless part of a holding was sold, a decrease in its portfolio prominence means that its price dropped. One could now buy more of it cheaper. But on the sell side rebalancing looks to me like the anchoring bias in action.

2.  A second common reason for selling is to prove that an investment was a success (taking profits). 
The sale is seen as a sort of finish line. Underlying this perception is a view that cash is somehow more real than stocks.

It’s not. Cash and stocks are different forms that wealth can take. Unrealized gains are not endemically less concrete than realized gains. Selling doesn’t demonstrate investing competence any better than does intelligent holding.


Yet another reason for selling is Industry compensation
There’s an additional reason that selling happens. It relates only to institutional portfolios, like hedge funds. It’s about compensation.

Investment funds often pay managers 2 percent of assets under management per year, plus 20 percent of any gain above some hurdle. That 20 percent is applied to pretax returns. It’s blind to taxes. For this reason professionals may emerge as more enthusiastic about selling than would their limited partners. After all, unless they’re tax-exempt, the limited partners are the ones that come to bear the bulk of the tax liabilities born of the fund’s realized gains.

One faces great impetus to sell. It feels good. It’s conclusive. It turns the brokerage statement into a congratulations card. But it also triggers a tax expense and—short of a pressing need for cash—forces a search for the next underpriced equity.

When a sale is wise, its justification is distinct. It’s an overpricing, an analytical error, a contextual change, a buyout, or a better opportunity. Absent that clarity, I hold.



#Equity portfolio can generate cash through buyouts and dividends
Even without active selling, an equity portfolio can generate cash. It can do so in two ways.

1.  The first is through acquisitions, as mentioned earlier.

2.  The second is through dividends. 
Dividends can become sizable. This fact gets lost in the commonly quoted metric of dividend yield.

Recall that dividend yield equals annual dividends divided by current stock price. But to an owner, current only counts in the numerator.

When I first bought Nike stock, the dividend yield was around 2 percent. Over a decade later when I sold it, it was still around 2 percent. But by then my dividend yield—the current annual dividend divided by the price I’d paid for the stock—was closer to 10 percent. Dividends had gone up over time, but my cost hadn’t. That’s how dividends can become a booming cash source underappreciated by all but those who get them.



#Over time, good focused (concentrated) stock portfolios outperform diversified portfolios.
Remember that my portfolio is concentrated. It contains no more than a dozen names, and usually far fewer. On purpose, it’s not diversified. Many good equity portfolios are, but mine isn’t.


1.  Good focused portfolio versus diversified portfolio
I choose to concentrate because I’ve observed over time that good, focused stock portfolios outperform diversified stock portfolios. This is because diversified portfolios are more like an index. They have more names in them. The more a portfolio looks like an index, the more it behaves like an index. It’s hard to both resemble and outperform something.


2.  Bad focused portfolio versus diversified portfolio
Of course a bad focused equity portfolio can certainly lag a diversified stock portfolio.

Concentration isn’t enough to assure outperformance. But if it’s purposefully constructed, a focused group of inexpensively bought good companies is particularly promising.



#Sequestered Cash outside of the equity portfolio for  ordinary expenses 
While I don’t diversify within my equity portfolio, I do diversify outside of it. I always keep enough cash on hand to cover expenses for a few years. As I get older, I expect to increase this number of years.

1.  In Federally insured banks
This isn’t cash inside the equity portfolio waiting to be invested in stocks. It’s cash outside of the equity portfolio, held in federally insured banks. It will never be anything other than cash or spent.

Sequestering cash enables me to confidently ride the wild price swings guaranteed to come with a concentrated equity portfolio. It’s what lets me take the long view. When the price of my stock portfolio halved during the 2008 financial crisis, I didn’t panic. I knew that I could meet all of my expenses. There was no basis for panic.

Many governments insure bank deposits. Coverage varies by country. In America, the Federal Deposit Insurance Corporation generally guarantees up to $250,000. In the United Kingdom, the Financial Services Compensation Scheme stands behind £75,000. In Canada, the Canada Deposit Insurance Corporation backs C$100,000.

Because the whole point of sequestered cash is to avoid the scare that forces ill-timed stock sales, it’s wise to stay well under the insured limit. Opening up accounts at several different banks is not hard.


2.  In same currency as one's expenses Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

As I write this, the British pound has slumped to a 30-year low against the U.S. dollar. This follows Britain’s decision to leave the European Union.1 Some American investors think the slump is overdone and have invested in the British pound.

To people whose expenses are in U.S. dollars, those pounds don’t count as sequestered cash. Instead, they count as a currency investment.



#These repositories for sequestered cash aren't really good
Two things that may look like good repositories for sequestered cash really aren’t.

1.   The first is certificates of deposit, or CDs. 

Outside of the United States they’re commonly called time deposits. They offer higher interest rates than do regular bank accounts. Money must stay in them for a predetermined period. If it’s withdrawn early, a penalty is applied that more than wipes out the extra interest.

If the CD interest rate is much higher than the regular interest rate, one could theoretically keep a portion of sequestered cash in CDs. The portion would have to be limited to that which shouldn’t be needed for the duration of the lockup period.

That said, I don’t use CDs. Since the timing of cash needs can surprise, I prefer to keep the focus of sequestered cash on costless accessibility.

2.   The other repository is cash-like funds (commercial paper). 
They too offer higher interest rates. An example is a fund that invests in commercial paper. Commercial paper is short-term notes issued by corporations.

Such cash-like vehicles usually behave like cash. One can pay bills with them. But I’ve seen instances when they don’t. During the financial crisis, an acquaintance of mine was surprised to learn that her financial institution had temporarily halted withdrawals from such a fund. She couldn’t make payments with it.

This potential—the inability to immediately liquidate—is the problem with these alternatives. The purpose of sequestered cash is to free one from worry during equity market gyrations. If what’s used for expenses ever can’t be used for expenses, that benefit is lost. One can wind up having to sell part of an equity portfolio when it’s underpriced, erasing the benefits of stock investing.


#Problems with cash
Cash has its own problems, of course. Inflation erodes its purchasing power over time. Expansionary monetary policies—governments printing money— exacerbate this. But if held in government-insured accounts under applicable limits, at least it’s always there. That availability is what makes the interim ups and downs of an equity portfolio’s price not only bearable, but almost trivial.





Summary
1. Conviction prepares one for the likely price drop that follows a stock buy.
2. Selling stocks can make sense 

• price flies past value, 
• when a company thought to be good turns out not to be, 
• in buyouts, or 
• when a clearly better opportunity emerges.

3. The problems with selling are taxes and alternatives.
4. Questionable reasons for selling include 

• rebalancing, 
• memorializing success, and 
• industry compensation.

5. Equity portfolios can generate cash without active selling through 

• buyouts and 
• dividends.

6. Good focused equity portfolios outperform diversified equity portfolios over the long term.
7. Cash sequestered for ordinary expenses in government-insured accounts makes equity portfolio price gyrations less troubling.


Reference:

Good Stocks Cheap by Kenneth Jeffrey Marshall 2017

Warren Buffett offers his 2 best pieces of advice for aspiring young investors

The best advice Warren Buffett can offer to young people who want to invest is to learn accounting. 

Furthermore, he warns investors against obsessing over stock price charts and urges them to focus on buying good businesses instead.

1.  Learn Accounting - the Language of Business

"You've got to understand accounting. You've got to. That's got to be like a language to you," Buffett told Yahoo Finance's Andy Serwer in an interview on March 10.

The 89-year-old billionaire CEO of Berkshire Hathaway (BRK-A, BRK-B), whose childhood consisted of running a paper route and selling packs of gum and Coca-Cola door-to-door among other entrepreneurial pursuits only to buy his first stock at age 11, taught himself the fundamentals of accounting.

"You have to know what you're reading,” he added regarding accounting. “Some people have more aptitude for that than others, but that's one thing I learned by myself. Now, I took courses afterwards, for example. But I learned it myself, and largely. So, you have to do that."

2.  Buying Good Businesses

According to Buffett, investors should also have an "attitude that you're buying part of a business, and not that you're buying something that wiggles around on a chart, or that has resistance zones, or 200-day moving averages, or that you buy puts or calls on, or anything like that."

Buffett is referring to technical analysis, or the study of how a stock’s price moves over various periods of time.

"You're buying part of a business,” he added. “If you buy intelligently into a business, you're going to make money.

And then you have to buy something that, in my view, which you'd do if you're buying a business, that you're not going to get a quote on for five years, that they're going to close the stock exchange tomorrow for five years, and that you'll be happy owning it as a business."

Example: Coca-Cola

For example, he pointed to Coca-Cola, a company that he's held stock in for more than three decades while remaining a faithful consumer of its products.

"If you owned Coca-Cola, it didn't make any difference in 1920 when it went public. The important thing was what it was doing with customers,” he said. “You probably would have been better off if there wasn't any market in it for 30 or 40 years, because then you wouldn't have gotten tempted to sell it. And you just watch the business, and you'd watch it grow, and you'd feel happy."

In Berkshire Hathaway's 1988 annual letter, Buffett said he expected to hold Coca-Cola "for a long time." True to his investment philosophy, he also described the investment as owning a portion of an "outstanding" business with "outstanding" management.

Favourite Holding Period is Forever

"[Our] favorite holding period is forever," he wrote in the 1988 letter. "We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."

He emphasized to Yahoo Finance that "the proper attitude toward investing is much more important than any technical skills."

Julia La Roche

Correspondent

April 28, 2020

Yahoo Finance

https://finance.yahoo.com/news/warren-buffett-investment-advice-for-young-people-120219862.html






Additional:

[Watch Warren Buffett LIVE at the 2020 Berkshire Hathaway Annual Shareholders Meeting exclusively on the Yahoo Finance app and desktop. Coverage begins May 2 at 4 p.m. ET. Set a reminder now!]

[See also: Warren Buffett has two ideas for ending inequality]

View photos

Warren Buffett, chairman and CEO of Berkshire Hathaway (Yahoo Finance)

View photos

Source: Yahoo Finance/David Foster

Warren Buffett’s stock moves for the first quarter are out: Net seller of equities during the first quarter.

Warren Buffett slashed stake in Goldman Sachs, exited Travelers

Julia La Roche
Correspondent
Yahoo Finance
May 16, 2020


Warren Buffett’s stock moves for the first quarter are out.

According to a regulatory 13-F filing for the first quarter ended March 31, Berkshire Hathaway (BRK-A, BRK-B)

• trimmed its stake in Goldman Sachs (GS) in the quarter, selling around 10 million shares to last hold 1.92 million shares. 
• Berkshire also slightly reduced its position in JPMorgan Chase (JPM), selling 1.8 million shares, to last hold 57.7 million shares.

Elsewhere, Berkshire exited its stakes in

• Travelers (TRV), selling 312,379 shares, and 
• Phillips 66 (PSX), selling 227,436 shares.

Buffett added to Berkshire’s position

• in PNC (PNC), snapping up 526,930 shares to last hold 9.19 million shares in the regional bank.

Net Seller of Equities; cash pile grew to $137.3  billion

During the first quarter, Buffett was a net seller of equities during the first quarter as the COVID-19 pandemic wreaked havoc on the economy. Meanwhile, Berkshire’s massive cash pile grew to $137.263 billion, up from $127.997 billion, but Buffett said Berkshire hasn’t acted “because we don’t see anything that attractive to do. That could change very quickly or it may not change,” Buffett said during Berkshire’s annual shareholders’ meeting in early May.






Berkshire Hathaway AGM


Warren Buffett, CEO of Berkshire Hathaway, speaks to the press as he arrives at the 2019 annual shareholders meeting in Omaha, Nebraska, May 4, 2019. (Photo by Johannes EISELE / AFP) (Photo credit should read JOHANNES EISELE/AFP via Getty Images)

During the annual meeting, Buffett also confirmed that after the first quarter Berkshire sold all of its stakes in airlines, including

• American Airlines (AAL), 
• Delta (DAL), 
• United Continental Holdings (UAL), and 
• Southwest Airlines (LUV).

“I wouldn’t normally talk about it, but I think it requires an explanation,” he said on Saturday. “We were not disappointed at all in the businesses that were being run and the management, but we did come to a different opinion on it,” he said at the time.

Because of the COVID-19 pandemic, airlines are among the industries being hurt by an exogenous shock “far beyond their control,” Buffett said. He later added that if Berkshire owned airlines now, “it would be a tough decision to decide whether to sustain billions of dollars in operating losses when you don’t know how long it’s going to happen or occur.”

Julia La Roche is a Correspondent at Yahoo Finance. 

Dealing with Uncertainties

It would be foolish, amid such uncertainty, to make overly confident predictions about how the world economic order will look in five years, or even five months.
(Neil Irwin)


Doubt is not a pleasant condition, but certainty is absurd. 
(Voltaire, 250 years ago)



Dealing with Uncertainties

The bottom line is clear:

• The world is an uncertain place.
• It’s more uncertain today than at any other time in our lifetimes.
• Few people know what the future holds much better than others.
• And yet investing deals entirely with the future, meaning investors can’t avoid making decisions about it.
• Confidence is indispensable in investing, but too much of it can be lethal.
• The bigger the topic (world, economy, markets, currencies and rates), the less possible it is to achieve superior knowledge.
• Even our decisions about smaller things (companies, industries and securities) have to be conditioned on assumptions regarding the bigger things, so they, too, are uncertain.
• The ability to deal intelligently with uncertainty is one of the most important skills.
• In doing so, we should understand the limitations on our foresight and whether a given forecast is more or less dependable than most.
• Anyone who fails to do so is probably riding for a fall.


Practise intellectual humility.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

The limitations imposed by future uncertainty

“Attentiveness to limitations in the evidentiary basis” (or to the limitations imposed by future uncertainty) is a very important further concept. 


Dealing with future uncertainty

Here’s how Howard Mark discussed it in his book Mastering the Market Cycle:

Most people think the way to deal with the future is by formulating an opinion as to going to happen, perhaps via a probability distribution.

I think there are actually two requirements, not one.

• In addition to an opinion regarding what’s going to happen, 
• people should have a view on the likelihood that their opinion will prove correct. 

Some events can be predicted

• with substantial confidence (e.g., will a given investment grade bond pay the interest it promises?), 
• some are uncertain (will Amazon still be the leader in online retailing in ten years?) and 
• some are entirely unpredictable (will the stock market go up or down next month?) 

It’s my point here that not all predictions should be treated as equally likely to be correct, and thus they shouldn’t be relied on equally. I don’t think most people are as aware of this as they should be.



Realistic view of the probability that we are right before we choose

In short, we have to have a realistic view of the probability that we’re right before 

• we choose a course of action and 
• decide how heavily to bet on it. 

And anyone who’s sure about what’s going to happen in the world, the economy or the markets is probably deceiving himself.




It all comes down to dealing with uncertainty. 

To me, that starts with acknowledging uncertainty and having an appropriate degree of respect for it.


As I quoted Annie Duke this past January, in my memo You Bet!:

What good poker players and good decision-makers have in common is their comfort with the world being an uncertain and unpredictable place. They understand that they can almost never know exactly how something will turn out. They embrace that uncertainty and, instead of focusing on being sure, they try to figure out how unsure they are, making their best guess at the chances that different outcomes will occur.  (Thinking in Bets)




“I’m not sure.”

To put it simply, intellectual humility means saying
“I’m not sure,” 
“The other person could be right,” or even
“I might be wrong.” 

I think it’s an essential trait for investors; I know it is in the people I like to associate with.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

Current Economic Issues: Fed Chair Jerome H. Powell

May 13, 2020

Current Economic Issues
Chair Jerome H. Powell

At the Peterson Institute for International Economics, Washington, D.C. (via webcast)


The coronavirus has left a devastating human and economic toll in its wake as it has spread around the globe. This is a worldwide public health crisis, and health-care workers have been the first responders, showing courage and determination and earning our lasting gratitude. So have the legions of other essential workers who put themselves at risk every day on our behalf.

As a nation, we have temporarily withdrawn from many kinds of economic and social activity to help slow the spread of the virus. Some sectors of the economy have been effectively closed since mid-March. People have put their lives and livelihoods on hold, making enormous sacrifices to protect not just their own health and that of their loved ones, but also their neighbors and the broader community. While we are all affected, the burden has fallen most heavily on those least able to bear it.

The scope and speed of this downturn are without modern precedent, significantly worse than any recession since World War II. We are seeing a severe decline in economic activity and in employment, and already the job gains of the past decade have been erased. Since the pandemic arrived in force just two months ago, more than 20 million people have lost their jobs. A Fed survey being released tomorrow reflects findings similar to many others: Among people who were working in February, almost 40 percent of those in households making less than $40,000 a year had lost a job in March.1 This reversal of economic fortune has caused a level of pain that is hard to capture in words, as lives are upended amid great uncertainty about the future.

This downturn is different from those that came before it. Earlier in the post– World War II period, recessions were sometimes linked to a cycle of high inflation followed by Fed tightening.2 The lower inflation levels of recent decades have brought a series of long expansions, often accompanied by the buildup of imbalances over time—asset prices that reached unsupportable levels, for instance, or important sectors of the economy, such as housing, that boomed unsustainably. The current downturn is unique in that it is attributable to the virus and the steps taken to limit its fallout. This time, high inflation was not a problem. There was no economy-threatening bubble to pop and no unsustainable boom to bust. The virus is the cause, not the usual suspects—something worth keeping in mind as we respond.

Today I will briefly discuss the measures taken so far to offset the economic effects of the virus, and the path ahead. Governments around the world have responded quickly with measures to support workers who have lost income and businesses that have either closed or seen a sharp drop in activity. The response here in the United States has been particularly swift and forceful.

To date, Congress has provided roughly $2.9 trillion in fiscal support for households, businesses, health-care providers, and state and local governments—about 14 percent of gross domestic product. While the coronavirus economic shock appears to be the largest on record, the fiscal response has also been the fastest and largest response for any postwar downturn.

At the Fed, we have also acted with unprecedented speed and force. After rapidly cutting the federal funds rate to close to zero, we took a wide array of additional measures to facilitate the flow of credit in the economy, which can be grouped into four areas.

• First, outright purchases of Treasuries and agency mortgage-backed securities to restore functionality in these critical markets. 
• Second, liquidity and funding measures, including discount window measures, expanded swap lines with foreign central banks, and several facilities with Treasury backing to support smooth functioning in money markets. 
• Third, with additional backing from the Treasury, facilities to more directly support the flow of credit to households, businesses, and state and local governments. 
• And fourth, temporary regulatory adjustments to encourage and allow banks to expand their balance sheets to support their household and business customers.

The Fed takes actions such as these only in extraordinary circumstances, like those we face today. For example, our authority to extend credit directly to private nonfinancial businesses and state and local governments exists only in "unusual and exigent circumstances" and with the consent of the Secretary of the Treasury. When this crisis is behind us, we will put these emergency tools away.

While the economic response has been both timely and appropriately large, it may not be the final chapter, given that the path ahead is both highly uncertain and subject to significant downside risks. Economic forecasts are uncertain in the best of times, and today the virus raises a new set of questions:

• How quickly and sustainably will it be brought under control? 
• Can new outbreaks be avoided as social-distancing measures lapse? 
• How long will it take for confidence to return and normal spending to resume? 
• And what will be the scope and timing of new therapies, testing, or a vaccine? 

The answers to these questions will go a long way toward setting the timing and pace of the economic recovery. Since the answers are currently unknowable, policies will need to be ready to address a range of possible outcomes.

The overall policy response to date has provided a measure of relief and stability, and will provide some support to the recovery when it comes. But the coronavirus crisis raises longer-term concerns as well.

1. The record shows that deeper and longer recessions can leave behind lasting damage to the productive capacity of the economy.3 
2. Avoidable household and business insolvencies can weigh on growth for years to come. 
3. Long stretches of unemployment can damage or end workers' careers as their skills lose value and professional networks dry up, and leave families in greater debt.4 
4. The loss of thousands of small- and medium-sized businesses across the country would destroy the life's work and family legacy of many business and community leaders and limit the strength of the recovery when it comes. These businesses are a principal source of job creation—something we will sorely need as people seek to return to work. 
5. A prolonged recession and weak recovery could also discourage business investment and expansion, further limiting the resurgence of jobs as well as the growth of capital stock and the pace of technological advancement. The result could be an extended period of low productivity growth and stagnant incomes.

We ought to do what we can to avoid these outcomes, and that may require additional policy measures. At the Fed, we will continue to use our tools to their fullest until the crisis has passed and the economic recovery is well under way. Recall that the Fed has lending powers, not spending powers. A loan from a Fed facility can provide a bridge across temporary interruptions to liquidity, and those loans will help many borrowers get through the current crisis. But the recovery may take some time to gather momentum, and the passage of time can turn liquidity problems into solvency problems. Additional fiscal support could be costly, but worth it if it helps avoid long-term economic damage and leaves us with a stronger recovery. This tradeoff is one for our elected representatives, who wield powers of taxation and spending.

Thank you. I look forward to our discussion.


https://www.federalreserve.gov/newsevents/speech/powell20200513a.htm?fbclid=IwAR0ZrRkqMbUqbmzWnv4l5MG0Fwqns_nD1eThWL-PoRe5zSCWLdsHU5_uRX4

"Intellectual humility is a personality trait; may influence people's decision-making abilities in many arenas.

The topic of dealing with what you don’t know brings up a very important:topic of  intellectual humility.


“Intellectual humility” has been something of a wallflower among personality traits, receiving far less scholarly attention than such brash qualities as egotism or hostility. Yet this little-studied characteristic may influence people’s decision-making abilities in politics, health and other arenas, says new research from Duke University.



Intellectual Humility is the Opposite of Intellectual Arrogance or Conceit

As defined by the authors, intellectual humility is the opposite of intellectual arrogance or conceit. In common parlance, it resembles open-mindedness.  Intellectually humble people can have strong beliefs, but recognize their fallibility and are willing to be proven wrong on matters large and small, Leary said. (Alison Jones, Duke Today, March 17, 2017, emphasis added)


To get a little more technical, here are a couple of useful paragraphs from a discussion of the paper cited above:

The term, intellectual humility (IH), has been defined in several ways, but most definitions converge on the notion that IH involves recognizing that one’s beliefs and opinions might be incorrect. . . . 

Some definitions of IH include other features or characteristics – such as low defensiveness, appreciating other people’s intellectual strengths, or a prosocial orientation . . .



Core Characteristic of Intellectual Humility is Recognizing that one's belief maybe wrong

One conceptualization defines intellectual humility as

• recognizing that a particular personal belief may be fallible, 
• accompanied by an appropriate attentiveness to limitations in the evidentiary basis of that belief and 
• to one's own limitations in obtaining and evaluating relevant information. 

This definition qualifies the core characteristic (recognizing that one’s belief may be wrong) with considerations that distinguish IH from mere lack of confidence in one’s knowledge or understanding.



Distinguishing Intellectual Humility from Uncertainty or Low Self-Confidence

IH can be distinguished from uncertainty or low self-confidence by the degree to which people hold their beliefs tentatively specifically because they are aware that

• the evidence on which those beliefs are based could be limited or flawed, 
• that they might lack relevant information, or 
• that they may not have the expertise or ability to understand and evaluate the evidence. 

(The Psychology of Intellectual Humility, Mark Leary, Duke University, emphasis added)

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

When do you allow for the possibility that you’re wrong? When does reason-based confidence turn into hubris and obstinateness?

Holding and adding to declining positions is only a good idea if the underlying thesis turns out to be right and things eventually go as expected.

• In other words, when do you allow for the possibility that you’re wrong?  
• When does reason-based confidence turn into hubris and obstinateness? 

Investor faces uncertainty in investing.  An investor having a sense of uncertainty is not a bad thing.


Howard Mark shared his experiences:

• “Investing scared” – a less glamorous term than “applying appropriate risk aversion” – will push you to
-   do thorough due diligence,
-   employ conservative assumptions,
-   insist on an ample margin of safety in case things go wrong, and
-   invest only when the potential return is at least commensurate with the risk.
In fact, I think worry sharpens your focus. Investing scared will result in making fewer mistakes (although perhaps at the price of failing to take maximum advantage of bull markets).


• When I started investing in high yield bonds in 1978, and when Bruce Karsh and I first targeted distressed debt in 1988, it seemed clear that the route to long-term success in such uncertain areas lay in limiting losses rather than targeting maximum gains. That approach has permitted us to still be here, while many one-time competitors no longer are.


• I can tell you that in the Global Financial Crisis, following the bankruptcy of Lehman Brothers, we felt enormous uncertainty. If you didn’t, there was something wrong with you, since there was a meaningful possibility the financial system would collapse. When we started buying, Bruce came to me often saying, “I think we’re going too slow,” and then the next day, “I think we’re going too fast.” But that didn’t keep him from investing an average of $450 million per week over the last 15 weeks of 2008. I think Bruce’s ability to grapple with his doubts helped him arrive at the right pace of investment.



The topic of dealing with what you don’t know brings me to a phrase I came across a few years ago and think is very important: intellectual humility.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

Active investors have to be confident; to do better than most, you have to depart from the crowd.

Investing is challenging.   Active investors have to be confident.

Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

To do better than most, you have to depart from the crowd. 


1.  Be greedy when others are fearful, be fearful when others are greedy

• All great investments begin in discomfort, since the things everyone likes and feels good about are unlikely to be on the bargain counter. 
• But to invest in things that are out of favor – at the risk of standing out from the crowd and appearing to have made a big mistake – takes confidence and resolve. 

2. Hold onto a position when it declines and add to it at lower prices

It also requires confidence to hold onto a position when it declines – and perhaps add to it at lower prices – in the period before one’s wisdom becomes clear and it turns into a winner.


3.  Holding a highly appreciated investment that still has upside potential (long runway)

And it takes confidence to continue holding a highly appreciated investment you think still has upside potential, at the risk of possibly giving up some of the gains to date.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

It is very important to acknowledge what we don’t know.

In Praise of Doubt

It is very important to acknowledge what we don’t know.

First of all, if we’re going to out-invest the rest, we need a game plan. There are a lot of possible routes to success on which to base your process: in-depth research into companies, industries and securities; arbitrage; algorithmic investing; factor investing; even indexation. But if I’m right about the difficulty of macro forecasting, for most people that shouldn’t be it.

Second, and probably more importantly, excessive trust in forecasting can be dangerous to your financial health. It’s never been put better than in the quote that’s often attributed to Mark Twain, but also to several others:

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

Just a few words, but a great deal of wisdom.


No statement that starts with “I don’t know but . . .” or “I could be wrong but . . .” ever got anyone into big trouble. If we admit to uncertainty, we’ll investigate before we invest, double-check our conclusions and proceed with caution. We may suboptimize when times are good, but we’re unlikely to flame out or melt down. On the other hand, people who are sure may dispense with those things, and if they’re sure and wrong, as the quote suggests, the outcome can be catastrophic.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

One of the biggest mistakes an investor can make is ignoring or denying his or her biases.

The thought process through which most of us arrive at our view of the future is highly reflective of our biases. Given the unusually wide chasm between the optimistic and pessimistic cases at this time – and the impossibility of choosing between them based on facts and historical precedents (since there are none) – think about the role of bias.




Ignoring or denying your biases is a big mistake

One of the biggest mistakes an investor can make is ignoring or denying his or her biases. If there
are influences that make our processes less than objective, we should face up to this fact in order to
avoid being held captive by them.



Our biases may be insidious, but they are highly influential. 

Examples of "confirmation bias"

When I read articles about how difficult it will be to provide adequate testing for Covid-19 or to get support to small businesses, I’m pleased to see my wary views reinforced, and I find it easy to incorporate those things into my thinking.

But when I hear about the benefits of reopening the economy or the possibility of herd immunity, I find it just as easy to come up with counter-arguments that leave my concerns undented.


This is a clear example of “confirmation bias” at work:

• Once we have formed a view, we embrace information that confirms that view while ignoring, or rejecting, information that casts doubt on it. 
• Confirmation bias suggests that we don’t perceive circumstances objectively. 
• We pick out those bits of data that make us feel good because they confirm our prejudices. 
• Thus, we may become prisoners of our assumptions. (Shahram Heshmat, Psychology Today, April 23, 2015)

As Paul Simon wrote 50 years ago for the song The Boxer, “. . . a man hears what he wants to hear and disregards the rest.”



More examples of confirmation bias

• While I didn’t know the name for it, I’ve long been aware of my bias. In a recent memo, I told the story from 50 years ago, when I was Citibank’s office equipment analyst, of being asked who the best sell-side analyst on Xerox was. My answer was simple: “The one who agrees with me most is so-and-so.” Most people are unlikely to think highly of anyone whose views they oppose. So when we think about which economists we quote, which investors we respect, and where we get our information, it’s likely that their views will parallel ours.

• Of course, taken to an extreme, this has resulted in the unfortunate, polarized state in which we find the U.S. today. News organizations realized decades ago that people would rather consume stories that confirm their views than those that challenge them (or are dully neutral). Few people follow media outlets that reflect a diversity of opinion. Most people stick to one newspaper, cable news channel or political website. And few of those fairly present both sides of the story. Thus most people hear a version of the news that is totally unlike the one heard by those on the other side of the debate. When all the facts and opinions you hear confirm your own beliefs, mental life is very relaxed but not very enriching.

What’s the ideal? 

A calm, open mind and an objective process. 

Wouldn’t we all be better off if those things were universal?

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf