0:00

You're listening to TIP. If

0:03

an algorithm out there could outperform the market,

0:05

would you be interested in learning more about

0:07

what that algorithm consists of? Now,

0:09

I'm not talking about algorithmic trading or anything

0:11

like that. I'm talking about

0:14

tried and true fundamental characteristics and strategies

0:16

that people like Buffett and many other

0:18

investing legends such as John Maynard Keynes, Charlie

0:20

Munger, Lou Simpson, and Bill Ruane have

0:22

utilized to outperform the market by a

0:24

very wide margin over long periods of time.

0:27

Well, today, I will be sharing a number

0:29

of traits that are necessary to be considered

0:31

a focus investor, which is the prototype of

0:33

Warren Buffett. We'll be looking at these issues

0:35

from the book, The Warren Buffett Portfolio by

0:38

Robert Hagstrom. We'll go over

0:40

some very interesting research that the book's

0:42

author, Robert Hagstrom, covered to better help

0:44

investors understand the details of concentration and

0:47

diversification, especially in relation to

0:49

returns. You probably won't

0:51

be surprised to learn that concentrated portfolios will

0:53

give you the highest probability of outperforming the

0:55

market. But on the flip

0:58

side, there is a potential downward risk of concentrated

1:00

portfolios that you should definitely be aware of, and

1:02

we're going to cover that in quite a bit

1:04

of detail. Another attribute

1:06

of focus investing is the emphasis on psychology.

1:09

I'll cover a few of Warren Buffett's biggest

1:11

influences on his own psychology and what he

1:13

learned from them. I'll

1:15

go over four psychological shortcomings that we pretty

1:17

much all exhibit to some degree and that

1:19

can wreak havoc on our investing returns and

1:22

on our ability to sleep well at all.

1:24

We'll also cover why focus investors spend a lot

1:26

of time thinking about their own psychological misjudgments and

1:29

some strategies to use investor psychology to

1:31

our own advantage. We'll also cover the

1:33

role of patience in successful investing. Mainly

1:36

there's two distinct areas. One

1:38

is ignoring market forecasts and two in waiting

1:40

for fat pitches. Now

1:42

I think patience is vital in these two

1:45

areas because without patience, you're going to be

1:47

looking to market forecasts to help fuel your

1:49

need for action. But if

1:51

you have patience, you can wait around for long

1:53

durations until a fat pitch presents itself. But

1:56

this is just scratching the surface of what I'll be covering today. I'll

1:58

also be discussing things like what makes a focus

2:01

investor and why it's an important concept, why

2:03

focus investors reject much of the premises

2:05

of financial academia, the

2:07

common characteristics of outperforming focus investors

2:09

throughout history, and a whole lot

2:11

more. So if you want to

2:14

learn more about the benefits and execution of the

2:16

focus investment strategy, then listen on, you won't be

2:18

disappointed. Now, let's get right

2:20

into this week's episode. Celebrating 10 years and

2:22

more than 150 million downloads, you are

2:24

listening to the Investors

2:30

Podcast Network. Since 2014, we studied

2:32

the financial markets and read the

2:34

books that influenced self-made billionaires the

2:37

most. We keep you informed and

2:39

prepared for the unexpected. Now,

2:42

for your host, Kyle Grieve. Welcome

2:53

to the Investors Podcast. I'm your host,

2:55

Kyle Grieve. And today, we'll be discussing

2:57

a book that deals with some of

2:59

the subtle nuances of Warren Buffett's focused

3:01

investing strategies. That book is

3:03

called the Warren Buffett Portfolio and

3:06

is written by Robert Hagstrom. This book is

3:08

great because it goes over a few

3:10

key areas that really differentiate what Robert

3:12

calls focus investors from the rest. Focus

3:15

investors engage in focus investing, and they

3:17

tend to think a lot differently. This

3:19

book is a wonderful guide to help you

3:21

understand how these focus investors think and why

3:24

thinking this way could benefit your financial health.

3:26

But first, let's really discuss exactly

3:28

what focus investing is. The essence

3:31

of focus investing has three primary

3:33

components. One, you choose

3:35

a few stocks that are likely to

3:37

produce above average returns over the next

3:39

five, 10, or 20 years. Two, you

3:41

concentrate your capital on a few of

3:43

these positions. And three, you maintain conviction

3:46

when warranted and are very resilient to

3:48

short term price fluctuations in market prices.

3:50

Now, let's go over each of these three tenants. You

3:53

might be asking how many stocks does a focus

3:55

investor need in their portfolio? Warren came

3:57

up with a really good solution that would make

3:59

sense. provided that you are the type

4:01

of investor who has an in-depth understanding of

4:04

a business's economics. So Warren says that

4:06

5 to 10 sensibly priced

4:08

businesses with long-term competitive advantage is really

4:10

all the diversification that is required to

4:13

succeed in investing. Over the

4:15

years, I've observed what other people think about

4:17

these numbers. Most people are shocked at the

4:19

thought of having such a small number of

4:21

position sizes. But here's the thing

4:23

about diversification. The more diversified you

4:25

are, the less information you really know about

4:27

each position that you own. Even

4:29

if you speak to the CEOs of the largest

4:31

asset managers in the world, I

4:33

can guarantee that they do not have an

4:36

in-depth understanding of everything that they manage. Instead,

4:38

they outsource that work to other people in

4:40

the business so they can specialize in whatever

4:42

they need to in order to continue improving

4:44

the business. But as individual investors managing our

4:46

portfolios or those of others, don't you think

4:48

you owe it to yourself to understand everything

4:51

that you own? If you do

4:53

not desire to understand businesses deeply, Warren would

4:55

tell you to diversify. This has the benefit

4:57

of not bothering to try to understand businesses

4:59

at a deep level as you can just

5:01

count on the strength of the underlying country.

5:06

But if you do decide to go the index route, there

5:08

is a really big key that you must take into account.

5:11

If you index, your returns will never beat

5:13

the index. You will be handcuffed to the

5:15

results of the index and never stray from

5:17

them. Many investors see this as

5:19

a positive. And to them, investing in indexes

5:21

and not paying any attention to them or

5:23

their result is a great strategy. But other

5:25

investors want more. They want market-beating

5:27

returns. If you're listening to this episode, I

5:29

bet a part of you is trying to beat the market with

5:32

a portion of your portfolio. In that case,

5:34

stock picking is the correct route, and

5:36

concentrated bets will help you get there. We

5:38

are going to discuss some of the

5:40

great data that Robert came to find

5:42

while researching diversified versus concentrated portfolios. Stick

5:45

around as I know you'll enjoy the

5:47

results. Third point here is on conviction.

5:49

Focus investors must have conviction. After

5:51

all, if you only hold a few stocks

5:53

and have a large percentage of your portfolio

5:55

in these positions, a few other things are

5:57

also valid. It means you aren't aren't

6:00

looking to trade in and out of stocks like

6:02

a kid trading snacks during lunch. It

6:04

also means that once you find an idea,

6:06

your ideal situation is that the business continues

6:08

to perform for many, many years into the

6:10

future. These two second order

6:12

effects of conviction have to do with your

6:14

timescale. You can't be a

6:17

focus investor while simultaneously always looking to

6:19

invest somewhere else. There

6:21

comes a point where you need to ride

6:23

with what you have and avoid the over-tinkering

6:25

that causes many investors to produce unsatisfactory results.

6:28

A sports reference here is going to work best. So

6:31

in the pre-season of any professional sport, the

6:33

team's manager assesses what he has to create

6:35

the best possible roster. And creating a stock

6:38

portfolio is really the same thing. You're

6:40

trying to build a roster of the best

6:42

possible businesses to fit into your portfolio. They

6:44

should not be players that can be easily

6:47

replaceable. If you're creating a roster of replaceable

6:49

players, then you really need to be more

6:51

discerning about what you let into your portfolio

6:53

in the first place. I personally

6:55

want a portfolio where deciding who to cut is

6:57

a very, very tough decision. And I feel like

6:59

I'm getting closer and closer to that point as

7:01

I gain more experience. But deciding who

7:04

to get rid of has been a lot easier over

7:06

the last few years. This concentration

7:08

style is far different from what is

7:10

traditionally taught in financial institutions. To best

7:12

understand how we should think, we must

7:14

also understand why everyone feels the way

7:16

they do. For that, we need

7:18

to go back in time and examine the ideas

7:20

of three influential people in financial academia. We

7:23

start with Harry Markowitz, who developed the modern

7:25

portfolio theory. This theory is

7:27

based on the simple idea that return

7:30

and risk are inextricably linked. Now

7:32

if you want a low risk portfolio, you

7:34

would construct a diversified portfolio of low covariance

7:37

stocks. So covariance is a measure of

7:39

the direction of a group of stocks. Let's

7:41

say we have two stocks with high covariance.

7:44

This basically means that they tend to move

7:46

together up and they move together down. Now

7:48

a low covariance would imply that these two

7:50

stocks move in opposing directions. Pags from Rights,

7:52

Markowitz is thinking the risk of a portfolio

7:54

is not in the variance of the individual

7:57

stocks, but the covariance of the

7:59

holdings. The more they move in the same

8:01

direction, the greater is the chance that economic

8:03

shifts will drive them all down at the

8:05

same time. By the same token, a portfolio

8:08

composed of risky stocks might actually be a

8:10

conservative selection if the individual

8:12

stock prices move differently. Either way,

8:14

Markowitz said diversification is key. Now,

8:16

since much of Wall Street is

8:18

educated using modern portfolio theory, it's

8:20

pretty easy to see why so

8:22

many fund managers have chosen to

8:24

over diversify. The next priest of

8:26

modern finance is Bill Sharp. Instead of

8:28

looking at the entire portfolio, Sharp looked at

8:31

the individual behavior of the stock market to

8:33

determine its behavior. If a stock's price is

8:35

more volatile than the market as a whole,

8:38

the stock will make the portfolio more variable

8:40

and therefore, more risky. But if the stock

8:42

is less volatile than the market as a

8:44

whole, the stock becomes less variable and thus,

8:47

less volatile. With this framework, you

8:49

could then measure the volatility of a

8:51

portfolio. And this measure was called Beta Factor.

8:53

Now, the third priest of modern finance

8:55

that Robert covers is Eugene Fama. Fama

8:58

believed that stock prices are not

9:00

predictable. The market is simply

9:02

too efficient. And as new information becomes available,

9:05

intelligent actors in the market price that

9:07

in. This causes prices to

9:09

adjust immediately before anyone can profit. His

9:12

theory states that future predictions have no

9:14

place in an efficient market because share

9:16

prices just adjust too quickly. When

9:18

you think about the investing industry,

9:21

these guys have their fingerprints all

9:23

over traditional investing practices, such as

9:25

diversification, reducing risks through owning low

9:28

risk stocks, and accepting market like

9:30

returns as beating it is impossible.

9:32

However, the focus investor like

9:35

Buffett rejects much of the premises on

9:37

which these modern financial theories are based.

9:39

Buffett believes that diversification is actually appropriate

9:42

for the right person in different dosages.

9:45

Mainly, people who just aren't interested in

9:47

learning about the intricacies of a business,

9:49

the skill set of management, a management's

9:51

competitive advantage of businesses, future prospects, etc.

9:54

But for individuals who are interested in

9:56

that stuff, then diversification is silly. Buffett

9:58

believes that diversification is a classification actually

10:00

increases risk. Buffett says, we believe that

10:02

a policy of portfolio concentration may well

10:05

decrease risk if it raises as it

10:07

should both the intensity with which an

10:09

investor thinks about a business and the

10:12

comfort level he must feel with its

10:14

economic characteristics before buying into it. Now

10:17

to Buffett, the better you understand the business

10:19

and its intrinsic value, the less risk you

10:21

take. And as I discussed, you cannot maximize

10:23

your understanding of a business with hundreds and

10:26

hundreds of names in your portfolio. Buffett's

10:28

next point on risk is the interplay

10:30

of intrinsic value, price, and risk. Buffett

10:33

has spoke about his investment in the

10:35

Washington Post where it seemed readily apparent

10:37

that the business was worth about 400

10:40

million dollars or so. However, under the

10:42

theory of beta and modern portfolio theory,

10:44

Warren would have increased his risk by

10:46

buying the stock at 40 million dollars

10:48

rather than buying it at 80 million

10:50

because the lower price had higher volatility.

10:52

Now just think about the logic of

10:54

that statement and it really becomes hard

10:57

to argue that some of these theories

10:59

just don't make a lot of sense

11:01

when you truly understand the value of

11:03

a business. When it comes to the

11:05

efficient market hypothesis, Hags from Covers three

11:07

areas where the theory just seems not

11:09

defensible. Number one is investors are only

11:11

sometimes rational and assuming that they're always

11:13

rational is just not a good representation

11:16

of reality. Number two is that investors

11:18

just don't process information correctly. They rely

11:20

on system one thinking and often jump

11:22

to incorrect conclusions as their default. So

11:24

these incorrect assumptions may only last a

11:26

short time before correcting, but it's during

11:28

these times that you can really take

11:30

advantage of the market. And three, the

11:32

performance yardstick emphasizes short term performance. So

11:35

in this light, it becomes nearly impossible

11:37

to beat the market quarterly. But by

11:39

extending your time horizons, outperformance does become

11:41

a possibility. Buffett says, observing correctly that

11:43

the market was frequently efficient, they went

11:45

on to conclude incorrectly that it was

11:47

always efficient. The difference between

11:49

these propositions is night and day. Now,

11:52

the interesting thing here is that even

11:54

as a focus investor who doesn't buy

11:56

into all these principles of modern finance,

11:58

you still need to follow them. them

12:01

loosely. Namely, that's the efficient market hypothesis.

12:03

I still think the market is mostly

12:05

efficient, but there is a difference between

12:07

being mostly efficient and being always efficient.

12:11

Value investors will often look for areas of the

12:13

market where inefficiencies are the highest. Then,

12:15

they use their knowledge and patience to exploit

12:17

these inefficiencies. This is what Buffett's career has

12:19

been built on. If you follow the tenets

12:22

of modern finance theory, it's easy to get caught

12:24

up thinking more like an academic and less like

12:26

a businessman. As Benjamin Graham has

12:28

famously said, investment is most intelligent

12:30

when it is most businesslike. I prefer to

12:32

think about investing through the lens of a

12:34

businessperson and as little as possible through the

12:36

lens of academics. Here is

12:38

a simple four-step framework to ascertain the probability

12:41

of a decent return on an investment that

12:43

Hags from Developed based on Buffett's thinking. The

12:47

certainty in evaluating a business' long-term economics. The

12:51

certainty in management's ability to maximize

12:53

a business' potential and property-allocate capital.

12:57

The certainty that management will prioritize shareholders'

12:59

interests over their own. The

13:01

purchase price of the business. Find

13:03

a business where you can be highly certain of points

13:05

1 through 3. There won't be

13:08

that many, and that's perfectly okay. But

13:10

once you find it, you should ensure that your

13:12

purchase price is reasonable and that you're

13:14

moving in the right direction in terms of that certainty.

13:17

Now, let's move to a more practical

13:19

way of looking at some of

13:21

history's greatest focus investors. Hags from Look

13:23

at some of the most significant focus

13:25

investors' historical performance and concentration levels. These

13:28

investors were John Maynard Keynes, Warren Buffett,

13:30

Charlie Munger, Bill Ruane, and Lou Simpson.

13:33

All five of these investors have incredible track records.

13:35

Let me break it down for you. So

13:38

John Maynard Keynes managed the chess fund during

13:40

the Great Depression and World War II, and

13:43

his average annual return was 13.2% versus

13:45

the UK market's performance of negative Now,

13:49

Warren Buffett managed the Buffett partnerships between 1957 and 1969.

13:53

In that time, his annual returns were 30.4%

13:55

versus the Dow's return of only 8.6%. Charlie

13:59

Munger had a partner. partnership, which was active from 1962 until

14:01

1975. And in that partnership, he generated annual

14:05

returns of 24.3% versus the Dow's return of 6.4%. Bill

14:10

Ruane, a friend of Warren Buffett, managed

14:12

the Sequoia Fund. Hagstrom lists

14:14

his performance between 1971 and 1997. Sequoia Fund had annual

14:16

returns of 19.6% versus the S&P 500's return of

14:22

14.5%. And lastly, Lou Simpson.

14:25

He managed Geico's investment portfolio from 1980

14:27

to 1996.

14:29

And he generated a whopping 24.7% annual return versus 17.8% for the S&P 500. Now,

14:35

these numbers are exceptional, but really the

14:38

most important point here is just the

14:40

generalities that a lot of these investors

14:42

shared. So for instance, risk management was

14:44

a major focus. But instead of worrying

14:46

about modern portfolio theory, they focused on

14:49

buying businesses with significant intrinsic value and

14:51

price gaps. They specifically thought about businesses

14:53

that they believed had the characteristics necessary

14:55

to continue outperforming the market only over

14:58

long periods of time. They focused their

15:00

portfolios on just a few names, which

15:02

definitely caused volatility in their yearly returns,

15:04

but overperformance in the long term. Now,

15:07

Robert received some criticism from skeptics regarding

15:09

the results of these investors who said

15:11

that five is just too much of

15:13

a small sample size to really draw

15:16

any reliable conclusions. Now, Robert

15:18

agreed and he actually found a Compustat

15:20

database and examined 12,000 portfolios instead

15:22

of just five. Now, this study broke

15:25

each portfolio into quartiles designed

15:27

to contain a different concentration of stocks. So

15:29

there are 3000 portfolios each of 250 stocks,

15:33

100 stocks, 50 stocks and 15 stocks.

15:36

Robert then calculated the average annual rate of return

15:38

for each portfolio group over two periods of time,

15:40

which were 10 and 18 years. Then he

15:43

compared the results of the S&P 500

15:45

for the time samples. The conclusion was

15:47

pretty profound. In every case, when we

15:49

reduce the number of stocks in a

15:51

portfolio, we began to increase the probability

15:53

of generating returns that were higher than

15:55

the market's rate of return. Now, there

15:57

are some very important takeaways here. The

16:00

portfolios as a group generated similar returns when looking

16:02

at the overall sample size of 3000. However,

16:05

the exciting part regards increasing the

16:07

probability of generating returns above the

16:09

market-rated return. The fewer

16:11

stocks in a portfolio generate the highest,

16:13

best returns but also the lowest, low

16:15

returns. These results lead us

16:18

to two conclusions. One, you increase

16:20

the probability of outperforming the index with

16:22

a focused portfolio. And

16:24

two, you increase the probability of underperforming

16:26

the index with a focused portfolio. Now

16:29

the key here is to really optimize for

16:31

point one while protecting yourself from point two.

16:34

And the best way to do this is to become an

16:36

expert business analyst. Suppose you can

16:38

discern what makes one business superior over

16:40

competitors like the five investors who I

16:42

just mentioned. In that case, you tip

16:44

the odds in your favor of avoiding

16:46

any significant losers who can drain your

16:48

long-term performance. If you go the

16:51

focused investor route, you also must be aware

16:53

that you will lose against the index with

16:55

some regularity. So you must

16:57

remember that the goal is to maximize

16:59

high absolute returns over the long period

17:01

and not to beat the index over

17:04

just a short, you know, 90-day period.

17:07

Nobody beats the index quarter to quarter anyway. So

17:09

I always really find it puzzling that people try

17:11

to do this. The last point

17:13

I want to discuss here in this section was the

17:15

role of frictional costs. Robert didn't

17:17

actually take this into account for the Compustat

17:19

study. However, he did note that the fees

17:21

involved in buying and selling 250 stocks are

17:23

obviously going to be much more

17:25

prominent on an absolute and relative basis than

17:28

a 15-stock portfolio. He said that if he'd

17:30

considered that adjustments would have been necessary for

17:32

the portfolio that would have actually widened the

17:34

gap even further. As an investor,

17:36

you couldn't really just use

17:38

diversification to your advantage. If

17:41

you're a newer investor, use diversification as you

17:43

familiarize yourself with an investing strategy that just

17:45

resonates with you. You could

17:47

keep the bulk of your capital in index

17:50

funds and then slowly add to individual stocks

17:52

once you become more comfortable with them. Let's

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more info. All

21:31

right, back to the show. If you

21:33

are an investor who doesn't hold the next funds but is

21:35

diversified in say 50 or 100

21:37

or more names, maybe you start trying to

21:40

figure out which businesses that you understand best.

21:42

Then slowly add to your highest conviction ideas

21:45

while removing your lower conviction ideas or maybe

21:47

removing ideas that are outside of your circle

21:49

of competence. Or maybe you are

21:51

a concentrated investor with single digit names, but

21:53

realize that you don't have the time to

21:55

really understand a business. In this

21:57

case, maybe allocating a portion of your portfolio.

22:00

to index funds is smart until you find

22:02

enough time to be much more comfortable with

22:04

just a few businesses. The possibilities really are

22:07

endless. Just realize that even though focus investors

22:09

tend to favor concentration, you personally don't have

22:11

to if you don't feel that it is

22:13

the right time. I mentioned here that these

22:16

super investors of Buffetville had some volatile results.

22:19

And this leads very well into the next section of the

22:21

book I want to cover, which is Measuring Performance. I'll connect

22:23

the two of these things to you very shortly here. But

22:26

first we need to get something out of

22:28

the way. So dogmatic thinking in investing has

22:30

caused the less sophisticated investor to believe that

22:32

the squiggles in the value of

22:34

the portfolio is the optimal performance measure. But

22:37

Warren Buffet disagrees. He thinks, and

22:39

I agree with him, that market prices

22:41

are frequently nonsensical. So using nonsensical feedback

22:44

to determine individual performance just doesn't seem

22:46

like the way to measure performance. Now

22:49

let's go back to the super investors that we

22:51

mentioned earlier. Out of all five of these examples,

22:53

Buffet, during his partnership days, was the only one

22:55

who never faced a year where he underperformed the

22:57

benchmark. But how did the rest fare? Here

23:00

are the percentage of the years that these

23:02

investors actually underperformed the market. So Keynes underperformed

23:04

33%, Munger underperformed 36% of the

23:07

time, Ruane underperformed 37% of

23:10

the time, and Lou Simpson underperformed 24% of the time. So

23:13

this shows that focus investors with very

23:15

enviable track records will still underperform the

23:17

market at least one quarter of the

23:19

time. And if that's not hard

23:22

enough, all of these investors besides Lou Simpson

23:24

had 3-4 consecutive years of underperformance at some

23:26

point during their investing career. So

23:28

this means that they had to field questions from

23:31

their investors and from themselves if their strategy was

23:33

still viable. Now in a recent

23:35

chat with Scott Barbee on TIP 651, he

23:38

discussed how he dealt with a brutal drawdown of

23:40

72%. He mentioned that

23:42

although the prices for many of his

23:44

holdings had decreased substantially, he saw incredibly

23:46

high divergences in price and value of

23:48

his portfolio. The businesses he owned were

23:50

oozing with value. Many of the

23:52

names he held were trading below the levels of cash per

23:54

share. So clearly, Scott understood the value of what he owned

23:56

and held through the market's punishment. And if has to be,

23:59

then I'd like to That same thing happened as a result.

24:02

In 2009, his fund generated 91% returns,

24:04

which got him on the cover of the Wall Street Journal.

24:07

When asked about what he did to achieve these results, he

24:09

said, Well, I feel very sheepish

24:11

about that because I didn't do anything. I

24:14

just held the same thing and the stock price went

24:16

down because they were purging out shares. Now

24:18

if you like mental models as I do, this is a perfect

24:21

example of regression to the meme. Due

24:23

to some of the harrowing down years, he

24:25

had a higher probability of that being followed

24:27

by some very high highs. But let's get

24:29

back to Keynes, Munger, Simpson and Ruway. If

24:31

we looked at their results regarding their percentage

24:33

of time underperforming the market and the multi-year

24:35

drawdowns, what can we assume about the ability

24:37

to work in today's environment? Hexham

24:40

writes, they would probably be canned to

24:42

their client's profound loss. Yet,

24:45

following the argument that the focus strategy

24:47

does sometimes mean enduring several weak years,

24:49

we run into a very real problem.

24:52

How can we tell using price performance as our

24:54

sole measure whether we are looking at a very

24:56

bright manager who is having a poor year or

24:58

even a poor three years, but

25:00

will do well over the long haul? Or

25:03

one who is just starting a string of bad

25:05

years? Well, we can't. To

25:08

address this problem, we need to change how we

25:10

think about our time horizons. Price

25:12

can't be the only measuring stick

25:14

we use, and making short-term judgments

25:16

on performance has to be tabled.

25:19

In Buffett's mind, measuring the performance of a

25:22

private company is the same as measuring the

25:24

performance of a publicly traded company. This

25:27

is the optimal way to measure performance. If

25:30

you owned a private business and had

25:32

no daily ticker, you would focus

25:34

on the profits or cash flow of the business,

25:36

as that would be the number that would concern

25:39

you the most. So why

25:41

should stocks be any different? Robert

25:43

looked at some of the data to see if

25:45

stock prices and earnings had any correlation. He

25:48

looked at 1,200 companies ranging between 3 and

25:50

18 years and measured the correlation of the

25:52

price and earnings. For instance, a correlation of

25:55

0.36 meant a 36% variance in price, explained

25:57

by the the

26:00

variance in earnings. So here's what he found in

26:02

each time cohort. With stocks that were held for

26:04

three years, the correlation range from 0.131 to 0.36.

26:09

With stocks held for five years, the correlation increased from a

26:11

range of 0.374 to 0.599. With

26:15

stocks held for 10 years, the correlation again increased from 0.593

26:18

to 0.695. And

26:21

with stocks held for 18 years, the correlation was about

26:23

0.688. So

26:26

this shows that for long-term focused

26:28

investors, buying businesses with increasing earnings

26:30

is highly likely to cause the

26:32

price to move up in lockstep

26:34

with the increase in earnings. Now

26:36

this research is in line with

26:38

Buffett's view on price and value.

26:41

While price will definitely track in an

26:43

uneven and unpredictable fashion, it still will

26:46

track. And the tracking improves

26:48

over long time periods. Buffett says, In

26:50

any given year, the relationship can

26:53

gyrate capriciously. Hegstrom notes that Ben Graham

26:55

has already given us this lesson when he wrote that in

26:57

the short run, the market is a voting machine, but in

26:59

the long run, it is a weighing machine. So

27:02

as individual investors, how can we

27:04

use the private business mindset to

27:06

determine performance? Once again, Warren

27:08

Buffett has a solution for us. So

27:10

he uses a mental model called look-through earnings

27:13

to get an idea of how your business's profits

27:15

are growing. The original machination of

27:17

the look-through earnings was explicitly created just

27:20

for Brickshire Hathaway as it included the

27:22

operating earnings of its privately held subsidiaries.

27:24

This is still a good mental model

27:26

as it allows you to look at

27:28

the entirety of your businesses to see

27:30

if the value of the entire portfolio

27:32

is improving. But as stock investors, we

27:35

only need to consider how he incorporated

27:37

look-through earnings specifically on his public equity

27:39

portfolio. Retained earnings carry

27:41

no value under GAAP accounting. For

27:43

an operating business, all earnings were

27:45

reported as you'd expect them to be.

27:47

But for publicly owned businesses, these retained earnings

27:50

still belong to Brickshire Hathaway, but they

27:52

were actually absent from the income statement. But

27:54

these retained earnings have obvious value because if

27:56

they were reinvested into the business at

27:58

high rates of return, return, the company

28:01

would increase in value and increase

28:03

retained earnings as a result. So

28:05

here's what you did. You find the total retained

28:07

earnings of each of your holdings. Since

28:09

you own a fractional share of business, you own

28:11

a fractional share of the retained earnings. Let's

28:14

say you own 50% of a company with $100 million

28:16

in retained earnings. That means your

28:18

share of retained earnings is $50 million. Now

28:21

let's say the same business increases its retained earnings to

28:23

$120 million the following year.

28:26

Now your share of those earnings has grown to $60 million.

28:29

The investor's goal is to think of

28:32

their portfolio as a holding company that

28:34

increases retained earnings over time. The thinking

28:36

is that if retained earnings increase at

28:38

say a 15% per annum, the value

28:40

of their holding company will also increase

28:42

at about 15% per annum. You

28:45

can also track this by simply adding earnings

28:47

growth and dividend yield as Francois Rochon does

28:49

at Givany Capital. Warren

28:52

believes that thinking in this manner will keep investors

28:54

focused on the long term and avoid short term

28:56

biases. The final point on

28:58

measuring performance I'll mention is using your

29:01

portfolio as a measuring stick. In

29:03

this case, Charlie Munger had some wonderful advice.

29:06

What Buffett is saying is something very useful

29:08

to practically any investor. For

29:11

an ordinary individual, the best thing

29:13

you already have should be your measuring stick.

29:16

And then another really good point he said

29:18

here was, the job of a portfolio manager

29:20

who is a long term owner of securities

29:22

and believes the future stock prices eventually match

29:24

with underlying economics and that

29:27

manager might well be you, is to

29:29

always find ways to raise the benchmark.

29:32

That's an enormous thought conservator, says Munger, and

29:34

it's not taught at business school by and

29:36

large. Now, I just love

29:38

thinking in this light from my own portfolio.

29:41

If a new business comes across my

29:43

inbox, I always have to determine if

29:45

it's better than my worst current holding.

29:48

If it's superior, then adding it to

29:50

my portfolio should actually raise the entire

29:52

benchmark of my portfolio. But

29:54

if it's inferior, then buying it will actually decrease

29:56

the quality of my portfolio as a whole. The

30:00

rates of return are equal, I will usually

30:02

always side with what I already own because

30:04

it generally means I already understand it at

30:06

a much better level. So

30:08

this discussion of the circle of competence leads

30:10

me to the next chapter of the Warren

30:12

Buffett portfolio, which covers Warren Buffett's tool belt.

30:15

So let's start by talking about the circle

30:17

of competence. The circle of

30:19

competence is an interesting concept because it

30:21

will defer based on your own life

30:24

experience and personal preferences. The

30:26

key with investing in your circle of

30:28

competence is to simply identify and leverage

30:30

advantages that you will have over the

30:33

majority of other investors. I

30:35

can tell you from a personal standpoint that I don't think

30:37

there are many subjects that I have much of an edge

30:39

in. As I learn more about a

30:41

business, the world around me, and reflect on my

30:43

own life experience, I have begun to paint a

30:46

picture, not only of what I understand, but also

30:48

what I want to add to what I already

30:50

know. Munger says each of you will

30:52

have to figure out where your talents lie, and

30:54

you'll have to use your advantages. But

30:57

if you try to succeed in what you're worst at,

30:59

you're going to have a very, very lousy career. I

31:01

can almost guarantee it. And I

31:03

think this is why a lot of

31:05

investors just have a hard time finding

31:07

success in the markets. Instead of focusing

31:09

on investing in what they already know

31:11

about, they search for stocks which give

31:13

the highest possible returns. But this just

31:15

removes the risk element from investing. And

31:18

whether you see it or not, that risk is going

31:20

to always be present. When you

31:22

understand something very, very well, you also

31:25

understand the potential downside. And

31:27

this downside recognition can really, really help

31:29

you avoid investing in things with the

31:31

possibility of losing a lot of money.

31:34

But just because you don't understand something doesn't

31:36

mean that you can never invest in it. Investing

31:39

is a lifelong process. And if you want

31:41

to learn more about a business or it's

31:44

in industry, just go buy some books, listen

31:46

to some podcasts, watch YouTube videos, or go

31:48

read some articles, or talk to people in

31:50

the industry. And I think if you

31:52

do this long enough, you can really understand many things

31:54

at a pretty high level. And then

31:57

also speaking, I think sometimes we

31:59

look at analysts and while

32:01

some of their analysis might seem impressive,

32:04

some of it's not quite as impressive.

32:06

And a lot of times while they may

32:08

seem smart and maybe they are smart, their

32:11

actual knowledge on a specific business or industry

32:13

just isn't as high as you think it

32:15

would be and yours would surprisingly be at

32:17

a much higher level. So

32:19

the next tool I want to discuss is the importance

32:21

of valuing a business. The notion is

32:23

very simple, but definitely abused. So in order

32:26

to value a business, all you need to

32:28

know is the future cash flows for the

32:30

entire lifespan of a business discounted to present

32:32

value. And that is all you need to

32:34

get intrinsic value. Now you may have

32:36

noticed I said that this is an abused figure. Let

32:38

me tell you why I think that is. I

32:40

think it's nearly impossible to find a business that

32:43

you can accurately predict cash flows out into eternity

32:45

for. For this reason, investors come up with all

32:47

sorts of wild evaluations of businesses based on things

32:49

like growth rates that are nearly impossible to forecast

32:52

a year from now, let alone 10 or 20

32:54

years. So while I

32:56

think this method is still one of the

32:58

better ways to determine a business's value, it's

33:01

important to remember that it really is just

33:03

an approximation. If you can find

33:05

wide discrepancies between your approximation and the

33:07

price, you offer yourself the best possible

33:09

situation and the highest possible margin of

33:12

safety. So let's move to the

33:14

next tool, which is the ability to evaluate management.

33:17

Hegstrom mentions that the highest compliment that Buffett

33:19

can give a manager is to say that

33:21

the manager thinks like the owner of a

33:23

company. I think this is just such a

33:26

valuable evaluation tool. It's really easy to go

33:28

out, find managers out there who talk the

33:30

talk, but don't walk the walk. A

33:33

manager who goes out and buys shares of a

33:35

business on the open market is a huge signal

33:37

that the manager thinks of themselves as an owner.

33:39

If a manager is constantly talking about how cheap

33:41

their business is and owns a negligible amount of

33:43

shares of the business, then you have a pretty

33:45

good signal that the manager is not managing the

33:47

business as an owner. So there

33:49

are three areas that Buffett focuses on

33:52

when assessing management. One is rationality. Is

33:54

the manager rationally allocating capital? Are they spending

33:57

money on areas of the business that they

33:59

are? off for the highest returns? Are

34:02

they spending money for the long-term wellbeing of

34:04

the business, or are they destroying the business's

34:06

long-term health to chase short-term incentives? Number

34:08

two is candor. Does the CEO

34:11

only mention the positives even when they've

34:13

made a massive blunder? Do they refuse

34:15

to accept the responsibility for past errors?

34:17

And do they deflect hard questions or

34:19

outright refuse to answer them? And three

34:21

is resisting the institutional imperative. Are they

34:23

contrarians? Are they doing things that the

34:26

industry is refusing to do that would

34:28

make sense for the betterment of the

34:30

long-term health of the business? Or

34:32

are they just following what everyone else is

34:34

doing and spending monies in areas that they

34:36

have no business spending? So here are

34:39

a few tips that Robert writes in regard to Buffett

34:41

that I think will help you get a better view

34:43

of management talents. Review annual reports

34:45

from a few years back. Pay special

34:47

attention to what management said then about

34:49

strategies for the future. Then after you

34:51

do that, you compare those plans to

34:53

today's results and just look at how

34:55

they were realized. You could also just

34:57

compare the strategies of a few years

34:59

ago and look at this year's strategies

35:01

and ideas and just look at how

35:03

the thinking has changed over that time

35:05

period. You can compare

35:08

the annual reports of the company that

35:10

you're interested in with reports from similar

35:12

companies in the same industry. It's not

35:14

always easy to find exact duplicates of

35:16

companies, but even relative performance comparisons can

35:18

really yield good results and insights. Now

35:21

there was a business I own that I won't

35:23

bother mentioning by name, but I didn't use the

35:25

framework of that. I just mentioned above after I

35:27

bought it, which is very unfortunate because if I

35:30

had used that framework, I probably would have saved

35:32

me a lot of time, headache, and money, but

35:34

oh well. So if I look back, management had

35:36

an initiative for a host of its products that

35:39

it thought it would carry the business into the

35:41

future and be responsible as kind of these growth

35:43

leavers. But when you fast forward just a few

35:45

years into the future, basically all these growth initiatives

35:47

would just been thrown out the window. They didn't

35:50

bother mentioning them at all. And even for the

35:52

few years that they actually did discuss it, things

35:54

just weren't moving very fast. And I think it

35:56

was very clear to them that even though growth

35:58

initiatives were what they wanted to be value added

36:01

for the business they just weren't. And so they

36:03

eventually just got rid of them. And to me,

36:05

this is just a massive red flag. Don't follow

36:07

me. This is when I was newer to investing,

36:10

but it would have been a big enough red

36:12

flag for me to just not buy it in

36:14

the first place. Now on the

36:16

other hand, maybe you go back in time and

36:18

see that a business such as Lululemon, which Clay

36:20

and I spoke about on TIP episode 627, has

36:24

this initiative that goes back to 2020.

36:26

So they call it the power of

36:28

three initiatives. So the three initiatives here

36:31

were product innovation, guest experience, and market

36:33

expansion. If you actually fast forward to

36:35

2024, they're actually already on the second

36:37

version of this initiative because they crushed

36:39

the goals of the first initiative years

36:41

before it needed to be done. So

36:44

these are the types of stories and management teams that

36:46

I think you should be looking for. The

36:49

final tool I want to discuss here is the

36:51

never ending debate on growth and value. Charlie Munger

36:53

has one of the best quotes of this subject

36:55

that I've ever read. The whole

36:58

concept of dividing it up into value

37:00

and growth strikes me as twaddle. It's

37:02

convenient for a bunch of pension fund

37:04

consultants to get fees, prattling about in

37:06

a way for one advisor to distinguish

37:08

himself from another. But to me, all

37:11

intelligent investing is value investing. Charlie's

37:14

point here about consultants using these kinds

37:16

of terms is profound. I

37:18

think a lot of complexity in investing

37:21

has been invented by third party interests

37:23

that are incentivized to make themselves look

37:25

smart. Paying someone to

37:27

tell you that all intelligent investing is

37:29

value investing isn't nearly as sexy as

37:31

paying a million dollars to some consultant

37:34

for a spiffy PowerPoint presentation exolling the

37:36

differences between growth and value. The key

37:38

here is to understand the basics of

37:40

investing and then ignore the unnecessary complexity

37:43

that you will constantly come across. I

37:46

often read about investing and think that I'm

37:48

a fool for not understanding some sort of

37:50

arcane lingo or subject that I'm reading about.

37:53

Then I remember that it's irrelevant for

37:55

me to think that way because Charlie,

37:57

Warren, and other business people wouldn't spend

37:59

a second thinking in that fashion. Previously

38:02

mentioned metrics like beta and sharp ratios

38:04

come to mind. I

38:06

have never used these metrics in my own

38:08

investing and the only time I've ever spent

38:11

thinking about them was in preparation for this

38:13

chat with you today. Part of the advantage

38:15

of learning investing on your own is that

38:17

it's easier to come to grips with this

38:20

great Charlie Munger quote, I think that one

38:22

should recognize reality even when one doesn't like

38:24

it. Indeed, especially when one doesn't like it.

38:27

If you pay money and invest time into

38:29

a formal finance education, it becomes harder to

38:31

embrace reality when your education is based on

38:33

academic concepts that I've already covered. As Warren

38:36

and Charlie pointed out on numerous occasions, they

38:38

disagree with many significant premises taught in financial

38:40

academia. Now here's what Munger

38:42

said about finance theory. We try to

38:45

think like Fermat and Pascal would if

38:47

they'd never heard of modern finance theory,

38:49

which leads us to the next subject

38:51

that I wanna discuss, which is the

38:53

mathematics of investing. Now, before

38:55

I scare you away with talks of math, please let

38:57

me put your mind at ease. I

38:59

won't be going over anything overly complex, just

39:02

a few mathematical notions that are worth understanding

39:04

to optimize your decision making the same way

39:06

that Buffett and Munger have done for so

39:08

many decades. So the most

39:10

important mathematical concept is to think in

39:13

probabilities. Luckily, it's quite simple

39:15

to learn, and you probably have already used

39:17

it many times in your life to a

39:19

certain degree. But let's go over here to

39:21

make sure you understand how it applies specifically

39:23

to the world of investing. So in investing,

39:25

nothing is absolute. We

39:28

are always forced to think in probabilities, because

39:30

even the best company, while the possibility may

39:33

be small, can be put through the ringer.

39:35

If we factor that into our investing

39:38

analysis process, it will greatly help

39:40

in making sure that the risk we take with

39:42

an investment isn't too much. You can

39:44

see the language of probability written all

39:46

over statements by Buffett. He said, when

39:48

we are unsure about a situation, but

39:50

still want to express our opinion, we

39:52

often preface our remarks with things like,

39:54

the chances are, or probably, or it's

39:57

very likely. When we go

39:59

one step further and attempt to- quantify

40:01

those general expressions, then we are dealing

40:03

with probabilities. Probabilities are

40:05

the mathematical language of uncertainty. Okay,

40:08

so now that we understand why probability is

40:10

so important, how do we calculate it now

40:13

in a practical way? The answer

40:15

here is going to be Bayesian analysis. So

40:17

this analysis gives us a logical way

40:19

to consider a set of outcomes of

40:22

which all are possible but only one

40:24

will actually occur. Let's go over

40:26

a quick example here to help you understand it best.

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back to the show. So

43:24

let's imagine that you are looking at a

43:26

business that listeners of TIP will be familiar

43:28

with, which is Evolution AB. For this example,

43:31

we're going to use three different types of

43:33

scenarios that many of you probably will be

43:35

familiar with. So that's going to be a

43:37

bear case, a base case, and a bull

43:39

case. For the sake of simplicity, we're going

43:41

to just assign each of these scenarios a

43:43

33% probability of

43:45

occurring. You may or may not agree

43:48

with these numbers, but it's my show, so you're going to have

43:50

to bear with me here. So let's

43:52

briefly discuss what could happen to reach

43:54

each scenario. So in the bear case,

43:57

let's say Evolution loses some of its

43:59

competitive advantage. as other gaming

44:01

operators take their business to other

44:03

businesses. As a result, their

44:05

net income decreases as they lose customers

44:08

and current clients just become static. They

44:10

fail to start adding new ones. In

44:12

this case, due to decreased earnings, let's

44:14

say the share price goes down about

44:16

20%. In the base case,

44:18

the business continues doing what it has done

44:20

historically on a smaller growth projection. They continue

44:22

growing earnings by about 15% and are further

44:25

boosted by a 3% dividend yield and a 2%

44:28

buyback yield. This caused the share price

44:30

to improve 20%. In

44:32

the bull case, the business extends its competitive

44:34

advantage versus competitors. Let's say they lock up

44:36

even more regulated market share. They boost their

44:38

earning growth to 25% along

44:41

with a 3% dividend yield and a 2% buyback

44:43

yield. This scenario causes the share price to improve

44:45

by 40%. So now that we

44:47

know the probability of the event and what will

44:49

happen to the share price, we can bring this

44:51

back now to just a single number. So the

44:54

bear case has a 33% chance

44:56

to reduce the share price by 20%. The base case

44:58

has a 33% chance to increase

45:01

the share price by 20%. And

45:03

the bull case has a 33% chance to increase the

45:05

share price by 40%. Now

45:07

the share price as of August 29th is

45:09

around 1067 SEK. So what we do here

45:11

is we multiply 1067

45:14

by 80%, which is our bear case. Basically, we're reducing

45:16

the price by 20%. So that's 80%. In

45:24

the base case, we're going to multiply that by 120%. And in the

45:26

bull case, we're going to multiply

45:29

that by 140%. So the next

45:31

steps is we just multiply the value of each

45:33

scenario happening by the probability. So

45:35

we made 33% our probability of all three

45:37

of these scenarios, and then you sum up all

45:40

the numbers. From there, we get a price

45:42

of around 1200 SEK, which

45:44

is an 11% premium compared to

45:46

the current price. So Buffett thinks this

45:48

way, take the probability of loss and

45:51

the amount of possible loss from the probability

45:53

of gain times the amount of possible gain.

45:55

This is what we're trying to do. It's

45:57

imperfect. But that's what it's all about. change

46:00

the probabilities or the expected

46:02

outcome, the premium will go up or

46:04

down on the example that I just gave. Now

46:06

this means that thinking in

46:09

probabilities requires you to make adjustments

46:11

to your assumptions over time. There's

46:13

gonna be new events that occur

46:15

that maybe will decrease the chances of your

46:18

bear scenario or maybe they'll make your bull

46:20

scenario even more likely or maybe even more

46:22

bullish. Once you think about investing

46:24

in terms of these kinds of decision trees,

46:26

you really amp up the ability to make

46:28

great decisions and protect yourself from risk. Hegstrom

46:31

gives an excellent example of Warren Buffett and

46:33

Wells Fargo. The gist of it was that in

46:36

the bear situation, Wells Fargo would actually just

46:38

break even and the possibility that Buffett attributed

46:40

to that scenario was low at just 10%.

46:43

So this would give him a 90% probability of

46:45

his base and bull case happening. So

46:48

this means that the downside was that

46:50

he didn't lose anything and the upside

46:52

offered a return that was

46:54

acceptable to Warren Buffett and Berkshire

46:56

Hathaway. So this kind of just

46:59

really plays into Moniche Pravai's concept

47:01

of asymmetric bets

47:03

where you can't lose too much

47:06

money if you're wrong and you win a lot when

47:08

you're right. So the next section

47:10

that I wanna discuss is how to use this

47:12

Bayesian analysis in the markets. If

47:14

we run Bayesian analysis and see that the

47:16

market is not seeing what we are seeing

47:18

in terms of value, how do we determine

47:21

when to make a bet? Charlie Munger has

47:23

famously said that the stock market is like

47:25

a peri-mutual system that you see at a

47:27

racetrack. The odds of a bet change based

47:29

on what is bet, just like the odds

47:31

of an investment change based on the market's

47:33

mood. And in terms of the market's mood,

47:36

it's the same thing. If the market's really,

47:38

really euphoric, it means more people are gonna be buying, meaning

47:40

they're gonna be driving the price up and it's gonna get

47:42

more and more expensive. So let's go back to

47:44

the racetrack analogy here. So let's say a

47:46

favorite horse pays two to one at the racetrack while

47:48

the long shot might pay 100 to one. If

47:51

I asked you which one you take, you might

47:53

make a choice, but it really isn't enough information

47:55

to know which horse is the better bet. In

47:58

the market, we often see mispricing. a business, let's

48:00

say with a price of $1, but

48:03

let's say the same business has a value of $10. This

48:06

is going to be a very, very attractive bet versus

48:08

let's say the same business is now priced at $20

48:10

with a $10 value. So

48:13

when the odds are in your favor due to these large

48:15

mispricings is when you really want to pounce on

48:17

opportunities because these opportunities don't come around very

48:19

often. So I'd like to close this section

48:21

off with yet another great Charlie Munger quote,

48:23

discussing the importance of thinking in decision trees.

48:27

Without question, Buffett's success is tied closely

48:29

to numbers. One of the

48:31

advantages of a fellow like Buffett, whom

48:33

I worked with all these years, confesses

48:35

Charlie is that he automatically thinks in

48:37

terms of decision trees and the elementary

48:39

math of permutations and combinations. Speaking

48:42

of Charlie Munger, one of the greatest contributions

48:44

to the world and not just in the

48:46

lens of investing was his presentation on the

48:48

psychology of human misjudgment, which is broadly speaking

48:51

the next area that I want to cover

48:53

in today's episode. The

48:55

book covers two of Buffett's big

48:57

influences in investing and understanding the

49:00

psychology of markets. The first

49:02

person being Benjamin Graham and the second

49:04

person being Charlie Munger. So

49:06

Benjamin Graham had three important principles that

49:08

I think have really, really helped shape

49:11

how Buffett thinks about investor psychology. Let's

49:13

go over those. The first

49:15

one is to look at

49:17

stocks as businesses. This

49:20

means that once you purchase a stock, think

49:22

of yourself as a partner with

49:25

the business and its management team and not

49:27

just the owner of a stock certificate or

49:29

a bunch of blinking numbers on a screen

49:31

that you should just sell to another person

49:33

on a whim. I think this mental model

49:35

really helps you try to build

49:38

a fictional relationship with management, which

49:41

can help you maintain a lot

49:43

higher conviction. So second one

49:45

here is the margin of safety concept. Now

49:47

the margin of safety is a concept which

49:49

gives you a competitive edge in investing when

49:51

you can just buy things for less than

49:53

their worth. So this accomplishes two things. One,

49:56

it allows you to make more money when you

49:58

were right as the wider gap between price and

50:00

value that closes the more money that you're going

50:02

to make. And then secondly, it minimizes your downside

50:04

risk when you were wrong due to the already

50:07

cheap price that you were paying. I

50:09

was just chatting with the TIP mastermind

50:11

community today, actually, about this book a

50:13

little bit. And one of the interesting

50:15

points that came up was that value

50:17

investors often lag during bull markets and

50:20

outperform during bear markets. And I think

50:22

this is the exact reason is that

50:24

they have this margin of safety. So

50:26

during bear markets, there, if

50:28

the market as a whole goes down, a lot

50:31

of the reasoning for that decrease in

50:33

price will be that expensive stocks see

50:35

these huge reductions in price. But

50:37

for value investors, they have more businesses in

50:39

their portfolio that are already cheap. And so

50:42

they're the ones that are least likely to

50:44

go down in price during market sell-offs. So

50:46

the third one here is the investors mindset.

50:48

When you think about investing as a business

50:50

person, Buffett says that you're 99% ahead of

50:53

the rest of the market. And that's just

50:56

an enormous advantage. Thinking like a business person

50:58

means you put the same type of work,

51:00

analysis, energy, and mental effort into buying a

51:02

private business as you would a stock. Arguably,

51:05

Graham's biggest contribution to investing was

51:07

flipping traditional wisdom in regards to

51:10

price fluctuations. Instead of

51:12

being sad and depressed when the price of

51:14

a stock goes down, he taught us to

51:16

use this to our advantage when we could

51:18

identify even wider mispricings due to the depressed

51:21

mood of the market. The key here is

51:23

to not participate in the market's mood and

51:25

develop your own perception of what an individual

51:27

business is worth. When the market

51:29

has soured on an idea that you really, really like,

51:31

then you can pounce on it because the price is

51:34

going to come down. Now, the

51:36

next person to help shape Warren's view on

51:38

the psychology of the market is Charlie Munger,

51:40

of course. Munger has all sorts of incredibly

51:42

useful thinking tools. And one of his best

51:44

known tools is his two-track analysis. So to

51:47

use this framework, you really only need to

51:49

answer two questions. One, what are

51:51

the factors that really govern the interests

51:53

involved, rationally considered? And two, what are

51:56

the subconscious influences where the brain at

51:58

a subconscious level is always automatically doing

52:00

things which by and large are useful,

52:03

but which often

52:05

malfunction. Let's run this on

52:07

a business, Broadcom. First, let's look

52:09

at some of the rational factors of this business. So

52:12

the EPS has declined from 80 cents

52:14

to 50 cents just in the last

52:16

year. Its stock price is

52:19

up 76% in the last year, and

52:22

it recently had a 10 for 1 stock

52:24

split. So now let's look at some

52:26

of the psychological misjudgments that could be factored in here

52:29

that might be responsible for this event. So

52:32

the business recently mentioned AI 51 times

52:35

in a call, even though it's not a

52:37

pure play AI business. So if

52:39

we go back to something like the tech bubble and

52:41

we look at the halo effect of adding.com to

52:43

your name, you can

52:46

kind of see where I think this halo

52:48

effect might also be happening in today's markets

52:50

where mentioning AI gives you this positive

52:53

effect because it's associated

52:56

with AI play such as Nvidia. But

52:59

the fact is while this business can talk about AI for

53:01

until it's blue in the face, it doesn't mean it's an

53:03

AI company. It doesn't mean that it's going to be getting

53:05

the type of fundamental benefits

53:08

that other AI companies are going to be getting. So

53:11

the next psychological misjudgment that

53:13

could be at play here is social proof. So

53:16

investors love AI plays as it's

53:19

just new and exciting. So some

53:21

investors will actually feel left out

53:23

when they don't take part. Now

53:26

businesses can take part in the

53:28

potential upside of joining in one of these

53:30

rallies when investors all just want to

53:32

fit in with the herd. And

53:35

so that's why a business like Broadcom, even

53:37

though it's not a pure play AI business,

53:39

it might not even necessarily be that they're

53:41

trying to manipulate the market or anything. Management

53:44

for all we know could also just be very

53:46

enthusiastic about AI and they want to try to

53:48

figure out ways to use their product in an

53:50

AI arena. Please be of note. I don't really

53:52

know like anything about Broadcom. I'm just going over

53:54

some of the metrics that I found that were

53:57

based on facts and then just looking at some

53:59

of the psychological. So

54:01

the final one here is just loving

54:03

tenancy. So investors out there who might

54:06

already own businesses like Nvidia might now

54:08

be looking for similar businesses that offer

54:10

upside that they hope will approximate what

54:13

Nvidia did for them. So

54:15

since they already judge these types of

54:17

businesses as favorable, because obviously Nvidia has

54:19

had this massive stock price appreciation, this

54:22

can dampen the realistic fundamental situations of

54:24

adjacent businesses such as Broadcom. So

54:27

this analysis is highly valuable and worth

54:29

running constantly. I know I should probably

54:31

be doing this a lot more often.

54:33

I really think it helps you think

54:35

more rationally and better understand psychological misjudgments,

54:37

which are just rife in the investing

54:39

world. And then the other

54:41

important part about thinking about

54:43

these psychological misjudgments is obviously

54:45

we can attribute them to the investing world as

54:47

a whole and the market as a whole. But

54:49

I think probably even the more powerful use case

54:52

of it is in self-reflection where

54:54

you're looking at yourself and seeing where you

54:56

could possibly be making these mistakes, because I

54:58

can guarantee you, you are making them. We

55:00

all do at some point in time. And

55:03

I think the quicker that you can

55:05

identify these mistakes, the less risk you

55:07

expose yourself to and hopefully you'll lose

55:09

less money and be able to reallocate

55:12

that into better bets. So Robert Hagstrom

55:14

mentions for specific misjudgments that he thinks

55:16

are a big part of behavioral finance.

55:19

So the first one here is overconfidence.

55:21

So investors believe that they are more

55:23

intelligent than everyone else, even though base

55:25

rates would suggest otherwise. The second one

55:28

here is overreaction bias. Investors

55:30

tend to overreact to bad news and

55:32

underreact to good news. If short-term news

55:34

is poor, investors will overreact and punish

55:37

the share price. And often

55:39

good news might actually take years to show

55:41

while the stock market refuses to account for

55:43

it. The third one is loss aversion. Investors

55:46

feel the pain of loss twice as powerfully

55:48

as the joy of gain. This is why

55:50

many investors will hold on to their loser

55:52

stocks hoping to recoup their losses when cutting

55:54

the cord is often the most rational decision.

55:57

I've definitely been responsible for this mistake in

55:59

the past. And it definitely

56:01

cost me money having to wait around

56:03

for a stock to improve its fundamentals

56:05

when looking back, the writing was just

56:07

on the wall that it was very,

56:10

very unlikely to happen. The

56:12

fourth one is mental accounting. So this

56:15

refers to our habit of shifting

56:17

our perspective on money as surrounding

56:20

circumstances change. We tend to mentally

56:22

put money into different accounts and

56:24

that determines how we think about

56:26

using it. So this concept

56:29

of mental accounting is interesting and I

56:31

want to touch on a little bit

56:33

more here because it has some very

56:35

profound effects, I think in financial history.

56:37

So Edward Chancellor in his excellent, excellent

56:40

book, The Price of Time mentions that

56:42

easy money ends up leading to speculative

56:44

manias. Now, I think part of this

56:46

can actually be attributed to mental accounting.

56:49

When money is easier to come by,

56:51

it can be thought of as being found money, especially

56:53

in the low interest rates that we've lived in here

56:56

for the past few years. This changes

56:58

investors perception of money versus having to

57:00

work hard for it or not being

57:02

able to have access to it as

57:04

easily. As a result, people invest money

57:07

differently and often into perilous and speculative

57:09

investments that eventually blow up in their

57:11

face. So one thing that

57:13

you'll notice about these four biases is

57:15

that they require large amounts of self-awareness

57:17

if you hope to try and combat

57:19

them on your own. And

57:21

this is precisely what Warren Buffett does

57:23

while he's thinking. Hegson writes about Buffett,

57:25

he puts his faith in his own

57:28

research rather than in luck. His actions

57:30

derive from carefully thought out goals and

57:32

he is not swept off course by

57:34

short term events. He understands the true

57:36

elements of risk and accepts the consequences

57:39

with confidence. So when you are investing,

57:41

I think you should go into

57:43

it knowing that both you and the

57:45

market will be biased at times. The

57:48

key is that you can control your

57:50

own behavior and develop your own self-awareness.

57:53

The market unfortunately will continue making the

57:55

same errors over and over again. So

57:57

the game plan should be one.

57:59

One, have guidelines to help you avoid

58:02

making the most common mistakes and

58:04

two, recognize other people's mistakes in time

58:06

to profit from them. So

58:08

the simplest way to avoid common mistakes is

58:10

just to first understand them and then think

58:12

about if you could be making them. And

58:14

that doesn't necessarily only need to be in

58:16

the realm of investing that could be in

58:18

anything in life. But I think the more

58:20

you think about biases that you could be

58:22

making and mistakes that you're making, the more

58:25

of a habit you make it and the

58:27

easier that it becomes to identify these biases

58:29

in yourself and in others. Now,

58:31

in terms of assessing others mistakes, once

58:34

you realize how you personally could be

58:36

making the mistakes, it becomes a lot

58:38

easier to identify them in other people.

58:41

Think about specific businesses and what is

58:43

assumed in their current stock price. If

58:45

you know a business very well, you

58:47

may understand that the assumption the market

58:49

is making are just very short term

58:52

in nature or could theoretically be outright

58:54

wrong. And that is how you profit

58:56

from other people's mistakes in the stock market. The

58:59

final chapter I want to discuss is why investors

59:01

as a whole have had such a hard time

59:03

outperforming the market. So Hags from

59:05

here uses a very good metaphor to describe

59:07

this problem. During a 29 year

59:09

period in the early 1900s, there were nine

59:12

seasons when a baseball player hit over 400

59:14

in a season. But

59:16

after that period, only one player has

59:18

ever done it, who was Ted Williams.

59:21

So famed scientist and baseball fanatic Stephen

59:23

Jay Gould hypothesized that the reason for

59:25

this was that all baseball players simply

59:28

have improved at a very rapid rate.

59:30

And because everyone got better together, it

59:32

erased the ability for these outlier performances.

59:35

Peter Bernstein, who wrote one of the

59:37

best books on risk I've ever read, which

59:40

was Against the Gods, said that a lack

59:42

of above average performance by professional money managers

59:45

is a result of the ever

59:47

increasing level of investment management education

59:49

and knowledge. As more and

59:51

more people become more and more skilled

59:53

at investing, the odds of a breakout

59:56

performance by a few superstars just diminishes.

1:00:00

is very, very hard, admittedly, it's not

1:00:02

impossible. Bernstein mentions that one key to

1:00:04

becoming a 400 hitter is to

1:00:06

make concentrated bets as we've discussed throughout

1:00:09

this episode. Now, while the sample

1:00:11

size is small, the five investors that

1:00:13

were outlined in this book would

1:00:15

probably all be considered 400 hitters. And

1:00:18

the thing is, is that all five of these people used

1:00:21

a very similar investing strategy. Peter

1:00:23

Bernstein says here, to become a 400 hitter,

1:00:25

the portfolio manager must be willing to make

1:00:28

the kinds of concentrated bets that are essential

1:00:30

if the aim is to provide high excess

1:00:32

returns. So to sum this

1:00:34

book up, and to give you the best chance of

1:00:36

hitting 400, Robert gives eight

1:00:39

wonderful pieces of advice. One,

1:00:41

think of stocks as businesses. Two,

1:00:44

increase the size of your investments. Three,

1:00:46

reduce portfolio turnover. Four,

1:00:49

develop alternative performance benchmarks.

1:00:52

Five, learn to think in probabilities. Six,

1:00:55

recognize the psychology of

1:00:57

misjudgment. Seven, ignore market

1:00:59

forecasts. And eight, wait

1:01:01

for the fat pitch. Now,

1:01:03

while these maximums seem easy to hear

1:01:06

and understand, following them in reality is

1:01:08

not, which is why just so few

1:01:10

investors follow them. They can't for various

1:01:12

reasons, whether that's psychological because of regulatory

1:01:14

constraints or just because of plain dogmatic

1:01:16

thinking. But the best part about being

1:01:18

an individual investor is that you have

1:01:20

the ability to truly do what you

1:01:22

want with your own money and follow

1:01:24

as a rational system as you deem

1:01:27

possible. Good luck out there. That's

1:01:29

all I have for you today. If you want

1:01:31

to interact with me on Twitter, follow me at

1:01:33

irrational MRKTS or on LinkedIn under Kyle Grieve. If

1:01:35

you enjoy my episodes, please feel free to drop

1:01:37

me a line and let me know how I

1:01:40

can make your listening experience even better. Thanks

1:01:42

again for tuning in. Thank you

1:01:44

for listening to TIP. Make

1:01:46

sure to follow We Study Billionaires

1:01:49

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1:01:53

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1:01:56

or courses, go to theinvestorspodcast.com.

1:01:59

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1:02:01

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1:02:03

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1:02:05

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1:02:08

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