3 principles for investing
1. Original insight
I believe the efficient market hypothesis is roughly correct: stock prices tend to reflect all available information, and new information is quickly incorporated into the price.
But information is not evenly distributed. The key is knowing that something is true before it becomes generally acknowledged. If a fact is obvious, it’s also unprofitable.
You can’t just do the opposite of everyone else, as the market is often correct. Instead, you must develop an alternative view of the world and identify opportunities where the majority is wrong. In other words, you need to have original insights.
Following this logic, the pool of potential investments must be small. It takes immense effort and time to develop original insights in just one area, let alone a few.
Put simply, don’t invest in things you don’t understand.
Twitter and TV are full of experts making predictions about the future. None of them correctly predicted the last 10 years.
I believe it’s generally impossible to develop original insights related to timing. There are too many unknowns and unknown unknowns.
Yes, we know that the market moves in cycles driven by excess fear and greed. But that’s of little help when the frequency keeps changing. History rhymes, but doesn’t repeat.
Luckily, making good investment decisions doesn’t require you to know anything about future stock price movements. It only requires understanding where we are today, and whether you’re likely to pay too much or too little for a stock.
When times are good and money is cheap, confirmation bias and FOMO drive up stock prices. When greed turns to fear, the opposite cycle is repeated.
Ignore the forecasters. Focus on that which is actually knowable. If the general sentiment is optimistic and reckless, be cautious. If it’s all doom and gloom, be bold.
Sizing gets little attention from retail investors. But I believe that knowing how much to invest is just as important as knowing what to invest in.
George Soros spent little time fretting over the details of a trade. Instead, he obsessed over the size of the trade. In the words of protege and fellow billionaire Stanley Druckenmiller: “when you’re right on something, you can’t own enough.”
It’s in our nature to be risk-averse and to think linearly. We lack an intuitive understanding of power-law distributions and exponential growth.
It takes mental fortitude, intellectual honesty, and the confidence derived from original insight, to make big enough bets.
If you take the whole history of Berkshire Hathaway, if you take out the twenty best transactions, our record is a joke . . . Life is not just bathing you in unlimited opportunities even if you work at being able to find them and seize them.” — Charlie Munger
Warren and Apple
I think all three principles are well illustrated by Warren Buffett’s investment in Apple.
Warren (in)famously never invested in Microsoft, despite being close friends with Bill Gates. He didn’t understand technology.
Warren only invested in Apple when he realized that its value is a function of its strength as a consumer brand (something he understands well), rather than innovations in technology.
He stayed within his circle of competence.
He waited until he had an original insight.
He didn’t try to time the market. He started buying the moment he recognized that the stock is undervalued.
And he bought a lot.
As of writing, that single investment has netted Berkshire Hathway over $100 billion.