Markets will stay in irrational longer than you can stay liquid” (John Maynard Keynes)

As Benjamin Graham in “The Intelligent Investor” said, “Mr. Market is an irrational unpredictable schizophrenic”. Opportunities arise, but unevenly and unpredictably. Patience and a long-term perspective are powerful weapons. One does not need to do anything most of the time. When to sell is more important than what to buy.

One of the biggest mistakes investors make is thinking that their purchase decision is the most important decision they will make. This is misguided because most losses are lost opportunities. They may be buying decisions that were never made, but most likely, they are selling decisions where the decision to sell was made too soon. When Warren Buffett owned 5% of Disney in the 1960s, he made a 50% return. He happily sold the stock. But investment decisions should not be made based on historical returns. Once again, all investments are predictions for the future. Regardless of whether the investment you currently hold has generated a great return or lost you money, what will it do from this point on? In the case of Disney, the sale of the stock meant a forgone opportunity to make more than 30 times on that investment. There are many other examples when selling, even after an attractive return, was a catastrophic mistake. Buying Amazon at $6.00 a share in 2001 was a great investment so, would it have been a good decision to sell it at $12 per share? $100 per share? $1,500 per share? Or now $3,000 per share? Selling it at any point is a far more important choice than what you have bought with the proceeds. Investors tend to ignore, and then tend to get wrong, the selling decision. Not enough understanding has gone into recognizing that any purchase today is within an unpredictable and sometimes irrational market, but, in the long term, it is the future value that you are acquiring and not current circumstances.

Mr. Market is irrational. Human behavior dominates market movements and valuations. Several components of human behavior have become clear influences. First, losses are valued much more than gains. Markets will move quickly downward at the slightest hint of bad news. It is impatient and short-term in its perspective. It wants immediate gratification and will overvalue bad news and, potentially, undervalue good news. This behavior creates opportunities. Over valuations and under valuations emerge. One must deal with the market one has, not the one we hope for. Patient with the right perspective, knowing that you are dealing in an irrational environment, but true value will emerge. Timing is unpredictable but irrational actions in response to that unpredictability will negatively impact investment decisions.

Price is what you pay, value is what you get.

There is a hierarchy for any investment. It is not simply picking a good security, company, or story. It is about more than momentum, publicity, or technological innovation.

First, pick an attractive security to own. It may be an outstanding company (or credit opportunity, etc.) where you believe you have superior growth and an attractive risk-adjusted reward. Examples include companies that meet specific investment criteria. Perhaps it’s growth and momentum where Amazon, Apple, Netflix, among others are good examples. There seems to be a sustainable competitive advantage in the high growth opportunity. Another example could be a stable business, such as energy or real estate, where there is a long history of predictable dividends and an attractive return on a cash investment. Others may represent speculation, which is fine so long as you understand the relative risks compared to the upside. Finally, may seek to avoid risk and own something like U.S. Treasury bonds where, regardless of the interest rate, it will pay its coupon and principal payments, no matter what. However, this is only the first step – determining good security to own.

Next, determine at what value is this investment attractive. In other words, what price should you pay? As discussed, value ultimately is the present value of future cash flows. So, what is driving this value and how is that changing. Is the price today a good reflection of what you determine the true value to be? It may be a great company, but is it overpriced? There are macro considerations – overall economic conditions, growth, inflation, budget deficits, trade constraints that will impact any companies’ value. There are also micro considerations – market sector growth, competition, new entrants, other competitive dynamics such as substitute products and industry structure (an example would be bricks and mortar retelling versus online retailing and its impact on future value). In other words, measure what matters and see if the price you pay is worth the value you receive.

Finally, how much should you own? No decision is made in a vacuum. Perhaps the most important thing to consider is how you compose a portfolio. How much should you diversify your risk, protect against a business and economic cycle, and protect against random events and unpredictable black swans? After all, the unpredictable dramatic economic events seem to be occurring every 7 to 10 years. A portfolio that does not consider its fragility to unpredictable and random and sudden catastrophic events is likely to end badly. After all, an annual 30% return for 5 years is great unless it all goes to zero in the sixth year. Create a portfolio that cannot only thrive under great economic conditions but also withstand random events.

Reversion to the Mean

Everything reverts to the mean. An investor’s job is to determine where a company is relative to the mean and how much longer it will either be above or below. Many companies can stay above the mean for a long time, generating extraordinary returns. But these do not last forever.

Sustainable competitive advantage is real, but not permanent. Positive changes happen but not as often as a reversion to the average. It seems, ultimately, everything goes back to its average. It may take years above-market returns during this entire run, but no security escapes its average. Economies cycle up and down, we have recessions and above-average growth, but, over the long-term, we referred to average economic growth. Markets have bull and bear cycles, but an extreme bear market leads to an extreme bull market, and we revert to an average once again. Nothing grows 15% annually forever, as the example of IBM shows. One can be a market leader for many years and generate extraordinary returns, but this also ultimately ends. Will this be the same fate for the current market leaders such as Apple and Amazon? High valuations, market dominance, inordinate growth, are not sustainable. When these trends stop is uncertain. The fact that they will is.

Buying or selling is a crucial investment decision because you are always either buying or selling. There is no such thing as “holding.” If you own something you have bought it. If you would not buy it today but continue to own it simply because you bought it in the past, and not making an investment decision, just simply being inactive. If you are an investor who is buying or selling. Selling decisions tend to be inefficient. One does not need to be active, but one does need to think like an owner. If you own a great company, there is little reason to do anything else other than stay on top of developments within that company and industry to make sure they can remain a great company. Eventually, they will revert to the mean. More than anything, that is an investor’s job – figure out when the company will revert to the mean. That means they will either be losses or tremendous gains in the future as this trend occurs.

Nothing stays above average.

 

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