All investors would like to be successful in their ventures. But sometimes, looking at unsuccessful ones may bring as well very good investing lessons. In this article, I will take two principles taken from Charlie Munger and another one coming from behavioral finance, to show how disaster happens – and how we can get better at investing.
First Principle : Invert, always invert
As promised, the first principle comes from Charlie Munger (and before him, Carl Jacobi), one of the investors who had the most influence on me. He advises that whenever you are stuck in a problem, try to invert it.
The inversion principle states that instead of trying to find a solution to a situation, we should instead focus on finding out all the ways in which we would fail to solve the problem, and then focus on not doing it.
It is best summed-up by two of his famous quotes:
All I want to know is where I’m going to die, so I’ll never go there.
It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.
The rationale here is that if we focus on limiting our downside, then the upside should take care of itself.
This is very relevant to the investing world. An investor may have a lot of qualities, but if he makes stupid mistakes his overall performance is going to be subpar. We don’t want a wonderful track record destroyed by a -80% mistake.
Well, today’s article is going to be about being successful by not being stupid. But how can we know what is stupid and what is not? There comes our second principle…
Second Principle : Vicarious Experience
This principle comes as well from Munger. Behind its fancy name it just says that we should learn from the experience of others, alive or not (whom he calls “The eminent dead”).
It is often used in the good sense in order to know from others what has worked in their lives (ex : Newton used to say “If I have seen further it is only by standing on the shoulders of giants.“).
However, the inversion principles states that we could learn as much, and even more, by looking at errors from others, as elegantly formulated by Munger:
You don’t have to pee on an electric fence to learn not to do it.
The image is clear enough, let’s learn others’ big mistakes and let’s not do them! But if we start digging, we will find out that a very big number of mistakes, especially in investing, come from one cognitive bias. Hence our third concept, borrowed from behavioral finance.
He who forgets base rates
So let’s introduce the third and last concept before moving on to the markets: the human brain’s insensibility to base rates.
To better explain it, let’s look at the two following examples:
1) In a university, you meet a guy named Tom. You notice that Tom is shy, he has a poor posture and is not making eye-contacts very often. If you had to guess, would you say that Tom is more likely to be in a Math PhD program, or in a business school? (Suppose that it can be only one or the other.)
2) You have a leaking sink in your kitchen, so you call a plumber. He soon arrives at your place, but you notice something strange : while he is inside your home, he stares at every room of your apartment. Would you be right if you fear the plumber is actually a burglar and he may come back and steal from your apartment?
If you answered that Tom is a math student or that the plumber is going to rob you, your brain fell victim of neglecting the base rates: it forgot to think bout initial distributions!
In Tom’s case, we are all prompt to have stereotypes about math students, so we tend to think that very shy student with poor posture are more likely to be in a math program. But we forget to think about the general case: how many students are there in a maths Phd, and how many students are there in a business school?
It turns out that in a population of 100 students, roughly 10 are in a Maths PhD and 90 are in a business school. Now even if 50% of maths students are shy and only 15% of business students are shy, that makes:
- 50% * 10 = 5 shy students in a math PhD
- 15% * 90 = 13.5 shy students in a business school
This means that shy students doing a mathematics PhD represent only 5/(13.5+5) = 27% of all shy students… Tom is therefore much more likely to be in a business school!
The above schema illustrates it better, for those who prefer a visual explanation: The fact that there are so much more business students (the blue/green area) compared to maths students results in having many more shy business students (blue area) than shy maths students (orange area).
In the case of the plumber, this is the same thing: we focus on the peculiar (the plumber is staring at your rooms) without looking at the initial repartition („if i did not know that the plumber is staring, how likely is it that he is honest?“). The initial repartition is called the base rate, and let’s see how it affects the results:
- In general, burglar plumbers are quite rare. Let’s say that 1% of all plumbers are burglars (that would be already high). So for 99 honest plumbers, we will have 1 burglar plumber.
- Burglars won’t always be so indiscrete by staring everywhere in your apartment, so let’s say that only 50% of all burglar plumbers are staring in your apartment. That makes 0.5 indiscrete burglar in a population of 100 plumbers.
- On the other hand, honest plumbers can be indiscrete, even if it is rare: let’s call them the curious plumbers; they may represent only 10% of all honest plumbers. Among the 99 honest plumbers, that makes 9.9 staring (and honest) plumbers.
- That makes a total of 9.9+0.5= 10.4 staring plumbers. Among them, only 0.5 is a burglar. This means that only 0.5/10.4 = 4.8% of the staring plumber population may rob you. This shouldn’t cause you to lose your sleep at night!
Another example: you may know a smoker who, when criticized about his smoking habit, answers:
„But I know someone who smoked everyday and lived up to 95 years!“
Clearly his mind does not want to think about the base rate of smokers’ life expectancy.
What happened in all cases? Our brain tend to focus on the peculiar, the shiny details, without remembering the general tendency. And we are very, very bad at evaluating base rates. We like the story more than the general case.
That’s why we should ask ourselves much more often:
“What usually happens in this kind of situation?”
Fortunately, there is a general formula called „Bayes’ Rule“ to manage these situations. Although I won’t dig into much more details here, you can find a lot of additional brilliant explanations about Bayes’ Rule on Arbital’s website.
But enough theory. Let’s move on to investing! We now know that:
- We want to avoid stupid mistakes
- It’s good to learn stupid mistakes from others
- A lot of errors come form the negligence of the base rate
How do we apply this to investing?
Base rates in the investing world
Let’s see what happens when investors forget to think about base rates and focus on the shiny details instead…
This is the quintessential example. A company is going public and everybody thinks it is a great business! The news of the initial public offering is well publicized and damn, all analysts concur to say that this is a great occasion, you’d better hurry to buy the stock! This is a big opportunity to participate in the company’s success and become rich!
And so retail investors buy the stock.
But is it really a good opportunity? What happens when, instead of focusing on the sexy story, we take some distance and think:
“What usually happens in this kind of situation?”
What happens after most IPOs? The answer is quite clear: people lose money.
For instance, Facebook, even if it is a good business, lost -40% in 4 months after its IPO, and it took along time for the stock to reagin it. Snapchat is even a better example: the IPO was in march 2017, and during the first day of trading it went as high as 29.44 USD per share. Now it is only at 7.18 USD per share…
Why is that?
IPOs are structurally conceived so it is very hard for the investor to make money on his investment:
1. Investment banks, who usually help the company to organize the offering and to structure the deal, will usually get a yummy 6-7% commission on the proceeds of the offering. This creates a big misalignment of incentives between the investor and the investment bankers. The higher the price of the offering, the higher the commission for the banks. That makes one reason why investors tend to overpay for the company.
2. Contrary to other companies already quoted on the stock market, a firm going public can choose when it will do the IPO, and especially take advantage of the general mood of the market. You don’t see a lot of IPOs in a bear market when most investors are pessimistic; but you see a ton of IPOs when the market is bullish. At this moment investors tend to be much more optimistic and will overpay for being part of the company. And of course, insiders of the company want to sell their shares at the very best moment for them, not for the outsiders…
3. Add to this the scarcity bias where the IPO is advertised as a one time opportunity to become rich, and for all these reasons people jump in the wagon and pay a very big premium to the intrinsic value of the company.
Therefore, the statistics of IPOs are not really enthusiastic…
(source: Jay Ritter, University of Florida)
Buying the new world-changing technology
At the beginning of the 20th century, a new technology surfaced and changed the world: the automobile. Seeing the capacity of this new technology, investors rushed into this opportunity and invested massively in the automobile business.
One hundred years later, we can objectively say that the car was a wonderful invention and that it provided a lot of value to the world. But did it provide returns to the investors?
There is a funny Wikipedia page named “List of defunct automobile manufacturers of the United States”
What do we see? More than 1750 automobile companies were started at the beginning of the 20th century. Unfortunately, 80% of them were already bankrupt by 1930. In other words, the automotive industry proved to be a terrible trap for investors. The automobile changed the world, but investors lost their shirts.
Several decades later, another technology transformed deeply the face of the world : airlines and aviation. Thanks to airline companies you were now able to quickly move to any place in the world! This for sure was an industry were investors would make a lot of money…
But did they ask „What usually happens in a similar situation“? Not at all! Instead they provided massive amounts of capital to the airline industry. Did they get rewarded? According to statistics, the cumulative earnings of the airline industry over its entire history is negative. Yes, it lost more money that the total of capital investors provided! Airlines changed the world, but investors lost their shirts.
Then in the mid nineties, the whole world discovered a new technology called the Internet that would for sure change the world forever. I think we can agree 30 years later that Internet has indeed had massive impacts on our lives. And investors could see this!
Did they ask „What usually happens in a similar situation?“
Looking at the curve of the Nasdaq at the time, I doubt they did:
They surely wanted to buy because „it went up a lot recently“. This is never a good reason to buy a stock and they would have known it had they applied lessons from history…
And then we are now, 20 years later. Last year investors rushed into a new technology that would shake the world for sure. Its name is the blockchain…
Did investors asked „What usually happens in a similar situation?“ Shhh, this story is not finished yet…
What is the common point here? All these technologies had a tremendous potential to change the world, and for most of them, they did.But I hope you’ll understand by now that changing the world and making you rich are two very different topics.
Buying regardless of price
Another frequent pitfall for investors is to invest in very good businesses regardless of price. The rationale behind it is that since it is a very good business, it will compound over time and the buying price will have little effect on the overall result.
Well, the investors thinking this way in January 2018 and buying Facebook at 16 times revenues learned a valuable lesson. And it’s really not based on on the benefit of hindsight: I was already warning at that time that Facebook was a very risky stock at this price.
But first thing first, let’s look at Facebook, the business.
There is no mystery that Facebook is a very effective business, drowning in cash. In 2017 it had net margins of 38% and an asset turnover of quasi 100%! A truly astounding business indeed!
But is it worth having at any price, especially at the very high valuations of 2018? A lot of investors thought so. They rationalized that FB has very high margins and such a valuation is not out of touch. Did they think one second „What usually happens in this kind of situation?“
Not at all, because they could have looked at the example of Sun Microsystems during the Dotcom bubble. At the peak of its valuation, Sun was priced at 10 times revenues (P/S ration = 10).
Let’s do some maths:
- The stock market has historically returned an average of 7% per year. Over a 10 year period it compounds to 100%: that’s why investors expect on average to double their money every ten years.
- In the case of Sun, if the investors buy at 10 times revenues and expect to get 100% return over 10 years, then each year Sun Microsystems has to return all its revenues to its investors. Is it realistic?
Let’s see what’s the CEO was saying:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
Of course, this is simplified because this speech was implying no growth in revenues. But anyway, this gives you an idea of the extreme growth expectation in revenues that investors had at the time. And all of this for a meager 7% returns annualized!
Now let’s go back to Facebook. Facebook, although a wonderful business, was not quoting at 10 times revenues, but 16! This was even more extreme. At such a high valuation, whoever bought the stock in 2018 had very little upside and a very big downside… So much that when the company published its second quarter earnings in July (which were, by the way, excellent), investors realized that their growth expectations were in no way reachable. And pffffffffff, the stock lost 20% of its valuation in one day…
When investing, it is always good to keep in mind the following words by Howard Marks:
– There is no such thing as a good idea without reference to price
– High quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.
Our final chapter in avoiding stupidity is about financial leverage. Whether it is located on the balance sheet of a company or directly on the account of the investor, my advice is the same: avoid at all costs excessive leverage. Don’t borrow money to buy stocks. Do not invest in overly leveraged companies.
Why? Of course leverage can magnify gains in a significant way. Investors also like to think that if a manager has a high leverage, it will increase his focus because he has less leeway to operate, and a focused manager is always a good thing to reach his objective. But that would be assuming that in the long term, the manager (or the investor as well) will always have things in control, and that they can act on 100% of events. This is of course impossible and, sooner or later, something unexpected happens.
Having a high amount of leverage is like driving a car with a dagger on the steering wheel pointing at your heart. If you do that, you will be a better driver. There will be fewer accidents, but when they happen, they will be fatal. Warren Buffett
And this happens to the brightest minds as well! What happens when you put together 2 nobel prize recipients, a team of superstar bankers and a lot of leverage? The LTCM catastrophe:
For your serenity, have a simple rule about debt. Just don’t use it.
That will conclude our discussion about how not to be successful in the stock market! As you see, it is mainly based on the principle to avoid stupid mistakes and stating that if you limit your downside, the upside will take care of itself.
As a general rule, when you see something peculiar, shiny, sexy or strange in a business, you now know that you should always ask „What happened in the past in similar situations?“ so you can see if you’re falling victim of a trap laid out by your own brain….