How not to invest
Sharing my thoughts on how not to invest in the stock market
Hello,
Reading time: About 13 minutes
“Invert always invert”- Charlie Munger
In his book, What I learned about Investing from Darwin, Pulak Prasad wrote a whole section on How not to invest. All of us are so busy focusing on how to invest, how to find the right companies, what we need to do, etc. That often times we forget to invert and ask ourselves what we should not do.
This inspired me to come with a sort of checklist of my own as to what we should not be doing when we invest. I will speak a little bit about what Pulak Prasad thinks we should not do as well.
The stock market is not an easy game to play is the first thing everyone should know. Let’s think from first principles. The simplest way to invest in the best businesses is to invest in the index fund (top 50,100,500 companies which are listed) . Now this method of investing requires you to do little work for great returns. But we humans always want more so we look at people like Buffett, Munger, Thorpe, Simons, Jhunjhunwala, etc. these people beat the index. We only look at the winners and we don’t see the great number of investors who cannot beat the benchmark index. So called ‘investment professionals’ the people you give your money to also underperform the index. More than half the fund managers cannot beat the index over the long term.
So the first question you should ask yourself is if these professionals who dedicate so much time and effort into researching stocks cannot beat the index what makes you think you can?
If you can answer this question and genuinely believe you can beat the index here are a few things history shows we should not be doing as investors.
Don’t be a stock owner be a business owner
"People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business. That is what Graham - the most fundamental part of what he taught me. You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn't pay a totally silly price. That is what it is all about." Warren Buffett
“De-emphasize individual quarters, recent stock performance, earnings estimates, macro forecasts, and the like. As much as possible, try to think like a private owner of a business. Think of the stock you own as you would think of real estate; it’s something you plan to own for a long time and sell reluctantly.” Chris Mayer
The first thing every investor should know is that the stock market is a means for an investor to invest in big businesses. We often forget that we are investing in a business and think we are investing in a stock and we are betting for the price to go up or down. The stock market is a very complex system if you try and predict the stock price you will not be able to get great returns. At least that’s what history and base rates tells me. Zerodha one of the biggest brokers in India released a statistic saying people who trade don’t make money and even those who do make money don’t beat the index. Very few traders are actually making money and beating the index. Getting this mindset of owning a business is vital in my opinion. This helps you become a permanent owner and enjoy the growth that a business can get for you.
Don’t forecast
"We've long felt that the only value of stock forecasters is to make fortune tellers look good." Warren Buffett
“Forecasts aren’t worth very much, and most people who make them don’t make money in markets.” Ray Dalio
The stock market is a very complex place. To predict or forecast what is going to happen is very hard. There are a lot of variables at play. The future is unpredictable. We as humans want some sort of certainty that we are accurate down to the last number because we want to be perfect and exact. In this attempt of accurate forecasting people produce numbers from Excel sheets that a baby can also play with. When they come up with exact numbers they get a sense that they are right. In fact even the people who see these forecasts; tend to believe the people who give exact numbers rather than approximate figures. It is crazy to believe these exact numbers and estimates are going to be right. Even the companies which forecast their earnings are almost always wrong and the ones which are always right are likely to be fudging their numbers. To predict/forecast the future to exact numbers is stupid. But the analysts think they are smarter than everyone else with these excel sheets.
It’s like buffet says you would rather be approximately right than to be precisely wrong.
A funny thing my dad says is “ Economy runs in cycles but analysts forecast run in straight lines”
Don’t let emotions drive your decisions
“The investor cannot enter the arena of the stock market with any real hope of success unless he is armed with mental weapons that distinguish him in kind—not in a fancied superior degree—from the trading public.” Benjamin Graham, The Intelligent Investor 1949
“Emotions are the enemy of rational decision-making.” Todd Combs
It’s important to stay rational when we invest in businesses. We should not get carried away by our emotions and we should not make decisions based on them. Humans are emotional creatures. There is nothing bad about it. Except when you are in markets. When you invest in the stock market especially in this day and age we tend to get carried away by our emotions without noticing. There is so much noise that is there that we cannot help but let our emotions take control. There is so much news coverage, quarterly reports, etc. that we are fed with information that will eventually make us react. On top of that we can check the stock price of companies every second. And it’s addicting.
As an investor there are a lot of emotions such as social proof, FOMO, contrarianism, etc. that play a huge role. This is why we need mental models to help us avoid these emotions when we are investing. We need to be right based on facts. We have to see whether the company is good or bad based on facts not emotions. We have to figure out when everyone is being stupid but make sure that we are also not stupid. We have to be critical of ourselves at all times because we have a lot of biases. The truth is though none of us can escape these biases. We can be aware of it and minimise it at best.
On top of all of this there is something even more important and basic. Sometimes when we have to make an important decision our mood is either anger, sad, etc. we need to make sure that we do not make decisions when we are angry, sad, etc. These emotions cloud our judgement and we end up making the wrong decision which we end up regretting later.
As someone who has just started out I can vouch for some of my mistakes here. I see the stock prices everyday. I try my best not to but I still see it at least once day. Even when there is some news that pops on my feed for the company that I am invested in I look into it and I definitely give it value to my opinion. I don’t know if the news is noise but most of it is. Luckily none of these biases have made me buy or sell. It has just changed my opinion.
Don’t try to time the market
It's in the nature of stock markets to go way down from time to time. There's no system to avoid bad markets. You can't do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go.~ Munger
“The lesson learned here is that we are never able to buy at the low. Almost every stock I’ve ever had in the portfolio has always declined after we buy it, and thankfully most usually don’t go down to this extreme, but I think it is pretty normal to have it go down and I almost expect it now.” Mohnish Pabrai
What is the job of investors?
Figuring out if a business has value and you hope that you buy the business at a price which is a discount to the value of the business. So we basically have to buy a great business at a price that we are comfortable with. Then we can sit back and relax like permanent owners and enjoy the growth of the business.
What most people try and do is different though. They think they can try and buy the business at the lowest possible price and they try to time their entry during bad times. It is stupid to be doing this and expecting the stock price to keep going up after this. What we should aim to do is to buy when the price is going down but the business is strong. When we do buy though we should acknowledge that the price can go up or down. We have to be comfortable with price movement.
Many investors also tend to sell their businesses when they think the price is high and the company that they own is not the value that the market is giving it. In this case it is a personal decision but there is no way to know when the stock price is going to be at its lowest or highest. But if you try timing the market and selling at the highest that you think and buying at the lowest that you think you are most likely going to lose the game. History has proven that once you enter a business at a good valuation considering the business is good you are better off holding then trying to sell at the highest and buy again at a lower price.
The buy and hold strategy works better. All you have to worry about timing is the entry point. (that also sometimes does not matter)
Don’t buy just because you have to buy
“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” ~ Munger
“Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” ~ Buffett
Let’s face it currently the market that we are in the opportunities to buy are not that many. Now everyone knows this. Yet they keep buying new businesses just because they feel that they will miss out on the great returns of this bull run. Now this is true you will miss out on some returns. But think of it as opportunity cost. When you buy all these businesses which are mediocre but performing well due to the nature of the market you are going to end up missing the great opportunity you will have during a bear market where great businesses are offered at great prices making it a no brainer. Remember I am not saying you should time the market. I am saying we should have the patience to wait till companies are at a stage where we buy at an attractive price.
Munger and Buffett speak extensively about CEO’s and top management acquiring companies and those decisions ending up being bad. Why does this happen?
Well it’s because these managers feel like they are stupid or not doing something, for them the more action they perform the more successful they will be.
All in all it is simple we have a do something bias and if you are an investor who is investing in businesses you are bound to be wanting to buy and sell as you keep track of more things, look at more and more companies, etc.
Pulak Prasad also emulates this model of patience and buying when times are bad in his fund Nalanda. He sits on the money and only deploys it when he believes there are great companies available for a discount.
What does he do when there is a long sustaining bull run?
Well he researches companies he likes and waits for them to be available at discounts. He keeps a shortlist of great companies. Sometimes these companies will never ever reach a valuation which he is comfortable buying at and he is fine with that.
What Pulak wrote in his book:
In his book he wrote;
Biology taught him that living beings prioritise survival over anything. He writes saying that living beings over time have chosen to commit errors of omission over errors of commission to survive.
He correlates this in investing. Warren Buffett has a famous quote,
"The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule. And that's all the rules there are."
The aim is to never lose money. The best way to do this in investing is to stay a little too cautious and have a very high standard of companies that you are investing in. You have to eliminate every single risk. To do this you would have to be permanent owners in high quality companies.
At Nalanda their aim is to minimise risk before maximising returns.
To minimise risk they are willing to lose out on many companies which get great returns. But because this is their philosophy they have no problem in letting go of these companies. Most investors cannot do this. They always make exceptions.
He avoids businesses run by crooks, turnarounds, serial acquirers, fast changing industries, businesses which have owners who don’t have the same goals as you, etc.
As Buffett says,
“Really successful people say no to almost everything”
In my opinion this is a sound process. Because I believe having such high standards for a company reduces the amount of errors of commission which means that you are not going to lose sleep over your investments. You can invest in high quality businesses and let them compound without having to worry about them not being around in the future.
To summarise, I thought ChatGPT would do a better job so I asked it to summarise the post:
Investing Approach:
Prioritize investing in businesses, not just stocks, focusing on long-term ownership.
Maintain high standards for selecting companies, aiming to minimize risk before maximizing returns.
Focus on the intrinsic value of a business, buying at a price that offers a margin of safety.
Patience is crucial; avoid buying mediocre opportunities due to a bias for action.
Market Dynamics and Decision Making:
The majority of investors, including professionals, fail to beat the index; thus, careful consideration is needed for those aiming to do so.
Avoid trying to time the market; acknowledging that price can fluctuate after purchase is essential.
Avoid making decisions based on emotions; staying rational and relying on facts is crucial for success.
Forecasting exact future market movements is unproductive; it's better to be approximately right than precisely wrong.
Investing Discipline:
Pulak Prasad:
Advocates for a cautious approach, prioritizing survival and minimizing errors.
Proposes a focus on high-quality companies, avoiding businesses with various red flags like being in fast-changing industries or having dishonest management.
Principle of Inaction:
Waiting for great companies to be available at a discount is preferable to buying for the sake of buying.
Conducting continuous research and maintaining a shortlist of desirable companies is beneficial.
Cautions and Pitfalls:
Avoid succumbing to FOMO (Fear Of Missing Out) during bull runs, instead wait for true value.
Refrain from excessive action; over-trading and over-analysis can lead to inferior decisions.
Shun the allure of exact predictions and speculative forecasts, focusing instead on approximate rightness.
That’s it!
If you finished reading the post and liked it please consider sharing the post, liking it or commenting on it giving any feedback!