# 21 Lessons in Investing



## RickyY (1 April 2020)

A few things I learned over the past year.

*1. Process first, analysis second, margin of safety last*
A robust process can prevent a poor analysis but a good analysis can still create silly mistakes. Let’s say a stock is an excellent buy for 10 reasons. That’s a good analysis; your judgment comes from facts and reasoning rather than false hope. But what’s even better is a robust process. A good process might tell you “Why is that my analysis only consists of supporting evidence? Am I having confirmation bias?” It could also tell you “An excellent buy only need 2-3 reasons max. If I need 10 reasons to convince myself this is a great deal, this could be a warning sign rather than a sign of confidence.” A good process catches things that fall outside of our analysis. And that often determines the long-term investment outcomes more than the brilliance of our analysis. 

*2. Don’t cross a river that’s average 4 feet deep*
A river that has an average depth of 4 ft. says nothing about how risky (or how safe) it is to cross it. The river could have a 2 ft. depth on most sections but a 50 ft. trench in the middle. Yes, the average is 4 ft, and no one would survive crossing it.

This can be translated into investing: Investing is non-ergodic. Average has little meaning in the stock market. If an investment has a 99% chance of making 100x of the original capital and 1% of total ruin, the average outcome is positive, but it is the same as crossing that 4 ft. deep river. Do it long enough, your chance of going bankrupt is 100%. Like playing Russian roulette. What matters in investing is surviving long enough to get out alive. Understand what’s the maximum risk, not the average. A maxim from Nassim Taleb: Better to take risks you can measure than measuring the risk you’re taking.

*3. Guard your small mistakes*
Toyota dismissed a sharp increase in brake complaints between 2000 to 2010 before the brake scandal leads to 5 deaths. The Soviets covered up several radioactive contamination incidents to preserve their international reputation before the Chernobyl nuclear disaster in 1986. In that same year, the Challenger space shuttle exploded 73 seconds after takeoff because of O-rings failure. NASA engineers didn’t take any preventive action against previous O-rings failures because they didn’t turn out disastrous. 

Big losses are the shadows of small mistakes. When you encounter near-missed situations that could have been a lot worse, pay attention. Those are telltale signs that there are holes in your investment process. Preventing small mistakes from snowballing into big losses is not as sexy as picking the next winning stock, but that’s the point: don’t lose money.

*4. Beware of classification*
Classifying companies and compare them to others within the same industry helps you understand the business model, competitive advantage and so on. But be careful not to bring classification into the valuation. We tend to judge how cheap or expensive a stock is by comparing it with its peers. If a stock is selling at 20x while all its peers are trading at an average of 10x, the stock must be overpriced, so our reasoning goes. But valuation has nothing to do with what price others are selling at. The value of a business comes from all the future cash flow it can generate. If your future free cash flow forecast tells you a stock selling at 20x is undervalued, then it is so regardless of the multiples of other companies.

*5. Be overprepared*
The worst thing that can happen in investing is not knowing what to do when things go wrong. As Jim Paul explains, you want to be prepared so “you know ahead of time what alternative courses of action you will take if event A, B, or C happens.” What happened when you don’t know what to do? You make the situation worse by making stupid decisions. As Chris Hadfield wrote, “Having safety procedures down cold would definitely help me avoid making dumb mistakes that actually increased the risks”. Many things in the market are outside our control. Therefore, the only way to deal with them as they come is through self-control, or what Bill Walsh described “reduce the randomness of my responses”. So, how do you practice self-control? Be overprepared. 

*6. Strong opinions, weakly held*
We all know the maxim “When the facts change, change your mind.” There is a fine line between knowing when your experience helps you and when it betrays you. In other words, avoid confirmation bias. How do you do that? You need open-mindedness. How do you stay open-minded? By destroying your ideas. Trying to destroy your ideas forces you to see the boundaries, know what you don’t know, and be ever ready to abandon your plan when it becomes irrelevant. You’ll be more open to opposing opinions when you think through all the unknown risks. Always ask “What do I need to see to change my mind?”

*7. Keep your identity small*
Investing is about making good decisions. But we often use it as a vessel to convey intelligence, status, and ego. We tell ourselves “I’m right” in a profitable position to shore up our ego, while justify our decision by constructing narratives such as “it is a bullish correction” or “it is going to bounce back” when suffering losses. Both are the same: we rationalize to preserve our pride and ego. Never confuse net-worth with self-worth. But it’s far from easy. Investing requires a dose of humility to know you can be wrong and a sense of self-awareness to detect any cognitive bias that may fool you. 

*8. High value-to-cost ratio*
Companies with competitive advantage are those whose products and services can deliver immense value to its customers relative to the cost incurred. The question to ask when assessing that is ‘What would happen if the products or services disappear tomorrow?” Would that have a huge impact on its customers? You want to examine the ‘criticality’ of the product. A bicycle parts manufacturer supplying to the casual cyclist market can easily be replaced by another manufacturer. But if it is serving pro cyclists where the product is a matter of winning or losing the Tour de France, now that has a high value-to-cost ratio. 

Another way to examine the criticality of the product is to ask “How much friction is a product eliminating?” Coca-Cola reduces the search friction; Bloomberg Terminal reduces the friction of curation; Rolls-Royce reduces the friction of engine maintenance. 

*9. What would you do?*
In 1985, Intel has a tough decision to make: expand its core memory chip business that is rapidly losing money due to heavy competition from Japanese counterparts or bet on their nascent but fast-growing microprocessor business. There was plenty of tension between the two factions of the business, both with justifiable reasons that Intel should exit the other business. Andy Grove, Intel’s CEO at the time, then turned to Gordon Moore, founder, and Chairman of Intel, and asked, “If we got kicked out and the board brought in a new CEO, what do you think he would do?” Gordon answered without hesitation, “He would get us out of memories.”

Our emotional attachment can sometimes blindside our ability to make good decisions. Sometimes, we make poor investment decisions not because there’s a lot of uncertainty, but because our emotion prevented us from seeing the obvious solution. So when you have to make a tough decision, imagine someone else has that problem and wants your advice, what would you do in that situation? 

*10. Favorite-Longshot Bias*
Longshots are turnaround stocks, stocks with multiple bad quarters, stocks with nascent products/technology, or simply stocks where the majority would not touch. They are longshots because only a few out of many of these longshots will turn into profitable investments. This bias explains we tend to overestimate the success rate of these longshots or our ability to pick the right ones. We might think a turnaround stock has a 10% chance of success when in reality it is only 1%, for example. 

The opposite is just as true: we underestimate high probability events, such as a favorite stock that has performed well consistently for a long time. We dismiss quality stocks because they look overvalued, uncertain if their past performance will continue, or just plain boring. That’s why there’s always more discussion on longshots because they catch our imagination. It is more fun to talk about a stock that goes up 100% in a month than one that has compounded 15% annually for 20 years. 

*11. Second Law of Thermodynamics*
The second law states that systems tend to move from ordered behavior towards random behavior, or entropy. A hot coffee sitting in a room will cool down until it reaches room temperature, for example. Or an ice cube (solid-state) in a hot pan will melt into water (liquid state) and turn into steam (gas state)—moving from less randomness (ice cube) to total randomness (steam).

How does this law apply to business? If a firm makes an excess profit, competitions will move in, increases supply, forcing down prices and eliminates those profits. Excess profit reverts to normal profit (mean reversion) just like the temperature of the hot coffee move towards room temperature. But if you put the hot coffee in a thermos, you delayed the reversion process. Instead of an hour or two for the coffee in a cup to reach room temperature, now it takes a day or longer to do so inside the thermos. Similarly, a firm that has some form of competitive advantage or a moat is like a thermos, it delays the orderly state of excess profit from moving towards the disorderly state of normal profit.

*12.  Moat is durability*
Peter Thiel explains the problem of focusing on growth, “If you focus on near-term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now? Numbers alone won’t tell you the answer.” Growth is not evidence of a moat because competition always acts as a negative feedback loop to counter that. The only way to measure moat is durability. Durability measures the strength of the ‘barrier’ that prevents entry. Or like my example above, the thermos acts as a temporary barrier that insulates excess profits from competitions. Michael Mauboussin called it the Competitive Advantage Period (CAP)—the number of years a business can enjoy excess profits. The bigger the CAP, the more valuable the business is. 

*13. Three types of failures*
There are preventable failures—you know what to do but didn’t do; complex failures—nonlinear unexpected outcomes; and intellectual failures—unknowable like a negative black swan.

A checklist, good investment process, and writing down investment thesis helps avoid the first failures. Learning from great investors, reading history, and studying success reduce the second failures. Margin of safety, optionality, and learn fast fail fast soften the third failures. 

*14. Large data set is your friend*
The base rate, or the outside view, is the statistical information about the collective average. When you look at online reviews for a restaurant, a travel destination or a product, you’re seeking the outside view—the wisdom of the crowd because their experience is a good indication of yours. 

How can we apply this to investing and life? Get into situations where the base rate is attractive and avoid unattractive ones. The base rate of success is non-stop learning, refining, and crafting skills. The base rate of happiness is compassion. The base rate of smoking is premature death. The base rate of fewer decisions is better decision quality. The base rate of good judgment is humility, process-driven, and open-mindedness. The base rate of wealth accumulation is to avoid big losses. The base rate of speculation is losses. The base rate of investment mistakes is preventable failures. The base rate of checking daily price is excessive risk-taking. The base rate of following the market is cognitive biases. The base rate of excessive financial leverage is ruin. 

*15. State of mind*
In the anime Rurouni Kenshin, Kenshin Himura has to master the ultimate technique, Amakakeru Ryū no Hirameki (天翔龍閃 Flash of the Heavenly Soaring Dragon) to defeat Shishio Makoto, his biggest nemesis, and save Japan in the process. The same goes for Bruce Wayne. In The Dark Knight Rises, Batman has to make that daring jump and climb out of the underground prison before he can stop Bane and save Gotham. Both fictional heroes learned that the secret to overcome their biggest challenges and save the world is the fear of death, not the lack thereof.

There is a heroic stature that one has to have a ‘go big or go home’ attitude and take massive risks to succeed in the stock market. Akin to Batman and Kenshin’s initial belief that the courage to sacrifice is their greatest strength. It turns out to be their weakness. Similarly, investing is never about trying to be a cowboy or Rambo. Rather, it’s the opposite: the will to survive through capital preservation by managing risk prudently.  

*16. Eight hours of sleep*
The easiest way to make better decisions (and not lose money) is to get 8 hours of sleep every day. What happens if you don’t? Matthew Walker puts it this way, “Under-slept brain swings excessively to both extremes of emotional valence, positive and negative.” 

In the context of investing, both emotional self-control and rational judgment deteriorate when you don’t get enough sleep. On one end, extreme positive emotions encourage excessive, reward-driven behavior. You’ll be overconfident and ever ready to pounce at the slightest hint of market suggestion. The fear of missing out goes overdrive. You’ll be thinking “How much can I make?” rather than “will I make money?”. On the other end, you’ll also slip into extreme negative emotions that trigger manic depressive behavior. You’re more likely to exhibit herd mentality, short-termism, and panic selling on the impulse. Not enough sleep gives you a cocktail of both extremes. 

*17. Outperformance comes from unconventional thinking*
Active investing is to outperform the market. Outperformance, or above-average performance, requires doing things differently from the majority. If you see the same thing, read the same news, follow whatever the market is doing, your thinking and actions will be similar to the majority. To be unconventional is to do the opposite. To be an independent thinker, you need original ideas. 

How do you get original ideas to have an edge? You start with what you already know and what’s around you. That can be your career, hobbies, social interaction etc. You also need a good dose of intellectual curiosity, observant, and don’t be afraid to ask silly questions. As you pay more attention, observe your habits as well as others, and began to think deeper, you’ll eventually develop your unique ways of finding great investment ideas that lead to outperformance. 

*18. How to make money? Don’t lose it*
Most investment mistakes that produce the biggest losses don’t come from the failure to predict the unknowable—what would happen in 10 years—but from the failure to manage the preventable: tiny, simple mistakes that snowball into catastrophic losses. Focus on avoiding these easy-to-kill mistakes would improve return exponentially by eliminating 80% of the losses.

This is also a reminder to spend more time on what’s not going to change. Just as the strength of a tree trunk decides how far the branches can grow, your ability to master the basics determines your long-term return. What are the basics? Self-control, mental models, robust process, open-mindedness, good preparation, and humility. 

*19. Keep it simple*
Metcalfe’s law states that the effect of a network is proportional to the square of the number of connected users of the system (n^2). This law is also called the network effect; a system (or network) becomes more valuable as more users join the network.

We can understand complexity using this law. An investment idea with 5 moving parts has 10 possibilities. 10 moving parts; 45 possibilities. 20 moving parts; 190 possibilities. Complexity increases exponentially while accuracy declines at the same magnitude. An investment with 3 moving parts (or variables) has a 73% success rate if you’re 90% certain in each of them (0.9 x 0.9 x 0.9). 10 moving parts? The success rate falls to 35% (0.9^10). Which is why macroeconomic forecast is often wrong. Keep your investment idea as simple as possible. Look for 3-5 most important variables that determine the investment value. Anything more than that should go into the ‘too hard’ bin. 

*20. Solve the big question*
Investing is about reducing the risk of permanent capital loss before thinking about any potential upside. To do that, consider the factors that are necessary for success.

If you buy a stock because “it has a strong brand”, then make sure your hypothesis is solid. Such as the product can change consumers’ behavior, there’s no clear substitute, or it can charge a premium price etc. Don’t go around looking for secondary factors such as the business has lots of cash, prudent management, expansion etc until you solve the big question. Because nothing else matters if the strong brand hypothesis is false. The question to ask is “What is the single most important thing that will make or break this investment?” and spend 95% of your time on that thing. 

*21. Make it count*
If Warren Buffett offers to swap his fortune and age ($87.3 billion and 89 years old) with you, would you take it? You most likely won’t because you can’t enjoy those fortune at that age with the remaining time you have. If you reject the offer, it also means that you believe your time is worth more than $87 billion. And depending on your current age, that’s at least worth $145,000 an hour or $3.5 million a day. That’s your hurdle rate. So now the question is how are you going to spend this precious time? Make it count. 

*Note*​
Kahneman, D. & Charan, R. (2013). _HBR’s 10 Must Reads on Making Smart Decisions_

Paul, J. (2013). _What I Learned Losing A Million Dollars_

Hadfield, C. (2015). _An Astronaut’s Guide to Life on Earth_

Walsh, Bill; Jamison, Steve; Walsh, Craig. (2010). _The Score Takes Care of Itself: My Philosophy of Leadership_.

Walker, M. (2018). _Why We Sleep: Unlocking the Power of Sleep and Dreams_.

Thiel, P. & Masters, B. (2014). _Zero to One Notes on Startups, or How to Build the Future_.

Heath, C. & Heath, D. (2013). _Decisive: How to Make Better Choices in Life and Work__._


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