PDF Link: http://bit.ly/2hQViD4
More information is creating 3 key challenges to investors:
- A more level playing field
Better information accessibility means a tougher time for investors to develop a sustainable, informational advantage over one another.
More information creates the desire to do something about it and mistaken action as productivity. As a result, average stock holding period has fallen from 8 years to 6 months over the past 50 years.
- Information overload
The biggest of all comes from the failure to properly synthesise information and differentiate noise from the signal, which inevitably leads to decision errors and mistakes.
Here several ways how you can manage information without compromising the quality of your decisions followed by some books and articles that will help you improve further. A majority would look into the best way to analyse information while the rest would examine it from a portfolio and psychological level.
Downsize your portfolio
The idea of downsizing your portfolio is intuitional. If you allocate the same amount of time over a smaller amount of stocks, your ability to process information and the quality of decisions should improve. A smaller portfolio simplifies things so you can organide your thoughts and focus on the few best ideas or ones with minimal downside. There’s no right answer on how many stocks to own as long you don’t feel overwhelmed. However, keep in mind overdoing it might increase portfolio concentration risk – the risk that any negative outcome on a stock can significantly impact your return. Which stocks should be on the chopping block? The questions below should be able to guide you. And beware of ‘cut the winners and hold the losers’ mentality.
- Which stocks consistently have their ROE (or ROIC, ROC) below 10%?
- Which stocks do you have the least understanding?
- Which stocks are taking up the most of your time?
Information overload comes from a disorganised mind. Instead of multitasking or doing ‘whenever I feel like it’, plan ahead and find a time when there’s minimal distraction. Time block that session so when the time comes, set everything aside and focus on your investing activities. An hour of full concentration beats a 3 hours effort done haphazardly. Personally, I find the early morning hours works the best for me. I feel refresh and my mind is sharper. I would print out things that I am planning to read and set it aside in a tray. You can do the same or use apps like Evernote for later reading. Whichever is suitable to your situation. Planning your time in advance sets your mind in the right framework on what needs to be done. And every cell in your body needs to focus only on that one task.
Reduce portfolio complexity
Complexity can arise from the business line, model and investment type. A company with multiple business lines operating in several industries require more time to analyse than one that runs on a single business line or sell limited product variations. A multi-business lines company tend to have more complex business models that utilize several strategies to address different market needs. Complexity is not limited to the size of the company because a small cap company can have multiple business lines just as easy as their bigger counterpart. If you are required to spend considerable time on a stock that carries a potential one-off 10% return, it is probably not worth your time.
Investment type is the categorization of stocks based on investment thesis such as asset play, cyclical, turnaround, spin-off, special situations, deep value/net-nets, moat etc. While having a mixture of these categories allow investors to exploit a bigger set of opportunities, there’s a fine line when exploiting too many investment types can lead to information complexity. Keep a journal when you buy a stock is an easy way for you to refer back so you can focus on answering the important questions instead of finding information blindly. (See: Keep a journal)
Avoid predict the unpredictable
“A butterfly flap its wings in Boston and causes a hurricane in Beijing.” – The butterfly Effect
You burned your hand after touching the hot kettle – this cause (touching hot kettle) and effect (burned hand) has a linear relationship that is direct and predictable. However, most systems such as weather, social or economics tend to be nonlinear where small changes can create a chain reaction that cascade into something bigger while other times big changes have a rather mute effect. Nonlinear system also means things can happen in a highly unpredictable fashion than you could possibly imagine. The power of compound is an example of nonlinearity.
In economics, many macro events such as interest rate, oil price or exchange rate are well known for their unpredictability. Spending too much time trying to predict the unpredictable is at best futile, at worse leads you into making a poor decision. Take exchange rate. The exchange rate is affected by changes in inflation, interest rates, trade balance between countries, public debt, economic performance and so on. If predicting those borders on the edge of impossibility, imagine trying to do that and predict its impact on earnings, and how the market would react as a result of the impact.
While top-down analysis definitely has its own success stories but if you are constantly being overwhelmed trying to keep abreast of what is happening around the world economically and politically, it is best to spend more time focusing on things where the potential payoff is high.
Determine value of information
“Not everything that can be counted counts, and not everything that counts can be counted.” – Albert Einstein, Physicist
Not all information carries the same weight. Generally, information derived from a large sample has better value than smaller ones (See also: Outside then inside). As an example, quarterly earnings are normally more volatile due to many temporary or cyclical changes, which tend to even out over the longer term, hence carry a lesser weight compare to annual figures. (See also: Expand investment horizon).
The same applies to information with poor diagnosticity. A piece of information has poor diagnosticity when more information is unlikely to improve decision. Take share disposal on the management level. It is a cause for concern but unless a reason is provided, no amount of information digging will improve your insight. It is also crucial to differentiate between factual and opinionated information. Most information from news or analyst report is 10% factual 90% opinion so take that 90% with many grains of salt. A factual information can be bullish or bearish depends on which lens you look at it.
Employ theories and mental models
“To the man with only a hammer, every problem look like a nail.”
Theory or model is a simplistic way to explain how the real world works. As an example, the law of supply and demand explains that as supply increases price would drop and as demand increases price would rise. It is not a perfect economic theory but good enough to explain how microeconomic works.
Many times we get buried under a load of information that we think is unique to a particular situation the company is facing, when in fact it is not. Instead of digging deeper, zoom out and search for a theory that can possibly explain the situation. Take the entry barrier theory. It suggests that if there’s nothing to prevent entrant from entering an industry, economic profit or excess return will be unsustainable. In this case, if you fail to find any supporting information on how a stock can continue to earn a higher than average profit margin, you should be more conservative and revise your estimation. What about the mathematical theory of probability? Instead of making judgement on the most likely outcome that will happen, looking at things probabilistically brings other potential outcomes to light and changes the way you find information. (See: Look for contradictory information)
The more mental models you have, the easier will be for you when analysing information. Microeconomic theory such as the game theory, economic of scale or theory on cognitive bias are some important ones that will improve your thinking.
Outside then inside
Similar to mental models, the idea of outside view is to ask “Had something similar to this happened before?”. Whereas inside view focus on the situation in front of you, outside view answers what happened to other similar situation. We are all familiar with the inside view. We analyze things that are unique to the current situation and derive a conclusion out of it. The problem with this approach is it almost always lead to overconfidence. Let’s say you are analyzing a stock that commands a high profit margin. There’s always a tendency to look into that specific situation and explain why it deserve a high margin. A better approach is to look at the industry and get an idea what the industry profit margin is. Once you’ve established a benchmark margin, switch into inside view and make your adjustment accordingly. This approach prevents you from anchor bias, overconfident and reduce the time required to find information.
Process over outcome
Being too focused on the outcome or holding yourself accountable over outcome tend to promote the temptation to search for more information, which ultimately leads to information overload. We are obsessed with the outcome because it is easily quantifiable. And things that are quantifiable creates a feedback loop that we measure ourselves against. The problem is that outcome provide little clue to how well you’re doing due to the element of luck involved (an amateur investor can make a profit on his first day). And focusing on outcome also fools you into finding an explanation for every single blip that has no reason at all. The key here is to focus on the how (process) instead of the why (outcome). How did you come to your conclusion for any sorts of decisions, whether that’s a buy or no buy, is what you’ll need to examine.
Use decision tree
“The first principle is that you must not fool yourself – and you are the easiest person to fool.” – Richard Feynman, Physicist
A decision tree is similar to a checklist, both are simple yet effective in structuring our decision-making process in a methodical way. We are the easiest person to fool when running things through our head and it is those simple things like “Do I understand the business?” rather than the hard ones that gotten most investors into trouble. Because the question is so simple and dumb, your brain just suddenly one day decides to skip it altogether in the name of efficiency. (See: Process over outcome)
A decision tree can be as simple as a 3-5 questions yes or no pathway and while it is commonly applied right before buying a stock, it can just as easily be applied to other stages of investment process such as research, selling or screening. What questions should be added into the decision tree will depends on what you’re after. As a general guideline, keep it simple and straight forward. Go through your portfolio over the last few years and find out what kind of mistakes are you making and add them in.
Ask the right questions
“A problem well stated is a problem half solved.” – Charles Kettering, Inventor
We have a tendency to do things without knowing exactly why or what we are after. Reading annual reports is a good example. We all know it is important to read it, but what should we be looking for? You can read every single page but without knowing what you are trying to get out of it, it’s meaningless. Same goes for searching for any information that requires considerable time. The value of the answers comes from the value of the questions. Ask yourself “Why is finding this information important? Would that make it easier for me to make a buy or no buy decision? What is the cost of not having the answers? And weight that against the benefit of getting it.
Keep a journal
Writing down every investment decision you made i.e reasons why you buy or didn’t buy a particular stock helps organize your thoughts, avoid hindsight bias, create a feedback loop, and improve decision making. Our brain has poor memory retention when dealing with things that involve many variables such as stocks. By writing down your investment thesis on a paper, it forces you to organize your thoughts and avoid tricking yourself into a bad investment.
Another reason is hindsight bias. When looking at past events, our brain has a way to convince ourselves that it is predictable, that we knew this is how it will turn out all along, which always leads to more bad decisions down the road. By putting things on record, you understand what was the mistake, how to prevent it next time, and this whole process creates a feedback loop that improves decision making.
When writing things down, keep it short and concise. If it takes more than 5 sentences to explain why it is a great investment, it probably isn’t. On the other note, a stock that has strong growth; bright future prospect; poor fundamentals etc has no meaning. How do you define strong growth, bright future and poor fundamental? It can be anything. Avoid ambiguous words. You need to ask yourself “When I come back and read this a year later, do I understand what am I writing?”.
Expand investment horizon
Your investment horizon has plenty to do with where you put your attention on, what you observe and what type of information you seek out. They all contribute to how much information you’ll need to process at any given time. An investor with a 6 months investment horizon operates differently to one with a 5 years horizon. If you need an investment to work out in 6 months, the information that would interest you are things like quarterly earnings, current economic situation, market sentiment and so on. And with all these information, there’s going to be a lot of noise, poor quality irrelevant information that you have to filter through.
When you expand your investment horizon, you change the questions you ask and the type of information you seek. Instead of asking “How will the next quarter results be?” and start analyzing forex volatility, market sentiment etc (See: Avoid predict the unpredictable), you ask “Will this investment turns out satisfactory in 5 years time?” and instantly the information you want to find out are how sustainable is the revenue, margin, cash flow and other sorts of key important drivers.
Named after Enrico Fermi, Fermi problem solving is a method of breaking big hairy question such as “How many piano tuners are there in Chicago?” into many smaller parts and solve it through ingenuitive ways. The issue with searching for information to solve a big question is that it always leads to information overload. Whether you are trying to figure out if a business venture will work out or how much the company is likely to make in the coming year, asking yourself “What needs to happen for this to be true?” allows you to break the big question into 3 to 5 key components. And if you are able to answer those smaller questions, whether it is a close-ended yes or no, or a range of estimates, you should be able to solve the big ones. As an example, a company is building a new factory to increase production capacity and you’re interested to find out how much extra revenue can be generated from that factory. What needs to happen in this case? You’ll need to find out the size of the factory, size of each machine, price of each product unit, and production capacity of each machine per day. The first 2 questions will solve how many machines can occupy the factory and the last 2 will solve the revenue side of each machine.
Dare to be imprecise
“It is better to be roughly right than precisely wrong.” – John Maynard Keynes
The obsession for more information could come from the obsession for being precise. More information on hand also increases the illusion of control and confidence without necessary improve the outcome. While absolute precision works in the field of physics and engineering, most human-based systems such as health, economy or society can only be explained in odds – as in what is likely to be true. That is why an investment relying on many dependent variables to succeed has a greater chance of failing.
Just as you don’t need to know the exact weight of a person to tell he is overweight, a range estimation gives you an idea when you are roughly right. Being imprecise also means building a margin of safety. And that means sometimes (many times actually) you have to say no to an investment idea.
Look for contradictory information
When you are trying to verify an information, i.e you found a stock that you think is undervalued, it is more time efficient to find information that does not support your view than those that do.
What are the things that will get you to dismiss an idea immediately? Go back to your investment thesis, why do you think it is undervalued? Because it is selling at (insert mouth-watering multiples here), or (insert bright future prospect here) etc, instead of searching for evidence to support why it is undervalued, find evidence that rejects why it is undervalued. Doing this achieve 3 things simultaneously. It reduces downside by looking at all negative aspects if it is indeed undervalued; save time by dismissing those that looks-undervalued-but-it’s-not type of stock quickly; and reduce information overload by avoiding analysis paralysis.
When something is selling at cheap multiples, we tend to compare it to its peers to support the idea it is cheap. The first thing you should be doing is check for distortion on margin, one-off gain, non-core operations, return on capital etc, things that allow you to dismiss it and move onto the next idea quickly. If something is undervalued due to a potential development, rather than continue to justify the idea, asking what can derail that idea (See also: Ask the right questions). Does the company need to raise capital? What resources are required to make it happen? What is the potential return?
“Think forward and backward – invert, always invert” – Charlie Munger
Invert is an extremely simple yet wonderful logic argument popularize by Charlie Munger. The premise is that many things can be solved by inverting the question or statement. Instead of asking your friends “What do you feel like for lunch?”, which is the hardest question of the day, invert and ask them “What don’t you feel like having?”. The former gives someone unlimited options (read: information overload), whereas the later is easier to answer for example he/she probably doesn’t want to have the same meal as the day before. Same goes for investing, many times when you are stuck or find it hard to answer a question, try to invert it. If you can’t figure out the potential upside of a stock, find out what’s the downside; if you wanted to know “Will the market react positively to this information?”, try “ Would the market react negatively without this information?”
The game of waiting
“An investor should act as though he had a lifetime decision card with just twenty punches on it” – Warren Buffett
Limiting ourselves to twenty investment ideas in a lifetime sounds like an impossible task but it underlies an important lesson – instead of searching for ideas to buy, wait for them to come to you.
A huge percentage of our lifetime return is going to come from a few great ideas – the 80/20 or Pareto law. And great ideas are rare. Even when they do appear, most would lie way outside our circle of competence for us to understand it, but that is perfectly fine. If after all the analyzing and you still can’t get your head around it, it is always alright to throw it to the too hard pile and move on to the next one. Always remember, it is not the missed opportunities that destroyed most investors, but envy. Being envious of others achievement and fooling yourself into doing things you don’t understand is one of the greatest investment risks. (See: Use decision tree)
What will happen when you say too many “No’s” to most ideas? That makes it very obvious when you can’t reject an idea, it is going to be the one that’s worth a punch on your card. (See: Invert). When you limit the choices you made, the quality of your decision naturally improves. By setting a powerful filter, any ideas that can flow through would certainly be so simple and straight forward that you know the odds are clearly in your favour (See: Dare to be imprecise). You don’t have to swing every time. Wait for the fat pitch.
If you find this helpful please share it and subscribe to our list http://eepurl.com/b93qbH