What Is True In Investing Over The Long-Term?


Pareto Law, Psychology / Sunday, October 23rd, 2016
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Jeff Bezos, the founder & CEO of Amazon.com, Inc once explained Amazon.com’s philosophy:

“I frequently get the question “What’s going to change in the next 10 years?” I almost never get the question “What’s not going to change in the next 10 years?”…that 2nd question is actually the more important of the two because you can build a business strategy around the things that are stable in time. In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, “Jeff I love Amazon; I just wish the prices were a little higher”, or “I love Amazon; I just wish you’d deliver a little more slowly.” Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.”

The concept is simple. Invest energy into something that won’t change, or unlikely to, so one can reap the benefits over the long-term. Yet as simple as it sounds, it is an unconventional wisdom in the modern world where short-termism pervades our society.

Many things changed throughout the history and will continue to do so at a faster pace driven by technology, demographic, competitions and other sorts of factors. But one thing has remained the same: Homo Sapiens. Our taste for fashion or lifestyle are certainly different now compare to a hundred years ago but our brain is still wired in more or less the same way such as our ability to sense danger and the emotion of fear and greed. The past 400 years is nothing short of examples from Tulip Mania in 1637, Japanese Asset Price bubble in the 1980s to Dot-Com bubble in late 90s and Real Estate bubbles across multiple countries in late 2000s. While each different in breadth and magnitude, they are all driven by the irrationality of greed, overconfidence, fear, and pessimism. The madness of market and human fallibility are what is true in investing over the long term.

If human behaviour is what’s unlikely to change, then we can put a lot of energy into it. By that, I mean learning the psychology of investing and guard yourself against human folly. Learn how to think well and think for yourself before asking for opinions. You can have good valuation skill but without a strong psychological makeup, you’re not going to last. Right temperament is the backbone of investing. You don’t need to be the brightest to win; you just need to make fewer mistakes.

The main reason that contributes to the folly of following the crowd is that most investors have no idea what they are doing. As I have written in the previous post about risk, we have herd mentality because we presume the crowd knows more than we do and it feels safer to follow what everyone else does. But the important question is, how are we suppose to know when the crowd is wrong since we know nothing? The key here is to cultivate a strong sense of awareness about your own psychological misjudgment. Having the courage to say no and go against the crowd starts from acknowledging how much we don’t know. Before you decide to buy a stock, write down a list of things that you don’t know about it. It would help to tame down your overconfidence and reduce mistakes. Focus on things that don’t change also has other benefits.

When Jeff Bezos refers the word ‘energy’, what does he implies? Energy is a kind of resources. What kind of resources? Capital, money perhaps. That would be partly true. He is actually referring to time. Time is the most important resources because our time is finite. Whereas fortune comes and go; time only flows in one direction. And if time is the most precious resources, it makes sense to invest it on things that matter. Coincidentally, things that matter are also things that don’t change much in the long term. Their significance begets longevity. And there’s another exponential truth.

The 80/20 rules or Pareto principle, explains that 80% of the effects come from 20% of the causes. A majority of effect can be explained by a few causes. A few example.

  • 20% of stocks in a portfolio contribute 80% of return
  • 20% of population control 80% of assets globally
  • 20% of information or variables determine 80% of outcome

Pareto principle explains the non-linearity fact of life. By shifting focus away from the trivial and focus on what’s really important, the result is not additive but exponential. If previously you spent 80% of your time doing trivial things that contribute 20% of the result, flipping that around can improve your result by over 300%. However, instead of focusing on the important 20%, many investors continue to spend their time on the opposite end of the spectrum.

Investors spend their time asking others’ opinions to validate theirs; studying currency effect on profit; pondering why major shareholder dispose of shares; worrying why share price keep falling; predicting next quarter’s earnings and so on. The reason why predicting quarterly earnings is not important is because it is nearly impossible to consistently get it right over the long run. And insider disposing shares can be a sign of problem just as easy as it can be a false alarm. Therefore, spending a disproportionally large amount of time on these questions will at most, yield 20% result; worse, result in loss of capital and time.

You might wonder if these are so straightforward, well most investors know the importance of keeping their emotions in check and avoid doing things they don’t understand, why aren’t more investors doing it? It is precisely because they are so straightforward, investors think they know it all already. Take margin of safety as an example. Your grandma might know nothing about investing, but I am sure she has certainly told you something along the line “Just in case something happens…do this…”. That’s the essence of the margin of safety. Allow room for error, have a plan B in case something unexpected happens. It is a classic wisdom. So common sense that most investors either find it too easy or has little value. You also hear the common advice of slowing down and don’t rush into things. Again another classic wisdom of advice that many investors easily throw out the window on the first sign of trouble.

There is no secret to successful investing. Important things are more likely to survive the test of time. So if something has stood the test of time, chances are it isn’t a secret anymore. However, there’s a huge difference between knowing and doing. And it is also one of the counterintuitive things that’s so hard for most people to do it. It is easier and fun to discuss the next profitable trade than evaluate a mistake made years ago because of some unknown psychological factors. One feels like progress while another feels like crawling in the dark. But if it is something true over the long term, we can afford to put a lot of time into it.

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