Hedge School of Applied Economics

Every person who has ever invested in the equities market starts off as a portfolio manager in his own right.   However, as he sees investors rush into a seemingly manic market and a huge avalanche of money betting on something that he neither understands nor comprehends his best attempts to stay rational and focused on the long haul are soon destroyed.  What then happens is a twisted logic: “Invest first, investigate later!” Very soon, most of his productive hours start mapping to the trading hours of the stock market, and researching a stock translates into merely watching each up/down tick in stock prices like a hawk, coupled with sporadic bets made for no apparent reason.  

If you wish to have any kind of longevity in the stock market (unless you are in it just for the intra-day kicks), you have to press a pause button and do some real soul searching.  If you find that you are predisposed to be patient, disciplined and psychologically appreciate the idea of buying bargains, then you're likely to be good at value investing.  On the other hand, if you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that's great, but you're not a value investor, and you shouldn't be one. Regardless of whatever you discover about your predisposition towards investing, it is essential to know that managing risk and determining the margin of safety should be the backbone of an investor’s investment process. He should look at what could go wrong in a company, the economy, how some event or issue could affect the company or the security. It is quite likely that one can like a company but not find an opportunity to invest in its securities, or maybe even not like an opportunity but find an opportunity to invest in its securities.  

Ultimately, anyone who invests must pick their poison, knowing that they are going to be wrong sometimes.  The question is what are we going to be wrong about? We can take a risk and lose our money OR not take a risk and keep the money intact but wind up missing an opportunity.  Rare is the investor who has a high degree of conviction and waits patiently.  Feeling the pressure to put money to work or unwilling to underperform for short periods of time converts many an investor into a speculator in the blink of an eye.   

Another issue that an investor constantly struggles to address in building his investment portfolio is – how much should I diversify?  Modern Finance theory has always advocated diversification as a means to reduce risk.  However, some of the great investors like Warren Buffet do not prescribe or practice diversification.  

Keynes, who was not just a brilliant economist but also a brilliant investor, believed that an investor should put a fairly large sum of money into just two or three businesses that he/she knows something about and whose management is trustworthy.  From this viewpoint, a strategy of financial and mental concentration may actually reduce risk by raising both the intensity of an investor’s understanding about a business and the comfort level he must have with its fundamental characteristics before buying it. 

Warren Buffet is also famous for his scorn for a much used investment metric used to measure risk, the beta.  According to Buffett, the fashion of beta suffers from in-attention to a fundamental principle, “It is better to be approximately right than precisely wrong.”  

In short, long term investment success depends not on a study of betas and managing a diversified portfolio, but on recognizing that as an investor, one is the owner of a business.  Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such “flitting from flower to flower” imposes huge transaction costs in the form of spreads, fees, commissions, not to mention all sorts of taxes that I have given up trying to figure. 

Sooner or later, you have to ask yourself, ‘Are you in it for a real or are you living in a la-la land where a balloon never runs out of air! As Warren Buffet so eloquently put it, You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right