by The Graham Investor on June 26, 2010
We all want to emulate Buffett, Graham, Klarman, Ruane, Greenblatt et al. Their success as value investors is not in doubt. But how did they achieve it? I recently read several related books: “Bounce” by Matthew Syed, Malcolm Gladwell’s “Outliers” and Levitt & Dubner’s excellent sequel to “Freakonomics” – “SuperFreakonomics”. A common theme in all of these is what an individual has to do to become an expert in a particular task or sport. The conclusion is that talent is not really an important precursor; but practice is. Specifically, deliberate practice, a particular type of practice detailed in a paper published in 1993 by K. Anders Ericsson, Ralf Th. Krampe, and Clemens Tesch-Romer, entitled The Role of Deliberate Practice in the Acquisition of Expert Performance.
The majority of people, when they practice something, do not do so with a specific aim or goal in mind. Their practice session is not designed to iimprove performance or a key aspect of performance. They do not have immediate feedback in the form of advice from a coach or mentor. They are distracted from their practice, rather than concentrating and sustaining effort. They tend to practice only what they are already good at instead of working on weaknesses to turn them into strengths. Their practice sessions are not repeatable, presumably because they are not documented.
In its conclusion, the paper states: “We view elite performance as the product of a decade or more of maximal efforts to improve performance in a domain through an optimal distribution of deliberate practice.”
A specific figure that comes up in the paper is that it takes a minimum of 10,000 hours of (deliberate) practice in order to become expert in a particular domain, i.e. 1000 hours per year for ten years.
“The dichotomy between characteristics that can be modified and those that cannot may not be valid when we examine Ihe effects of over 10,000 h of deliberate practice extended over more than a decade.” In other words, the findings were that modification of characteristics believed to be fixed was in fact possible when the practice was sustained over a long period of time.
How is this related to investing? Well, there is no doubt that Buffett, Graham, etc., spent many many years developing and refining their investing techniques. They probably discarded what didn’t work, but – importantly – refined and stuck to what did work. They most likely easily exceeded 10,000 hours of deliberate practice in investing; perhaps many times over. They most likely kept journals and logs; indeed both Buffett and Graham, in their writings, have referred in great detail to trades made many decades earlier. How many everyday investors remember all their trades, especially the bad ones? We all may remember trades that were big winners and think they bestowed genius upon us, but did we even learn from the losers, of which there may be many more? Did we have a process? More importantly, did we follow it?
Success in investing probably starts with motivation; without motivation to learn, there can be no progress. Motivation drives us to achieve knowledge. Repeated use of this knowledge leads to know-how, or the ability to carry out a task efficiently, quickly, and accurately with little or no effort on our part. Our motivation is most likely a desire to make a decent return on our money.
If you aren’t happy with your investing returns, perhaps it would be worth looking at how you are going about it. First, design a process, and document it. Make rules you will unswervingly follow. Determine your comfort zone in terms of risk. Figure out what your asset allocation should be. Learn from your mistakes, and do not make the same mistakes again. Treat investing as a business (Graham) and be diligent about it.
But, most importantly make your practice of investing deliberate. And have fun.
by The Graham Investor on March 5, 2010
Much is made of stock buying strategies, but the truth is nobody makes a dime from their investments until they sell. Selling stock is easy – knowing when to sell maybe not so much. Or is it?
It certainly should be.
Ben Graham variously suggests keeping stocks for 2 years, and/or selling 50% of a holding. Warren Buffett hardly ever sells, if ever. Buffett is no ordinary value investor in that he buys entire companies, not just hundreds or thousands of shares of stock. For the majority of individual investors, there are probably only a handful of selling strategies in use, most of which are more or less random depending on their emotional state.
- Sell after X amount of time.
- Sell when I need the money.
- Sell when I’m in profit and the tax consequences are minimal.
- Sell to record a tax loss.
- Sell this stock because I don’t like it anymore.
- Sell because my original investment is 10 percent, 50 percent, even 90 percent gone. Ouch!
- Sell because EPS missed estimates by one measly cent.
- Sell because today is as good a day as any and my gut says so.
And so on. You get the picture, more often than not there’s precious little logic involved.
Then there is a selling strategy that starts with the process of buying and is built into an overall goal for your portfolio. As you analyze XYZ stock for purchase – because you have determined it to be undervalued and with an adequate margin of safety – before you even pull the proverbial trigger you wonder out loud: at what price will I sell this stock?
The simple answer might be: when it reaches fair value. But life is never simple in investing. When will XYZ get to fair value? Will it ever? Will I still be around when it does?
A better answer might consider the fact that you have a set target for your entire portfolio to make an annualized return of, say, 20% per annum. You can then give each of give your individual purchases a set amount of time to make a profit, say 20% each in any one year period. Suppose you buy 5 stocks at the beginning of the year, investing one fifth of your portfolio in each. If 3 of your 5 stock purchases should make a tidy 50% gain in 6 months (the other two staying flat) and you sell them at that point, you can afford to lose 25% on your other two purchases by the end of the year and still meet your portfolio’s annual 20% percentage gain goal. Should the other two purchases remain flat through year end, your portfolio gain for the year is 30%, comfortably beating your target.
I like to think of maintaining my personal CAGR or Compounded Annual Growth Rate over the years. This means I pay attention to annualized gain and sell early winners, or at the very least lock in profits with trailing stops. That, in turn, means I can give the laggards more time.
If a stock gains 20 percent in a year thats the annualized gain for the year. If the 20 percent gain happens in the 30 days after buying, the annualized gain is way more than 20%. We can extrapolate to find the annualized gain from our 30 day period gain as follows:
((1 + Rate of Return)^1/N) – 1
N = Number of periods
Since our gain happened in 30 days, we calculate N as 30/365= 0.08219178
(( 1 + 0.20)^(1/0.08219178)) – 1
(( 1.20 )^12.1666667 ) – 1
9.19119181 – 1
8.19 or 819%
The longer we get to a full year, the lower the annualized gain becomes. That 819% will diminish exponentially unless the stock continues to gain at the same rate.
In simple terms, sell after 2 years any stocks that have gone nowhere or contributed less than your target CAGR. Lock in profits on those that go up steeply, or sell a percentage such that your remaining stock is free. Or sell if they have already reached fair value and you have found something else that’s undervalued.
What about stocks that go down? If you calculated your margin of safety well, you shouldn’t have too many of those, and your personal CAGR should be boosted enough from the winners and good years that you can ride out any losers while maintaining that minimum rate of return.
