Very often, I find investors are more excited about the act of investing than the acquisition of the wisdom. Investors are more fixated on short-term gratification than to focus on generating long-term sustainable returns.
However, we are very fortunate to be made aware of a fool-proof philosophy by Seth Klarman, that will guide us through our investing journey – if we remain disciplined in what we learn.
In this article, we will be sharing with you the 10 important things that you must know before investing like Seth Klarman. These nuggets of advice are taken from his famous book Margin of Safety and interviews over the years.
1. Risk first, then return
Psychologists have found out that we are a lot more affected by losses than earnings. When prices start to plunge, the amount of fear that we experience may overwhelm any rational thinking we should have.
At that juncture, if you are dead-sure that things won’t go awry, you will soon regain the confidence that your investments will turn out well in the long run instead.
Question is, how can you be dead-sure?
This can only be done if you are well prepared for the unexpected. Companies that are weak and vulnerable will suffer when the market heads south as the capital cycle reverses. If you have made sure that the risk of permanent loss of capital is minimised, you have nothing to be afraid of.
2. Price isn’t always the true value
There exists a perilous illusion that the market price reflects the intrinsic value of the company all the time. This follows from the financial theory called the efficient market hypothesis where prices are supposed to reflect all available information.
If that is true, value investors will not be able to generate sustainable profits in the long run. But as we all know, exploiting the price-value gap has been very profitable since the beginning of time.
Price is the most important aspect of making investment decisions. No matter how amazing a business is, there is always a right price to pay for.
Remember, price is not always value.
How do you know whether the price is right?
The short answer is that you should compare the price to the intrinsic value of the company, of course. Just because a company’s shares at $100, it doesn’t mean it’s more expensive than another at $1. You have to compare the price against the valuation in order to determine whether a company is currently cheap or not.
That said, you not only have to be aware of the price-value differential of the company, you have to compare different options. While investing at 50% of intrinsic value seems to be very cheap, you never know if another company is currently priced at 25% of intrinsic value.
Do your homework, compare price-value between different companies and maximise your portfolio potential.
4. Importance of psychology
Most think that there isn’t much relation between generating profits and understanding psychology, most think wrong.
The reason why most investors understand the value approach but fail to implement it is due to the influence of psychological forces. When markets start to slide, all thesis and philosophy may suddenly disappear at an instant.
With a firm understanding of our emotions and the reason why the market behaves irrationally, we can avoid being the victim.
5. Fluctuation of prices shouldn’t make you waiver
Markets go up and down all the time. If the fundamentals do not change, you shouldn’t get too caught up with the emotions of the market.
Stocks aren’t pieces of paper with numbers that swivel all the time, they represent interests in businesses. As an owner of a business, do you start selling the company just because you are temporarily having some difficulties?
We hope not!
6. Think bottom-up
While it is important to be cognisant of the macroeconomics of the economy, you should never be affected by the ever-present noise that exists in the financial market.
Most people adopt a top-down scholar-like investment approach. They take stands about whether the industry will boom or not and places their bets in the form of investments.
Taking a bottom-up approach will allow you to focus on deriving the fundamental value of the company rather than to be influenced by the noise in the economy.
7. You will underperform
Underperformance in the short term is expected and normal. Just because you aren’t doing as well as those investment firms investing in the “hot” stocks, it doesn’t mean you are doing it wrong.
Be steadfast and keep to your philosophy and the results will show.
It is extremely easy to be distracted by such underperformance in the short term. Especially when the market is climbing higher by the second, value investors will usually be left on the sidelines.
You need the right discipline and patience for your time-tested strategy to pay off.
8. Beware of excessive diversification
Diversification greatly reduces the risk where your judgement goes terribly wrong after accounting for a large margin of error. We aren’t perfect and sometimes these do happen.
The purpose of having diversification is to reduce the impact of such an unfortunate event.
However, if you employ excessive diversification, your portfolio will be seriously dragged down by it. Your 100th investment idea is definitely not as good as your 5th. Your portfolio will be dragged down by poor returns and costs.
9. Don’t time the market
As we have repeatedly cautioned our readers about the perils of timing the market, we will once again bring up this very important point.
The temptation to time the market stems from fallacies that supposed to promise quick and easy returns. The idea of taking the easy way out and not having to bother about understanding the fundamentals of the company is very alluring.
You should be very skeptical of your own’s ability to predict the future. If the professionals can’t even do it with an arsenal of cutting-edge information technology, what makes you think you can?
10. Greed is NOT good
By attempting to pursue $0.10 more when you sell, you are risking the possibility of not being able to sell at that range at all.
Sell when it is time to sell. Don’t be motivated by greed and fear.
We hope that these nuggets of wisdom would set you on the right path before you start investing. Learning how to invest is like piecing pieces of a huge puzzle together. With a strong fundamental, your learning will gradually become more enlightening as you understand more concepts.