More than you know (Michael J. Mauboussin)

It is better to approach investment from a multi-disciplinary perspective.

Philosophy

• Probabilistic thinking:
  • Decisions should be judged on the balance of odds when making it, not on the final outcome. If the odds are good, given enough such decisions, good overall outcome is almost guaranteed.
  • You want to bet not on the horse that's the most likely to win, but on the horse that gives you the best odds (given its chance of winning).
  • Despite uncertainty, we must act (waiting is also an action).
  • Probability distributions > target prices.
  • You don't want to be right >50% of the time. You want to make money in aggregate. One 100-bagger could be enough to beat the index even if all other investments lost money.
  • Think in probability trees.
  • If the odds don't look good, don't play -- there's no penalty for that.
  • Mind the difference between probability distributions and knightian uncertainty.
• Long horizon makes risky assets less risky
• What sets apart active funds that beat the index (compared to an average active fund)?
  • Low turnover (35% vs 89%),
    • Optimal holding period is ~5 years for value, ~1.5 years for growth.
  • Concentration (35% in top 10 holdings)
  • Intrinsic value based investment approach
  • Not based in East Coast financial centers: NY and Boston
• Build models, verify them against evidence, update.
  • Inside view (gears model, combine probabilities from trees) vs. outside view (base rates, additional evidence).
  • Best performance by domain - choose the best tool for the job:
    • experts
    • collectives
    • statistical models
• Evaluating the management of a company:
  • Leadership: learning, teaching, self-awareness
  • Incentives: stock (options), mission, other: what motivates people in this company to do their best?
  • Capital allocation skills:
    • Where did they invest in the past? How was the return?
    • M&As worth it? Most of them are not.
    • How do they explain their capital allocation framework?

Psychology

• Individual decision making vs. collective decision making: when people err individually, the outcome is usually still reasonable, when they all err together in the same direction, then you get irrational prices.
• Influencing factors relevant to investing:
  • Consistency and commitment - becoming more confident in companies that you invest in,
  • Social validation - if lots of people agree, we become overconfident,
  • Scarcity (including informational scarcity).
• Market participants are not rational and sometimes we can take advantage of the resulting mispricing of securities. However, market in general can still be quite rational if there's sufficient investor diversity (but oftentimes there's not).
• Keyne's beauty contest, Visiting El Farol: these models work reasonably ok under diverse thinking but lead to bubbles and crashes if most participants think similarly.
• It's often difficult to complete a full analysis for any investment in any reasonable time. Thus shortcuts and pattern recognition become key and many experienced investors actually use them extensively. However, the best investors also use frameworks and careful analysis where necessary and have good intuitions about that.

Innovation and competitive strategy

• New industries follow this pattern: lots of companies to explore the space -> consolidation/pruning -> growth of the best. Sometimes this cycle repeats with the new wave of innovators figuring out the next step.
• Growth of companies: S-curves. You want to buy before the first bend (when expectations are too modest) and sell before the second (when expectations are too optimistic).
• Products take some time to develop but company processes take 2-5 times more. It's usually the process that determines long term stars and you can time the process based on the product cycle.
• Extrapolation is difficult.