In these crazy times, all one could ask for is sanity. Yes, sanity – a clear mind, free of noise, to with which to face the insanity that the volatile, noisy stock market thrusts upon us. We find ourselves glued to our computer screens or CNBC, waiting to find out what the Dow’s next tick is going to be. What do we get out of it? Only a headache and wasted time.
Here is my advice: read. Read books that will bring you sanity, the ones that will snap you back into the mindset of investor and out of being a nervous observer of the daily stock market melodrama. The following books are excellent choices and offer plenty of sanity and sage advice.
I’ll start with Its When You Sell That Counts, by Donald Cassidy, which aims to help readers recalibrate their decisions about when to sell stocks. During secular bull markets, selling is frowned upon, as buy-and-hold turns into investing religion. The investor who buys and sells is labeled as a heretic, or even worse, a trader (if you say “trader” fast enough, it sounds like “traitor”).
In secular bull markets, on average, sell decisions are not as rewarding as hold decisions, as market valuations are expanding and even the second-rate dogs of the equity markets start looking like pedigreed cocker spaniels. Every investor is now a “long-term” investor and sell becomes a four-letter word. But being a long-term investor is not about the longevity of your hold decisions; it’s an attitude. Holding a stock because you bought it is a fallacy; you should only hold a stock if its future risk-adjusted return warrants it.
Warren Buffett has been mistakenly promoted into deity status in this buy-and-hold temple. Let’s correct this mistake. Warren Buffett became a buy-and-hold investor when his portfolio and positions got big enough, pushing $60 billion, that selling became a difficult undertaking. In his early career, before the “Oracle of Omaha” was his moniker, he was a buy-and-sell investor. Being on the boards of some of his biggest holdings (like Coke and the Washington Post) made selling even more difficult for Buffett.
One doesn’t need the benefit of hindsight to know that at 55 times earnings Coke was tremendously overvalued in 1999. Coke, like the majority of Buffett’s top public holdings (the Post, Procter & Gamble, Johnson & Johnson, and many others), did not go anywhere for a decade. Take a look at his top public holdings and tell me whether he would have done a lot better if he had sold them when they became fully valued. In most cases, that would have been a decade ago.
Emotions assault us from different directions when we face a sell decision: If it is a losing investment, we want to wait to break even. This is the wrong attitude. Our purchase price and our sell decision should not be related . When it comes to selling a winner, on the other hand, we want to sell only at the top. Again, this is the wrong attitude: The top is only apparent in hindsight, when it is usually too late.
We should sell the stock when it reaches our price or valuation target, determined at the time of purchase. We are our biggest enemy when it comes to investing, and especially selling. Cassidy’s wonderful book has been written to fix this. Its objective is to recalibrate your mind and free you from the imprisonment of your past decisions, to break you free from the buy-and-hold state of mind and turn you into a buy-and-sell investor.
It’s a terrific and a very important work. Proper sell discipline makes the difference between great and mediocre returns for even the best-crafted buy decisions. Pros may want to skip a few chapters, but it is an important read for everyone, especially in today’s environment.
Think and behave like an investor
The following books should help you to think like an investor, forcing you to think beyond stock tickers and focus on what is under the hood: the businesses and the people who run them. The first book is The Essays of Warren Buffett, a compilation of Warren Buffett’s annual letters to shareholders dating back to the 1970s. As you might expect, Buffet’s annual reports themselves, are fairly repetitious. His wisdom doesn’t vary that much from year to year. This book organizes main concepts and removes annoying redundancy.
You Can Be a Stock Market Genius by Joel Greenblatt is one of those books that should be read more than once. Greenblatt shares unique approaches to finding undervalued stocks. On top of being a very good investor, Joel has a healthy sense of humor. Joel also has written The Little Book That Beats the Market. At the end of the book, Joel offers a “magic formula,” a screen that has beaten the market over a long period of time. The magic screen is very simple: buy low price-to-earnings stocks that have a high return on capital. Low P/E is an indication of cheapness, while high return on capital is an indication of competitive advantage and the possibility to grow earnings quickly. Here is the book’s Web site, which provides a weekly list of stocks that score high on both measures.
Margin of Safety by Seth Klarman is another gem. Unfortunately, you won’t find this book in book stores. It is out of print, and it occasionally sells on eBay for thousands of dollars. This book lacks Greenblatt’s humor, but it is full of Buffett-like lucidity, and it is a must-read for anyone who is serious about value investing. In fact, even though Joel Greenblatt receives the credit for identifying and popularizing spinoffs as an often-mispriced subset of stocks, Klarman dedicated a good portion of a chapter to spinoffs in his book, which was published eight years earlier than Greenblatt’s.
Klarman talks about how investors’ time horizon has shrunk over the years:
Like dogs chasing their own tails, most institutional investors have become locked into a short- term, relative-performance derby. … The short-term orientation of money managers may be exacerbated by the increasing popularity of pension fund consultants. These consultants evaluate numerous money managers, compare their performances, contrast their investment styles, and then make recommendations to their clients. Because their recommendations can have a significant influence on the health of a money management business, the need to impress pension fund consultants may add to the short-term performance pressures on money managers.
Since Klarman wrote his book in 1991, the investment industry has gotten even worse. The precipitous cost decline of micro processing and color printers’ ink has elevated the influence of consultants over the investment industry to absurd levels. Armed with Modern Portfolio Theory – a Nobel Prize-winning framework, consultants now port alphas and deport betas. Unfortunately, in the process of quantifying the unquantifiable to the precision of a basis point, common sense was lost. Though they hide behind Greek symbols and fancy, colorful presentations, these are the same folks that persuaded their gullible pension fund clients to allocate a greater portion of their assets to “growth” stocks in late 90s, real estate and alphabet soup investments in mid 2000s, and long-term treasuries today. These people are always chasing the latest fad.
In this consultant-infested environment, a long time horizon is a competitive advantage.
The Super Analysts by Andrew Leeming is a book few people may have heard of. The
author interviews successful investors (not academics), and they discuss their approach to investing and their analyses of common stocks and of some specific industries.
Pilgrimage to Warren Buffett’s Omaha by Jeff Matthews is not another biography of Warren Buffett, but rather the most insightful, critical, and balanced analysis of Buffett and Berkshire I’ve ever read. I also encourage you to read Jeff’s musings on his blog; I’ve been reading it for years.
Finally, I also recommend The Little Book That Builds Wealth by Pat Dorsey. Michael Porter wrote Competitive Strategy a few decades ago, and it quite deservingly it turned into a bible of industry analysis that is taught in all business schools and management programs. Pat Dorsey adopted Michael Porter’s concepts into this little book and applied them directly to investing. To be honest, if this book had been out when I was teaching my investment class, I’d be using it instead Porter’s – sorry, Michael!
The right temperament is crucial in investing. Being a critical thinker and knowing how to value stocks is important, but it is all a waste if your emotions get the better of you. The following books will help you to recognize the shortcomings of your hard-wiring and help you to devise strategies to deal with it.
Psychology of Investing, by John R. Nofsinger, is short and to the point. You’ll become an expert on behavioral investing in about an hour. Well, not quite, but close.
Why Smart People Make Big Money Mistakes And How To Correct Them, by Gary Belsky and Thomas Gilovich is a fun and easy read. It also addresses how shortcomings in our wiring affect money decisions, like buying cars and stereos.
The Little Book of Behavioral Investing by James Montier is another good read. James used to be a global equity strategist at SocGen – a large European financial institution. I read his research religiously, the only sell-side research (with the exception of Albert Edwards, who was James’ partner, and Dylan Grice, who took James’ place) that’s worth reading. This book is written for value investors by a value investor who happens to be the leading thinker in behavioral finance. This is the only behavioral investing book that I am aware of that that quotes Ben Graham, Seth Klarman, John Templeton and Warren Buffett throughout the book and synthesizes their lessons with those of behavioral investing.
While the three books above cover many topics in Your Money and Your Brain, by Jason Zweig, Chapter 10 is what makes this book a must-read: it addresses happiness – yes, happiness. Although, as most of us know, money doesn’t buy happiness(unless you are starving or living in a cardboard box), money spent on buying things brings a burst of happiness that quickly fades away. Think of how happy you were on the day you bought your first car. Now fast-forward a few weeks later. The rush almost certainly faded. Money spent on experiences, on the other hand, brings a higher utility of happiness. Recollecting experience brings happiness. ( take a lot of pictures and videos to remember things better.) Zweig also provides a list of things you can do that will make you happy, and none of them require you to spend a penny, which is a big positive in today’s economy.
Though traders and value investors fish in the same pond – the stock market – and may even catch the same fish at times, their approaches and analytical timeframes are diametrically different. Value investing and trading, however, share a common element: Both are done by humans, and thus are affected by emotions. That’s why I also recommend a fictionalized novel that provides a great introspective look inside a trader’s mind and teaches many behavioral and common-sense lessons. Reminiscences of a Stock Operator, written in 1923 by Edwin Lefevre, depicts from a first-person perspective the early years of the great trader Jesse Livermore. It is rumored that this book was actually written by Jesse Livermore and edited by Lefevre. Here is a sampling of the book’s insights:
Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again.
A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip.
The recognition of our own mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a licking, you do not hanker for a second dose, and, of course, all stock-market mistakes wound you in two tender spots—your pocketbook and your vanity.
One of the most helpful things that anybody can learn is to give up trying to catch the last eighth or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.
I’ve read this book a few times, but couple of months ago I was fortunate to read a brand new edition annotated by Jon Markman. Jon’s skillful annotation takes you behind the scenes of the Lefevre’s story and provides important insights into characters and the backdrop of that very interesting time period. Jon’s annotations are almost like a book within a book.
Another good book about Livermore is called Jesse Livermore, by Richard Smitten. Here’s one of its best passages:
After several months of despair, Livermore finally summoned up the courage to analyze his behavior and to isolate what he’d done wrong. He finally had to confront the human side of his personality, his emotions and his feelings. . . . Why had he thrown all his market principles, his trading theories, his hard-earned laws to the wind? His wild behavior had crashed him financially and spiritually. Why had he done it? He finally realized it was his vanity, his ego. . . . The outstanding success of making more than $1 million in one day had shaken him to his foundations. It was not that he could not deal with failure—he had been dealing with failure all his life—what he could not deal with was success.
The Big Shortby Michael Lewis. Michael Lewis is one of the best story-tellers Wall Street ever produced. So you would expect from the author of “Liar’s Poker” a fun, well written book that tells you how Wall Street machine does what it does best: taking an average-size bubble and making it enormous. No surprise there. But this is not just another “how Wall Street screwed everyone” book.
Lewis tells a story of a few brave investors who shorted subprime mortgages at the height of the real estate bubble. From today’s perch, it seems like a no-brainer trade after all, we are blessed with the wonderful benefit of hindsight. But Lewis sets aside this hindsight, delves into guts of Wall Street in the midst of the housing bubble, and shows the emotional rollercoaster his heroes went through before they were proven right. This book teaches a valuable lesson about the difficulty, frustrations and rewards of being a contrarian, a tiny minority daring to contradict 99% of investors. This book reinforces that when you make a contrarian bet, you better do your own research, otherwise the pressure of the crowd will overwhelm you. Be prepared to be “wrong” for longer than you rationally expect; make sure your investors will stick around long enough to allow you be proven right; and finally, have a support system – a few friends and colleagues who will provide vital emotional support.
Politicians, God rest their souls, always try to appeal to the lowest common denominator. They try to “protect” us from evildoers by insisting on minimum-wage laws or rent controls, or by threatening windfall taxes on oil companies. They paint themselves as heroes fighting for the little guy against the evil-doers. All they are doing, however, is feeding on the economic illiteracy of the average Joe. Given this reality, the following books should be required reading in high schools and colleges: Basic Economics by Thomas Sowell and A World of Wealth by Thomas G. Donlan. Another excellent book is economic romance – Invisible Heart by Russell Roberts. No I did not go soft on you here, in fact I have to admit, the “romance” part of this novel did not appeal to my sentimental senses, but the discussion about capitalism and free markets is Milton Friedman worthy.
Atlas Shrugged by Ayn Rand is a novel, not an economic tome, but it accomplishes a lot more than most economics books ever do. It vividly illustrates what happens to the economy when the invisible hand of capitalism is replaced by the “fair” and “compassionate” hand of socialism: The economy collapses.
Ayn Rand immigrated to the US from Russia in 1925 when she was 20, when her father’s business was seized by the Russian government, ostensibly for the greater good. I left Russia 66 years later, a decade after Rand died, and my family suffered a lot less than hers. However, we (as well as millions of thinking Russians) both saw the ugly consequences of socialism.
In Atlas Shrugged, Ayn Rand defines her individualist philosophy. Individualism is not a politically correct term in our society. One doesn’t make a lot of friends by advertising his selfishness and greed. So call it anti-collectivism, where independence, self-reliance, and individual pursuit of happiness are superior goals, as opposed to collectivism, where the pursuit of communal and national goals is often undertaken at the expense of individual liberty.
According to Jennifer Burns, who published Ayn Rand’s biography, Rand’s popularity surges during every political cycle when the merits of our political system are being debated. To paraphrase Winston Churchill : “Capitalism is the worst of all possible economic systems, with the exception of all the others.” I hope we only see the alternative system to capitalism – a compassionate socialism that is often offered to us as an alternative to our dispassionate system – only in the pages of Atlas Shrugged.
You may think Alan Greenspan had a hand in today’s crisis. I know I do. He took interest rates down to incredibly low levels and kept them there for too long, causing the real estate bubble. He also did not think Wall Street needed regulation. But that doesn’t make his book, The Age of Turbulence, any less of an excellent read. It is not written in Fed-speak. It seems that Sir Alan, after he left the Fed, learned how to use English in a very clear and engaging way. This is not just another autobiography, either. The book goes far beyond that. It covers the workings of the Fed, lessons on macroeconomics and history, and relays Greenspan’s unique perspective on American politics as an insider who served under or worked with the last eight presidents.
Stock Market History
I’ve really enjoyed reading Stocks for the Long Run by Jeremy Siegel, but it took me a while to recognize how dangerous this book is.
It is well written and provides a good overview of the performance of different asset classes over last two centuries. But the book needs a different title, maybe something like “Stocks for the Really, Really… Really Long Run.” That way, it would not lure investors into a false sense of security when it comes to stocks. Probably unintentionally, Siegel’s book preaches that the stock market is always a buy, no matter what valuations are, and that a 7% real rate of return is a birthright for stock investors, no matter if the stock market is extremely cheap or ridiculously expensive. This is very true if your time horizon is 30 years or you plan to live forever. It is also true if you can tolerate seeing your portfolio go nowhere for a decade or longer. Unfortunately, most of us don’t have that idealized time horizon. We need to pay for our children’s educations, weddings, boats, etc. I don’t know anyone who has the patience to see their portfolio of stocks do nothing for decades.
That is why Siegel’s book should only be read alongside the following antidote: Unexpected Returns, which is a truly terrific book by Ed Easterling. Unlike Siegel, Easterling shows that even though stocks are a great investment for the (really, really) long run, they have periods when their returns are unspectacular. Ed calls these periods bear markets. I call them range-bound or sideways markets, which is just a difference in semantics. Those bear (sideways) markets take place after secular bull markets.
What is the appropriate way to look at risk?
Fooled by Randomness is my favorite nonfiction book, period. I’ve read it at least five times. This book turns upside down the way we are taught to look at risk. Nassim rebels against the current establishment of finance that measures risk with elegant formulas that receive Nobel Prizes but lack common sense.
Any model that solely focuses on past observations and dismisses outcomes that lie outside of what happened in the past is worthless and dangerous. One way of understanding how randomness works is by studying alternative historical paths. This means more than just focusing on what took place in the past. Observed history was actually just one of many possible outcomes. One should focus on what could have taken place, what alternative paths might have existed. With that added insight, we can then predict and prepare for what might happen in the future.
Let’s take the current crisis: Wall Street and the rating agencies dismissed the possibility that housing prices might decline nationwide. That hadn’t happened since World War II, and everyone assumed that meant it wouldn’t happen in the future. On that leap of faith, Wall Street took subprime (risky) mortgages originated in different parts of the country, lumped them together in mortgaged-backed securities, and – voila! – declared the risk to be diversified away. Junk was turned to gold. Since rating agencies used the same underlying assumption – housing never declines nationwide – they announced to the world that the junk was AAA and should be bought in truckloads – and it was. We know how this story ended.
The Black Swan is a follow-up to Fooled by Randomness. Nassim takes a lot of the concepts discussed in Fooled by Randomness and explains them in greater detail, providing new and unexpected insights. I have to warn you that The Black Swan is not an easy read. This book, which has more insights per page than most, is not a beach read. If you’re looking for a Cliff’s Notes version, in this lecture Nassim covers major concepts described in both books in great detail.
In the second edition of The Black Swan, Nassim added a section that talks about how Mother Nature deals with black swans through redundancies. One way to avoid catastrophic failure is spare parts – we get two lungs, two eyes, and two kidneys, and each has more capacity than we ordinarily need. Taleb writes:
“An economist would find it inefficient to maintain two lungs and two kidneys: Consider the costs involved in transporting these heavy items across the savannah. … Also, consider if we gave Mother Nature to the economists, it would dispense with individual kidneys: since we don’t need them all the time, it would be more “efficient” if we sold ours and used a central kidney on a time-sharing basis.”
This reconfirms of why I’d like to own stocks with “sub-optimized”, debt-light (cash rich) balance sheets, as Taleb eloquently puts it “Debt implies a strong statement about the future, and a high degree of reliance on forecasts”.
Books for the Soul
What would you do and what would you share with others if you only had months to live? This is the theme of the following two books: Tuesdays with Morrie by Mitch Albom and The Last Lecture by Randy Pausch and Jeffrey Zaslow. In both books, terminally ill teachers share their life lessons with readers. Pausch, who sadly passed away last year, also gave this great lecture on time management; and here is his last lecture.
Another book I’ll add to this category is The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This is an authorized biography of Warren Buffett. I am not sure this is the best book to read if you want to learn to invest like Mr. Buffett, but it gives a fascinating view of his life. There are many great lessons we can learn from Mr. Buffett that go far beyond investing, for example about honesty and treasuring one’s reputation. But I thought this book was important for a very different reason: It shows that Warren Buffett is not a perfect human being and that we can also learn from the maestro by not repeating his mistakes. He achieved his unparalleled success in his business life at the expense of his personal life.
I find myself wanting to work 24/7. I bring my laptop home, or start reading The Wall Street Journal on iPad at the dinner table – my work life starts pushing out my personal life. This book made me realize that no professional success is worth regretting 20 years down the road that you didn’t spend enough time with your kids. Unfortunately, Buffett has that regret.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or you can read them on ContrarianEdge.com.
Copyright Vitaliy N. Katsenelson 2010. This article may be republished only in its entirety and without modifications.