Against The Gods The Remarkable Story Of Risk By Peter L. Bernstein

Against The Gods by Peter Bernstein is a wonderful, historical account of mankind’s intellectual understanding of risk. The book follows the intellectual development of risk management and how people throughout the centuries have changed their views of what constitutes risk and how investment risk can be mitigated.

Anyone who likes the history of mathematics or investment will probably enjoy this book. It is scholarly, but also fun-to-read and interesting. It will help investors think about how they, themselves, interpret “risk.” And, it gives us insight into how some of the world’s greatest minds have viewed risk.

The book’s cover is a reproduction of Rembrandt’s Storm on the Sea of Galilee, which depicts a group of people fighting to maintain control of their sailing ship (or, just trying to hang on!) while their craft is tossed about by the storm.

Long ago, people felt they were at the mercy of arbitrary gods or forces, which could act at whim, either to support a person or defeat him. The gods played dice with us mere mortals. So, there was no point in contemplating risk management. Just as the storm tosses the wooden ship about, so, too, would our lives and destinies be determined by fate.

Of course, people of ancient times played games of chance and wagered. But, it was not until years later that many thinkers, philosophers, mathematicians, and merchants realized that the study of simple children’s games offered great lessons for adults-especially relating to financial decision making.

People learned that they could evaluate risk and take steps to mitigate it. They no longer were at the mercy of the gods. They could control their own fate. They could minimize risk in their endeavors. They could evaluate probabilities and chance.

Against The Gods tells us many stories. One of my favorites is the story of a coffeehouse opened by Edward Lloyd in 1687 where merchant sailors met to discuss colonial trade and seafaring issues. The chance of any given vessel going down in a storm was not great, but it did happen. And, if it did, it could wipe out a trader financially.

So the traders began contributing small sums of money to be paid to a member who lost a ship. The merchants benefited from the deal. In all likelihood, their ship did return safely. In that case, they were out only a small portion of the profit the ship earned on the journey. But, if the unfortunate happened, and the ship was lost at sea, they remained solvent. They recovered the financial loss of their ship from the pool of money. The merchants learned to protect themselves from the volatility of negative events.

Soon people specialized in the business of pooling money to protect against misfortune. They became known as underwriters. The insurance industry was born. And, the coffeehouse evolved into Lloyd’s of London, one of the pioneer insurance companies.

Bernstein tells how farmers, who were previously helpless against uncertain market prices for their crops, learned to mitigate risk by entering into contracts with food producers, who agreed to buy their crops at a fixed price in the future, regardless of the future open market price of the crops.

If the future market price of the crops were significantly less, the farmer was protected from the danger of having produced crops with no or low market value. Of course, if the market value of the crops rose, the farmer would not receive the extra benefit, as he had agreed to sell them at the lower price.

Similarly, the food producer is protected against a significant increase in prices. Overall, such contracts lower price volatility and risk to both farmers and food producers. Both parties benefit. The concept of a futures contract was born.

Many stories later, Bernstein tells us of Black and Scholes who developed a mathematical model of options’ pricing. Rejected by the editors of prestigious financial journals, who only published papers from authors with Ph.D’s, eventually the paper was published and went on to become “one of the most influential pieces of research ever published in the field of economics or finance.” Uncertainty, itself, could now be valued.

Bernstein writes:

“Options bear a strong family resemblance to insurance policies and are often bought and sold for the same reasons. Indeed, if insurance policies were converted into marketable securities, they would be priced in the marketplace exactly as options are priced. During the time period covered by the premium payment, the buyer of an insurance policy has the right to put something to the insurance company at a prearranged price-his burned-down house, destroyed car, medical bills, even his dead body-in return for which the insurance company is obliged to pay over to him the agreed-upon value of the loss he has sustained….”

Later, in an attempt to reduce stock portfolio volatility, Bernstein tells us the story of how “portfolio insurance” came to be and how and why it failed.

Some of the academic studies are downright funny in their classification of the obvious. For example, the “endowment effect” which states that people tend “to set a higher selling price on what we own (are endowed with) than what we would pay for the identical item if we did not own it.”

For example, when you were a kid and another kid wanted to buy a candy bar of yours, you asked $5. When you wished to buy one, you offered five cents. That’s called “Greed.” Whatever you want to call it, it’s discussed in Against The Gods.

Bernstein writes:

“Why corporations pay dividends has puzzled economists for a long time. … From 1959 to 1994, individuals received $2.2 trillion of the dividends distributed by all corporations, financial as well as nonfinancial and incurred an income-tax liability on every dollar of that money. If corporations had used that money to repurchase outstanding shares in the open market instead of distributing it in dividends, earnings per share would have been larger, the number of outstanding shares would have been smaller, and the price of the shares would have been higher. The remaining stockholders could have enjoyed “home-made” dividends by selling off their appreciated shares to finance their consumption and would have paid a lower tax rate on capital gains that prevailed during most of the period. On balance, stockholders would have been wealthier than they had been.”

To explain this, Bernstein discusses behavioral finance, saying investors psychologically divide their money into two pots. One pot for spending. One pot for saving. Selling shares for consumption could injure the psyche.

While it is true that dividends are a very-heavily-taxed way for a large corporation to reward its shareholders, I’m a big fan of dividends for consumption, rather than selling shares. Always willing to unpuzzle economists.

I found Against The Gods by Peter Bernstein to be excellent reading, which I highly recommend to all serious investors. I found myself not only reading, but rereading this top-notch work.

 

Common Stocks and Uncommon Profits by Philip Fisher

Common Stocks and Uncommon Profits is one of the classic investment texts written for the lay person. The legendary investor, Warren Buffett, has credited Philip Fisher’s investment strategy as strongly influencing him.

Rather than just seeking value, as the Ben Graham school of investment taught, Fisher realized that even a greatly “undervalued” company could prove a horrible investment. Sure, you might occasionally buy a stock for less than the company’s cash-in-the-bank (back then, at least!). But what if the business is horribly run? It might not take long for the company to lose all that cash!

Even if the company returns to “fair” value, that ends the potential profit from investing in such a business. Holding an average company, because it was once undervalued, but is no more, makes little sense.

Fisher points out that the largest wealth via investing has been made in one of two ways. First, buying stocks when the markets crash and holding them until the markets recover. Secondly, with less risk and more potential return, you can also just invest in a small portfolio of companies which continue to strongly grow sales and earnings over the years. Then, if the company was correctly selected, you might never have to sell, while accruing a huge return on your initial investment.

Fisher pioneered the school of growth stock investing. In Common Stocks and Uncommon Profits, Fisher explains how he selects a growth company. He lists fifteen points which a company must have to be considered a superior investment.

Fisher’s first point seems obvious: “Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?”

Fisher shows that some companies might have potential substantial sales increases for only a few years, but after that have limited potential due to some factor, such as market saturation. For example, Fisher mentions the growth in sales of TV’s until the U.S. market was saturated.

He also wisely suggests looking behind the products to seek other superior investments. While many TV manufacturers were competitive and it was difficult to tell which was best, Fisher points out that Corning Glass Works was, by far, the company most capable of producing the glass bulbs used in TVs.

Fisher tries to clearly distinguish between companies which are “fortunate and able” and those which are “fortunate because they are able.” The second kind, the superior investments, are highly innovative and create new products which have growth potential. Fisher uses Dow Chemical as one example of a “fortunate because they are able” company.

The second point wants to know if management has the drive to innovate new products. A man ahead of his time, Fisher wonders about how much of a company’s future sales might come from products not yet invented.

A constant theme of Common Stocks and Uncommon Profits is examining what the company is doing to prepare for the future. Is the company spending wisely on Research and Development? Or, is the company just trying to maximize its current profit and reinvesting nothing for future growth?

Fisher explains why answering that question is difficult in practice. What different companies account for under R&D is one problem. Another is that some companies are more successful than others at turning money spent on R&D into future marketable products. Today, we must assume this question is far more difficult to answer!

In addition to questioning a company’s R&D, Fisher wants to see a company with a strong sales organization and distribution efficiency. “It is the making of a sale that is the most basic single activity of any business,” he writes.

Yet, why don’t investors focus upon such key factors instrumental to a company’s future growth? Fisher points out that certain issues are not quantifiable. That is why many investors tend to focus upon financial issues which can be expressed in a simple ratio.

How does the investor go about answering the “unquantifiable”? How does the investor know how well-managed the company is? Or, how does one evaluate the people factors, which Fisher says are the real strength of a superior growth company?

Fisher suggests the “scuttlebutt” method. This involves talking to suppliers, customers, company employees, and people knowledgeable in the industry, and, eventually, company management. From this information, an investor can get a good feel for the quality of the company as a growth investment. Fisher teaches us how to learn to ask the correct, company-specific questions.

Fisher acknowledges the “scuttlebutt” method is a lot of work. But, he asks, should it be easy to find such great companies, when finding only a few can easily lay the foundation for building huge future wealth?

I tend to think the average individual investor will not use the “scuttlebutt” method. And, for most investors and most companies, even if the investor had the desire to use this method, it would not be practical.

The average investor will not have access to all the people with whom Fisher suggests talking. Imagine trying to use this method on a larger company with tens of thousands of employees worldwide. What is said about the company in one area may differ greatly from what is believed about the company in another region. Applying such a method to evaluate a large, innovative company, such as 3M, for example, seems utterly impossible.

Yet, for investors seeking to make investments in smaller, local companies, the “scuttlebutt” method might be of value. For angel investors or mini-venture capitalists, readingCommon Stocks and Uncommon Profits is probably also worthwhile. However, Fisher is quick to point out that such company evaluation is far more tenuous when the company hasn’t any history behind it.

Entrepreneurs seeking to build companies should also give the book a quick read. The fifteen points are very important to company growth and success. And, encouraging these strengths from the perspective of a company’s CEO trying to build the company is far easier than seeking to answer these questions from the perspective of an investor who is a company outsider!

Common Stocks and Uncommon Profits also has an excellent chapter titled, “Hullabaloo About Dividends” which tells us investing in growth stocks with smaller dividend payout ratios often leads to greater total future dividends because the dividends are growing, while high-yielding stock tends to grow far less, and hence, the dividends grow far less.

The book also has some excellent thoughts about buying-and-holding a stock and when to sell a stock. Fisher’s thoughts on diversification are also well worth reading, although I would recommend more diversification than Fisher claims is adequate.

Overall, this is a great book for the individual investor. You will not be able to follow the “scuttlebutt” method in practice, for most investments, and, maybe, the complexity of today’s companies and scientific research in many growth companies make Fisher’s method less practical today than in the past, but there is much to learn about business and investing from this book.

Financial Shenanigans How To Detect Accounting Gimmicks & Fraud In Financial Reports By Howard M. Schilit

Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud In Financial Reports by Howard M. Schilit should be read by all serious, long-term, stock investors.

Schilit writes: “Financial shenanigans are actions or omissions intended to hide or distort the real financial performance or financial condition of an entity. They range from minor deceptions (such as failing to clearly segregate operating from nonoperating gains and losses) to more serious misapplications of accounting principles (such as failing to write off worthless assets; they also include fraudulent behavior, such as the recording of fictitious revenue to overstate the real financial performance). Since management is clever about hiding its tricks, investors and others must be alert for signs of shenanigans.”

Schilit goes on to discuss a wide range of financial shenanigans which devalue the investment worth of a company. The shenanigans range from “recording revenue when important uncertainties exist” to “failing to accrue expected or contingent liabilities.”

Each financial shenanigan is discussed in detail, and a real-world example of a public company affected by the shenanigan is given. Stock-versus-price charts are also given to show the stock-price behavior of the company’s stock following the disclosure of the shenanigan (usually the stock price drops like a rock after accounting trickery is discovered).

For example, Tie Communications stock fell from a high of $40.38 per share in 1983 (five years after going IPO) to a low of $0.31 per share by 1990. The 1983 stated profits of the company were “given a shot in the arm by the sale of some investments at a substantial gain….” Schilit goes on to explain that some companies use the sale of appreciated assets to hide losses from normal business operations and make the company appear more profitable than it really is.

Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud In Financial Reports is very easy to read, unlike many books which deal with the topic of accounting. Investors will read through this book rather quickly and that is a tribute to Schilit’s writing. Yet, most investors will learn a great deal about financial reporting. Most importantly, readers will learn how to protect themselves as investors.

In addition to shenanigan busting, Schilit gives an excellent tutorial to help readers understand the basics of financial reporting and accounting. Plus, he does an excellent job of pointing out the logic of sound financial reporting.

For example, Schilit writes various “guiding principles” throughout the book to help the reader, such as “Guiding Principle: An enterprise should capitalize costs incurred that produce a future benefit and expense those that produce no such benefit.”

Schilit explains that capitalizing costs which have no future benefit is one way to enhance current earnings at the expense of future earnings. Shilit discusses De Laurentiis Entertainment, a producer and distributor of motion pictures, as an example. In 1987, the SEC charged Laurentiis Entertainment with improperly capitalizing expenses which should have been charged against current earnings. Schilit’s stock chart shows that shares of DEG fell from a high of $19.25 in 1986 to a low of $0.06 in 1989.

Serious, long-term investors don’t want to hold stock in companies such as De Laurentiis Entertainment in 1987 and Tie Communications in 1983. Schilit gives a list of fifty-two techniques to help the investor spot financial shenanigans in advance when evaluating a company for investment.

These techniques range from looking for management incentives which encourage false reporting, to not being fooled by profits enhanced by retiring debt, to watching for worthless investments the company is making. Examining these factors together should help the investor evaluate the overall honesty and viability of the company long-term. The investor will gain insight as to whether the company is being conservative in its accounting or being too aggressive in its accounting.

I highly recommend Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud In Financial Reports to all investors who buy individual stocks and who focus upon buying solid businesses. The book will help weed out the businesses which are only reporting “accounting” profits for the temporary benefit of management.

 

Book : The Little Book That Builds The Wealth

 Chapter 1

In the opening chapter, justification is presented for why the identification of moats is important. Just as a longer lasting appliance is more valuable than one that breaks down soon after purchase, so too is a company with a moat more valuable than one without.

Companies with moats generate economic profits (as measured by returns on capital or excess returns on capital) for longer stretches than those without moats. For example, consider tow companies with identical financials, but where one has a moat and the other doesn’t. The company without the moat will see their financials erode over time as competition challenges their market position, whereas the company with the moat will keep on earning strong returns.

Investors must therefore learn to recognize and understand moats so they can avoid the erosion of capital that can occur when investing in a company that sees its financials deteriorate because it has no moat.

 Chapter 2

This chapter is about some pitfalls investors fall into when trying to identify moats. Not all examples of high market share and strong returns on capital are signs of a moat! Investors must be able to recognize the difference.

For example, Chrysler practically had a license to print money when it came out with the minivan in the 1980s. But there was no structural characteristic that kept competitors from coming out with “me too” products that eroded Chrysler’s profits.

Commodity products are another example of this. A supply/demand imbalance can make commodity producers look like “moat” companies for a while, but the lack of moat makes profit margin erosion likely. The author describes the relatively short boom and bust period for the ethanol production industry as an example.

Management effectiveness can also fool investors into believing a company has a moat. But one can’t predict how long a manager will stay at the helm. Absent a competitive advantage, a company will revert to being an average performer eventually if it has no moat.

Any time a company does not have a structural advantage, profitability is bound to be eroded. In the next four chapters, Dorsey describes the four categories of competitive advantage that investors should look for to help them find companies with moats.

Chapter 3

Intangible assets are the first of the four sources of competitive advantage that Dorsey argues investors should look for. Such assets include items such as brands, patents and regulatory licenses that can’t be physically touched, but that are valuable nevertheless. But this is a challenging category to understand and excel in. Brands can lose their luster, patents expire and can be challenged, and government licenses can be revoked at any time.

First, it’s important to realize that a brand only creates a moat if it increases the customer’s willingness to pay or increases captivity. After all, brands are expensive to maintain (requiring investments in marketing etc). Sony is an example of a brand without a moat, as most buyers compare their electronics purchases on price and features. But Tiffany is an example of a firm with a brand, as Tiffany can sell the exact same rock as another jeweler, but for a significantly higher price.

Patents also confer an advantage, but the sustainability of a competitive advantage based on patents is hard to predict. A firm that is successful based only on a few patents faces a high risk that competitors will challenge those patents, and/or the company will suffer when the patents expire. The only time patents represent a truly sustainable advantage is when the firm has a proven ability to innovate and constantly build upon its patent portfolio

Chapter 4

This chapter is about the second category of competitive advantage: switching costs. When switching costs are high, firms are able to charge existing customers a little bit more than they otherwise could, and this often leads to strong returns on capital.

Switching costs come in a variety of flavours, from tight integration with a customer’s business to high retraining costs. Dorsey uses a multitude of examples to illustrate how prevalent high switching costs are.

For example, deposit account turnover rates at US banks are just 15%. Not only does it take a chunk of time for a customer to switch accounts to a competing bank, but there is the added stress of a potential missed bill payment or absent pay-cheque as a result of the switch, keeping most customers locked in with their bank.

Some individual examples are cited, including Intuit, with its QuickBooks software. While strong competitors such as Microsoft may try to erode its space, the competition is mostly unsuccessful, as a business that has already entered its data into QuickBooks is unlikely to be willing to change to a competing software program unless there is a very compelling reason.

Oracle databases don’t just lock in data but also customers. To switch out of Oracle, not only would a customer have to incur the expense of moving all of the data itself into a competing database, but also alter all of the software programs (e.g. web programs) that access these databases.

One group of industries noticeably absent from the discussion on switching costs are consumer-oriented segments such as retailers and restaurants. This is because it’s very easy for a consumer to shop for clothes at a different store or drive a few miles to save a few cents a gallon on gas.

Chapter 5

This chapter is about the network effect. Some products or services increase with the number of users. It’s a simple concept, but rare and powerful. Dorsey argues that only 2 companies in the Dow 30 benefit from network effects, but this advantage propels them to high returns on capital.

Dorsey introduces the concept of nonrival goods; that is, goods that can be used by more than one person at a time. For example, you can only use one tractor at a time, but you can use a Windows program at the same time as someone else. It is these kinds of goods/services that enable network effects.

Again a number of examples are offered to illustrate this advantage. American Express has millions of merchants supporting its card-paying system, which encourages more card holders, which encourages more merchants to become Amex customers. Microsoft’s Windows and Office user bases make it difficult for a competing program, even if it offers better features, to compete. Who wants to produce document files and PC programs that Office and Windows users can’t use? eBay, several exchanges, and Western Union are also examined for their network effects and their vulnerabilities

Chapter 6

Cost advantages are explored in this chapter. Cost advantages can come from cheaper processes, better locations, unique assets and greater scale. The next chapter is devoted to the important scale advantage, while this chapter focuses on the first three cost cost advantages.

In theory, process advantages shouldn’t exist for long, as competition should figure out ways to copy incumbents. But in practice these advantages can last a long time. Dell (with PCs) and Southwest Airlines are examined to understand why competition was unable to replicate their efficient processes for many years.

Location-based advantages are more durable than process-based ones because locations are much more difficult to duplicate. This can occur frequently in commodity-based businesses, where transportation costs are high relative to product costs.

Finally, unique assets are a catch-all category. An example of a unique asset providing a cost advantage is an easy-to-extract-from (relative to the competition) oil resource.

Chapter 7

This chapter is about the powerful scale advantage. When considering this advantage, it’s important to evaluate a firm’s size relative to the competition. Scale advantages occur most when fixed costs (vs variable costs) form a larger part of an industry’s cost structure.

To illustrate this advantage, Dorsey describes the trucking industry. The cost of trucks and the salaries of drivers and the fuel required for a particular trip can be seen as fixed costs. The company that has more customers along the route, however, can spread these large fixed costs across higher revenues, thus benefiting from a competitive advantage.

A number of examples are described to illustrate this advantage in action. Darden supplies 650 restaurants with fresh seafood at lower costs because of the number of locations it services; Stericycle collects and disposes of medical waste, and is 15 times larger than its nearest competitor; Sysco, Fastenal, Coke, Pepsi and Diageo all benefit from strong distributor networks that lower costs.

Chapter 8

Moats don’t last forever. NYSE specialists, Kodak, and newspaper companies all had moats at one time, but no longer do. This chapter is about how to get an early read on a weakening competitive advantage.

The author gives a number of examples of companies that lost their moat, describing why this occurred and therefore what early warning signs investors should look out for. This includes technological change, the concentration of a customer base (e.g. consumer product companies faced with consolidating and therefore large retailers), and growth into areas where a company does not have a competitive advantag

Chapter 9

Convinced that you should be investing in moats in order to generate a strong return with low risk? If so, you will need to know how to find companies with moats, and that’s what this chapter is about.

The first thing to realize is that not all industries are created equal; some are more conducive to having companies with moats than others. Dorsey cites the asset management industry as one where moats are easy to find, but the auto parts industry as one that is not conducive to moats.

Similarly, Dorsey argues that software firms tend to have moats where hardware firms don’t, as software has to be integrated with other pieces of software, leading to high switching costs. Many moats exist in telecom, where favourable regulatory structures (outside the US) or niche markets protect incumbents.

Dorsey goes on to describe the economics (and moat potential) of a number of industries including restaurants, retail, b2b, industrial, utilities and more. Once you think you have found a company with a moat, check its historical returns using ROIC, ROA and ROE to see if the numbers bear out your thesis.

 Chapter 10

It’s important to distinguish between companies that derive strong returns because of their managements and those that do so because of they have economics moats. When it comes to companies with economic moats, managements don’t matter as much as you may think. Competitive advantages are rooted in structural characteristics that can’t be altered much in the near-term.

The author quotes Buffett: “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Dorsey’s advice is clear: bet on the horse, not the jockey. A wide-moat company managed by a mediocre manager will generate better returns on average than a no-moat company managed by a superstar.

 Chapter 11

Dorsey now brings it all together in this chapter, taking the reader through the multi-step process of determining whether a company has a moat. First, he looks for returns on capital; if a company hasn’t proven it has a moat with strong returns, you probably don’t want to pin your hopes on it.

Second, he tries to identify the moat, and determine whether it will continue or is subject to erosion. Finally, he attempts to ascertain how strong the moat is and whether it is likely to last a long or short time.

After discussions of each company, Dorsey concludes that Deere, Arch Coal, and Fastenal have moats (of varying degree, however) while Martha Stewart Omnimedia, Hot Topic and Pier 1 do not.

Chapter 12

Though a great deal of emphasis has been placed thus far on identifying companies with moats, investing is not as simple as buying the companies with the largest moats. This is because the price you pay for a stock is critically important to your future investment returns.

Valuing a company is difficult, as a company’s value is tied directly to its future economic performance, which is unknowable! Instead of figuring out what a company is worth exactly, therefore, Dorsey argues that all that is required is determining that the company is trading for less than what it’s worth.

To do this, Dorsey recommends estimating the company’s current free cash flow and reverse-engineering the growth rate the market is implying for the company based on the company’s market price. If your growth rate estimate is larger than that of the market, it may make sense to buy.

Chapter 13

The author discusses more valuation tools to help the investor determine if a company is undervalued. Dorsey first discusses the price to sales ratio, but warns investors to avoid making comparisons between firms in different industries, as margins can vary substantially by industry.

The second tool Dorsey recommends is the price to book ratio. But it’s important to understand the nature of the assets that make up book value. Specialized equipment or intangibles may have no redeeming value, whereas brand names that aren’t included in book value may. Nevertheless, book value may have a lot of meaning for financial or real estate firms, for example.

Finally, Dorsey concludes this chapter by introducing the price to earnings and price to cash flow ratios. However, readers are warned that earnings and cash flow can be volatile from year to year, and therefore investors should look at a number of years worth of data in order to estimate what the company is likely to be able to earn in the future.

Chapter 14

In this the final chapter, Dorsey tackles the difficult subject of when to sell. Dorsey argues that there are only four right reasons to sell. Before you sell, the answer to one of the following questions must be a yes:

1) Did you make a mistake?
2) Has the company changed for the worse?
3) Is there a better place for your money?
4) Has the stock become too large a portion of your portfolio?

Unfortunately, we anchor ourselves to price and have a hard time selling at a loss even when it may be justifiable (based on the questions above) to sell. The author suggests a way to avoid anchoring: when you buy a stock, write down the reasons you bought it. If the company takes a turn for the worse, pull out your reasons and see if your reasons for buying are still intact.

Finally, avoid selling simply for price. Just because a stock has dropped does not mean you should sell!

Checklist Charlie Munger

These principles can further be condensed into four most basic guiding principles of life and investing –Preparation. Discipline. Patience. Decisiveness.

These principles cannot be prioritized in terms of any importance. Rather, together, they make up a sensible, thinking, and disciplined investor’s mental toolkit.

Munger’s Investing Principles Checklist
1. Risk – All investment evaluations should begin by measuring risk, especially reputational.

• Incorporate an appropriate margin of safety
• Avoid dealing with people of questionable character
• Insist upon proper compensation for risk assumed
• Always beware of inflation and interest rate exposures
• Avoid big mistakes; shun permanent capital loss

2. Independence – “Only in fairy tales are emperors told they are naked.”

• Objectivity and rationality require independence of thought
• Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
• Mimicking the herd invites regression to the mean (merely average performance)

3. Preparation – “The only way to win is to work, work, work, work, and hope to have a few insights.”

• Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
• More important than the will to win is the will to prepare
• Develop fluency in mental models from the major academic disciplines
• If you want to get smart, the question you have to keep asking is “why, why, why?”

4. Intellectual humility – Acknowledging what you don’t know is the dawning of wisdom.

• Stay within a well-defined circle of competence
• Identify and reconcile disconfirming evidence
• Resist the craving for false precision, false certainties, etc.
• Above all, never fool yourself, and remember that you are the easiest person to fool
• “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”

5. Analytic rigor – Use of the scientific method and effective checklists minimizes errors and omissions.

• Determine value apart from price; progress apart from activity; wealth apart from size
• It is better to remember the obvious than to grasp the esoteric
• Be a business analyst, not a market, macroeconomic, or security analyst
• Consider totality of risk and effect; look always at potential second order and higher level impacts
• Think forwards and backwards – Invert, always invert

6. Allocation – Proper allocation of capital is an investor’s number one job.

• Remember that highest and best use is always measured by the next best use (opportunity cost)
• Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
• Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven

7. Patience – Resist the natural human bias to act.

• “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
• Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
• Be alert for the arrival of luck
• Enjoy the process along with the proceeds, because the process is where you live

8. Decisiveness – When proper circumstances present themselves, act with decisiveness and conviction.

• Be fearful when others are greedy, and greedy when others are fearful
• Opportunity doesn’t come often, so seize it when it comes
• Opportunity meeting the prepared mind; that’s the game

9. Change – Live with change and accept unremovable complexity.

• Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
• Continually challenge and willingly amend your “best-loved ideas”
• Recognize reality even when you don’t like it – especially when you don’t like it

10. Focus – Keep things simple and remember what you set out to do.

• Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
• Guard against the effects of hubris (arrogance) and boredom
• Don’t overlook the obvious by drowning in minutiae (the small details)
• Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
• Face your big troubles; don’t sweep them under the rug

In the end, it comes down to Munger’s most basic guiding principles, his fundamental philosophy of life:Preparation. Discipline. Patience. Decisiveness.