Just finished Better Than You Know by @mjmauboussin. Definitely one of the best books I have read thus far on investing. FWIW, sharing my highlights.
(1) Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.
(2) I defined variant perception as holding a well-founded view that was meaningfully different from market consensus.... Understanding market expectation was at least as important as, and often different from, the fundamental knowledge.
(3) A thoughtful investment process contemplates both probability and payoffs and carefully considers where the consensus—as revealed by a price—may be wrong.
(4/1) The only certainty is that there is no certainty. This principle is especially true for the investment industry, which deals largely with uncertainty. In contrast, the casino business deals largely with risk. With both uncertainty and risk, outcomes are unknown.
(4/2) But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky.
(5/1) People are too confident in their own abilities and predictions. As a result, they tend to project outcome ranges that are too narrow. Over the past 80 yrs alone, the US has seen a depression, multiple wars, an energy crisis, and a major terrorist attack.
(5/2) None of these outcomes were widely anticipated. Investors need to train themselves to consider a sufficiently wide range of outcomes. One way to do this is to pay attention to the leading indicators of “inevitable surprises.”
(6) Decisions are a matter of weighing probabilities. We’ll take the liberty of extending Rubin’s point to balancing the probability of an outcome (frequency) with the outcome’s payoff (magnitude). Probabilities alone are insufficient when payoffs are skewed.
(7) the frequency of correctness does not matter; it is the magnitude of correctness that matters
(8) smarts and talent are like a motor’s horsepower, but that the motor’s output depends on rationality. “A lot of people start out with a 400-hp motor but only get 100 hp of output,” he [Warren Buffett] said. “It’s way better to have a 200-hp motor and get it all into output.”
(9) a horse with a 50 percent probability of winning can be either a good or bad bet based on the payoff, and the same holds true of a 10-to-1 shot. [...] it is not the frequency of winning that matters, but the frequency times the magnitude of the payoff
(10) focus not on the frequency of correctness but on the magnitude of correctness
(11/1) Focus. Professional gamblers do not play a multitude of games—they don’t stroll into a casino and play a little blackjack, a little craps, spend a little time on the slot machine. They focus on a specific game and learn the ins and outs.
(11/2) Similarly, most investors must define a circle of competence—areas of relative expertise. Seeking a competitive edge across a spectrum of industries and companies is a challenge, to say the least. Most great investors stick to their circle of competence.
(12/1) Limited opportunities. As Thorp notes in Beat the Dealer, even when you know what you’re doing and play under ideal circumstances, the odds still favor you less than 10% of the time. And rarely does anyone play under ideal circumstances.
(12/2) The message for investors is that even when you are competent, favorable situations—where you have a clear-cut variant perception vis-à-vis the market—don’t appear very often.
(13/2) Ante. In the casino, you must bet every time to play. Ideally, you can bet a small amount when the odds are poor and a large sum when the odds are favorable, but you must ante to play the game.
(13/2) In investing, on the other hand, you need not participate when you perceive the expected value as unattractive, and you can bet aggressively when a situation appears attractive. In this way, investing is much more favorable than other games of probability.
(14) Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like.
(15) S& P 500 Index price changes from Jan 3, 1978, to March 30, 2007. The index’s annual return was 9.5%. Had you been able to avoid the worst 50 days, your annual return would have been 18.2%, versus the realized ten percent. Without the 50 best days, the return was just 0.6%.
(16) The attractiveness of the risky asset depends on the time horizon of the investor. An investor who is prepared to wait a long time before evaluating the outcome of the investment will find the risky asset more attractive than another who expects to evaluate the outcome soon.
(17/1) Psychologists discovered that after bettors at a racetrack put down their money, they are more confident in the prospects of their horses winning than immediately before they placed their bets.
(17/2) After making a decision, we feel both internal and external pressure to remain consistent to that view, even if subsequent evidence questions the validity of the initial decision.
(18) Investors in particular seek informational scarcity. The challenge is to distinguish between what is truly scarce information and what is not. One means to do this is to reverse-engineer market expectations—in other words, figure out what the market already thinks.
Correction: the book is called More Than You Know
(19) Soros’s theory of reflexivity argues that there is positive feedback between a company’s stock price and its fundamentals, and that this feedback can lead to booms and crashes. Soros’s strategy was to take advantage of these
(20) “Behavioral finance assumes that heuristic-driven bias and framing effects cause market prices to deviate from fundamental values.” The simple (and somewhat intuitive) message is that the aggregation of irrational individuals must lead to an irrational market.
(21) Herding is when many investors make the same choice based on the observations of others, independent of their own knowledge. Markets do tend to have phases when one sentiment becomes dominant. These diversity breakdowns are consistent with booms and busts
(22) The key to successful contrarian investing is to focus on the folly of the many, not the few.
(23) Known as hindsight bias, or more commonly the Monday-morning-quarterback syndrome, this research shows that people are not very good at recalling the way an uncertain situation appeared to them before finding out the results.
(24) Hindsight bias stands in the way of quality feedback—understanding how and why we made a particular decision. One antidote is to keep notes of why you make decisions as you make them &become a valuable source of objective feedback and can help sharpen future decision making.
(25) The finest investors appear to combine innate ability (hardwiring) with hard work (diverse information input).
(26/1) Seeking new information is a worthy goal for an investor. 13 My fear is that much of what passes as incremental information adds little or no value, because investors don’t properly weight information, rely on unsound samples,
(26/2) and fail to recognize what the market already knows. In contrast, I find that thoughtful discussions about a firm’s or an industry’s medium-to long-term competitive outlook are extremely rare.
(27) Industry sales and earnings trace an S-curve after a discontinuity or technological change. Growth starts slowly, then increases at an increasing pace, and finally flattens out. Investors (indeed humans in general) often think linearly.
(28) most of an entrant’s excess shareholder returns versus its industry come in the first 5 years. In the subsequent 15 years, the entrant delivers total shareholder returns that are roughly in line with the industry. 20 years after entry, a company’s stock tends to underperform
(29) Soros has the macro vision of the entire world. He consumes all this info, digests it all, and from there he can come out with his opinion as to how this is going to be sorted out. He’ll look at charts, but most of the information he’s processing is verbal, not statistical
(30) Experience, of course, looks to the past and considers the probability of future outcomes based on occurrence of historical events. Exposure, on the other hand, considers the likelihood—and potential risk—of an event that history (especially recent history) may not reveal.
(31) Investors that actively seek explanations for the market’s moves risk one of two pitfalls. The first pitfall is confusing correlation for causality. The second pitfall is anchoring [...] on the first number or piece of evidence they hear to explain or describe an event.
(32) An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the supercontagious emotions that swirl about in the marketplace.
(33) Companies with the greatest return improvement, on average, tend to significantly outperform the companies with the largest return degradation. These data suggest that the market does not fully anticipate the full degree of return changes.
(34) Reversion to the mean is a powerful force with company-level returns. High-return businesses face competition that drives down their returns, and capital tends to flee low-return businesses, allowing returns to drift up.
(35) From a company’s perspective, strategy is about pursuing a set of activities that allow it to generate returns above the cost of capital. Successful strategies typically put a company in a unique position, with either a differentiated offering or a low production cost.
(36) Trillions of dollars are exchanged in global markets every day. Yet despite the high stakes and considerable resources [.] there is much we do not grasp. This book celebrates the idea that the answers to many of these questions will emerge only by thinking across disciplines
