Tuesday, February 28, 2017

Investing: Riding a Bicycle Up a Mountain in the Night

I have been thinking about yet another an apt analogy for investing and so far here's the best that I have come up with - investing is pretty much like riding a bicycle up a mountain in darkness. To further elaborate, it's also a mountain located in Finland where the signs are in Finnish and daylight won't come in a few months. Yet, we still have to climb up. The summit is waiting. How's that for encouragement huh?

Ok, let's not get too discouraged. It's tough but not that tough. First you need to learn how to ride a bicycle. Then you need to learn basic Finnish in order to navigate well to reach the summit. That's the easy part. The tough part is really about cycling uphill and riding in pitch dark, that's psychology and that's really tricky. One negative thought and one wrong turn and you are going downhill. It might be easier if life was like the Edge of Tomorrow, the sci-fi flick starring Tom Cruise and Emily Blunt.

For those not familiar, this movie was Groundhog Day with aliens. Tom Cruise gets to relive each day while trying to learn to fight aliens, get the girl and save the world. If he dies, the day is reset, and he tries to figure out how to make the right decisions. Over time, since he relived like thousands of the same day, he got really good at wearing exo-suits to fight aliens and learnt every trick to win the heart of Emily Blunt.

Emily Blunt in Edge of Tomorrow

Unfortunately, in real life, there is no reset button. If you are riding a bike to the summit of a Finnish mountain in darkness, you better think well and cycle carefully. So how should we navigate this adventure? Are there better techniques we can use? Well, this is what this post is about. But first, let's describe the analogy in better detail. There are five points to consider:

1. Learning to Ride
2. Learning Finnish
3. Riding Uphill
4. Navigation
5. Pitch Dark

First let's talk about learning to ride. I would like to invite the reader to think back to those days we first learned to ride. This is something that cannot be taught. We simply have to go through it ourselves. I can give you all the theory, but ultimately, to be able to ride smoothly requires practice and experience. Investing is really like that. Every decision to buy and sell will accumulate and over the years, we get better. The difference between bicycle riding and investing is perhaps this - riding once mastered, you can ride anywhere. But investing is a continuous improvement process and you won't know when you have actually mastered investing.

Then there is learning Finnish. This is the easy part. This is like learning the hard skills like accounting, financial analysis etc. If we put our minds to it, we can get to some level of proficiency. Reading financial statements, annual reports have been described in detail on this knowledge site around 2005-2007, interested parties do refer back to those old posts. It's not rocket science. Even for Finnish, after basic lessons, at the very least, we would be able to read road signs. Right?

Now, everyone who had ride would know, riding uphill is crazy effort. Sometimes it's better to just walk. In my opinion, investing, from another perspective, is like riding uphill. It's a lot of mental hardwork: reading newspapers, reading annual reports, analyst reports and journals and notes of other investors. A real investor spends 80% of his time reading, not sitting in front of the trading screens pressing buttons to buy or sell. We spend a long time on analysis, not action. When we do, it's like choosing which fork to take. Making the buy and sell decisions are akin to navigation: taking the right paths.

Binomial  Tree

Over a lifetime of investing, we will literally make hundreds of buy and sell decisions, like going through hundreds of fork roads on our way up the mountain. Hopefully, after rounds and rounds of decisions, we inch upwards. This is the goal, or rather the process. This is real investing. It's mostly not betting it big on one or two occasions. Okay, Warren Buffet had said that we shouldn't diversify too much. Yes, when we are confident we need to size up our bets. But he also said we need to think we have only 20 bullets in life. This is the key statement. We have 20 bullets, not 2 bullets. We never bet 100% of our wealth on one idea. We don't over diversify but we also don't put all our eggs in one basket. Hope this is clear.

In other words, we can think of all our investment decisions in the form of the binomial tree above. Over time if we make more right decisions, we inch up and we move up the curve. We will not make all the right decisions. Hence it goes up and down at each node. But if we are good, after many decisions, we will creep upwards. And the curve would compound over time, meaning it's not linear. If we plot our paths well, we get the compounding curves below.

Compounding returns

We go up faster if we can compound faster. Starting with $10,000, we can hope to get to $70,000 if we compound at 8% or $180,000 if we compound at 10% over 25 years. Alas, it is still not easy. This is the last point in our analogy. We are riding in the dark. There is no clarity and the future is not predictable. At every fork, we rely on our knowledge and insights to make a good decision. We cannot predict the outcome. This is an important point. Please try to visualize this. We are riding on our bicycle uphill, tired and thirsty and we reached a fork with signages in Finnish. We deciphered one of the direction saying, "Yellen will raise interest rate twice this year", the other sign says "Global GDP grows 1.1%". We need to make a decision. Right or left? Buy or sell? How can we predict which way will make money? Everything is based on our best guesses. We then sit down to read the wind direction, we also try to have a good feel of the slope. Doing all this in the dark. That's investing.

When some pundits come and say, markets will do this, and that. Time to buy this, sell that. Obviously he is not in the game. He is like a random guy who is chatting you up on the walkie talkie common frequency, from the base camp, drinking his hot cocoa, telling you to go left, when he has no clue where you are, nor which direction is really upwards. No one can predict markets. People who are trying to predict have no clue. 

It is always easy to claim credit. Maybe we were riding with a group of friends up this Finnish mountain in pitch dark. All were new to this mountain. One loud guy at the fork said go left and he was right. He claimed he knew, see I was right! I am good. Listen to me. Did he really have foresight? What was his reasoning then? Had he called it right over ten times? Or over twenty times? This is the reality, no one knows, those who claim they know probably don't. 

So what do we do? 

Let's think back to the analogy, it's really back to common sense. Make sure we know our hard skills well. At every fork, we muster our best efforts. Read the difficult Finnish signs. Read the wind direction, talk to the team-mates. If we make the wrong turn, follow our gut, go back and take the other fork. We won't know if the fork we took was right until later. So we move slowly. In investment terms, these would be:

1. Knowing the hard skills well: reading financials, industry analysis
2. Constant voracious reading akin to workouts i.e. mental aerobics
3. Discussion with like minded investors
4. Making incremental investment decisions and constantly checking

Just to re-emphasize on bet sizing, we don't pump our 100% into the one direction we chose. We tread carefully. When we have a high conviction idea, we can size up. In portfolio terms, I would say never bet more than 20% on something. Set a limit. Have a few bets, not one or two showdowns. There is so reset button here. A wrong move in the Edge of Tomorrow, Tom Cruise wakes up and start to try to get the girl again. Live. Die. Repeat.

For us, we lose momentum, get discouraged, our assets drop and it takes more effort to get back to where we were. Hence it pays to move carefully. Maybe it should be Think. Move. Repeat. Never give up. One day, we will reach the summit!

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