Here, I set out my approach to investing; a thesis statement, if you will.

My 3 investing axioms:

1. I could be wrong
2. Value works
3. Momentum works (until it doesn’t)

“I could be wrong”

When investing, I take a counterintuitive approach by accepting that I could be wrong and always look out for what would prove me wrong. This approach stems from the work of George Soros, and particularly on his theory of reflexivity.

In his books The Alchemy of Finance and The New Paradigm for Financial Markets, George Soros explains that the way we understand and perceive the world, along with our active participation in the world, impacts the way financial markets function. As people, we perceive the world but we also participate in the world, and the interplay between these two aspects has major implications for investing.  These two functions, termed the cognitive function (perception of reality) and the manipulative function (participation in reality), sometimes work simultaneously with disastrous consequences.

Firstly, Soros seeks to demonstrate that we cannot separate our perception of the world with our actions within it.  He argues that attempts to understand the world through rationality and reason are inherently limited and incomplete because rationality and reason are a part of the word we are trying to understand – there is no separation between the tools we use to understand reality and reality itself because these tools exist within the realm of reality.

Secondly, Soros agrees that when the cognitive and manipulative functions occur independently or sequentially (e.g. in a scientific settings), worthwhile results can be achieved. But situations involving people result in the cognitive functions and manipulative function occurring simultaneously. Perceptions give us a awareness of reality (cognitive function). But we also live and act in this reality, so our awareness of reality determines our actions in reality (manipulative function). These actions have an effect on reality; thereby changing the reality we had an awareness of in the beginning.

Here is an illustration of the cognitive and manipulative functions acting separately:

We all know that our perceptions affect how we see the world, and that how we see the world affects our actions. But Soros goes further by suggesting that, through our actions, we can affect the world and so affecting our perceptions. Sometimes, our perceptions lead to actions that cause changes in the world which then reinforces our prior perceptions, which results in a feedback loop. If  an incorrect perception underlies this feedback loop, dangerous phenomena such as 'bubbles' can occur.

Soros terms this feedback loop as “reflexivity”:

This reflexivity can cause catastrophic problems when perceptions of reality are wrong, and the resulting action reinforces this incorrect perception of reality.  For example, If potential home buyers in the US think that house prices will always keep going up, they will buy more houses, which will increase the price of houses – thus not only translating their perception into reality, but also creating a feedback loop based on a misguided perception (‘home prices will keep going up’) with disastrous consequences:

 

Soros’s ideas develop heavily from the work of Karl Popper, a philosopher, who laid the foundations for a much of Soros’s thinking. Popper’s influence can be captured in a single theme:  redefining knowledge.

Popper rejected the common ‘justificationist’ theory of knowledge and the induction approach to the scientific method – the idea that science discovers truth by putting forward hypotheses and then seeking to prove them by taking observations and then generalizing those observations into theories. Rather, Popper took the opposite view by arguing (convincingly in my opinion), that knowledge could only be disproved and not proved. Scientific method may conclude, by induction, that all swans are white because all swans that have been observed are white.  But Popper turned that on its head, arguing that the statement ‘all swans are white’ is only provisionally true until it is proved false.  This philosophy is called ‘empirical skepticism’. Popper’s theories allow Soros to build up his ideas of reflexivity.

I have reduced the work of Soros on reflexivity and Popper on his empirical skepticism to 4 guiding words for my investing: I could be wrong

 

“Value Works”

Investing in ‘value’ works. Period.

But how do you define value? Thankfully someone already has.

Benjamin Graham (b. 1894) pioneered that approach that would later be called ‘value investing’.  In his book Security Analysis, written with David Dodd (b. 1895), Graham & Dodd rejected Wall Street’s focus on company earnings. Instead, they detailed an approach to identify the fundamental value of the operating business behind the company, and laid the foundation more future study in financial analysis and fundamental analysis in investing. Written as a textbook, Security Analysis is still used today and still has influence among professional investors. Graham later wrote a book on investing targeted at lay investors, The Intelligent Investor.

The Intelligent Investor is the one book you’ll ever really need to read on investing.  Graham not only addresses how to identify value in companies, but more importantly he identifies the common emotional mistakes investors make and aims to mitigate these weaknesses.

Graham succinctly defines what investing is all about:

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Graham also clarifies the fact that an investor ‘scarcely ever is forced to sell his shares’. Here, Graham identifies a common investor’s pitfall – panicking in a down market and then selling when everything is down. But if you’ve done your research and hold confidence in the strength of the business, why sell?

With luck and by ignoring the day to day moves in the market, I happened to follow this line of thinking during the crash of 2008 and did not sell any of my investments resulting in considerable gain. Graham also explains this approach using his parable about ‘Mr. Market’:

“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.” (emphasis mine)

Graham teaches another central concept: Margin of Safety – always keep a margin of safety in your investments to minimize that potential for losses.  This concept is Warren Buffet’s first rule of investing:

Rule #1: Never Lose money, Rule #2: Don’t forget Rule #1.

So, why is ‘Margin of Safety’ and ‘Never lose money’ so important?

Because:

So, if you lose money, the percentage gain required to make up your losses will always exceed your percentage loss.

For example, if you lose 5%, you’ll need a 5.3% gain to make up that loss

If you lose, 20%, you’ll need a 25% gain to make up that loss

But if you lose more than 20%, your required gain really goes exponential; if you lose 50%, you need a 100% gain (double) to make up your loss.

So in investing, taking small losses is significantly better than taking a big loss because big losses can never really be recovered from.

So, value works by identifying the true value of the underlying business, avoiding common emotional pitfalls and avoiding large, catastrophic losses.

 

“Momentum works (until it doesn’t)”

Benjamin Graham argued that using methods such as trend following, or momentum, do not work because they argue against common business sense; momentum says buy stocks that are going higher whereas common sense might say that’s the time to sell. So does momentum work? Essentially, Yes.

In, A Quantitative Approach to Tactical Asset Allocation, Mebane Faber, a portfolio manager, studies a simple trend following method and demonstrates that trend can work. Basically, Faber took a equal weighted portfolio of 5 ETFs that cover the 5 main asset classes (US Stocks, International Stocks, Bonds, Real Estate & Commodities), and tested a simple trend following method:

Buy when:

Monthly price > 10 month simple moving average (SMA)

Sell and move to cash when:

Monthly price < 10 month SMA

Faber compared this strategy to the common ‘Buy and Hold’ strategy and tested it across 20 international markets (to eliminate the possibility of achieving a false strategy through data mining). Faber found that while that returns for the Timing Model and ‘Buy and Hold’ were around the same, risk in the Trend Following model was measurably lower. For instance, the Trend Model had a lower standard deviation of returns, lower maximum drawdown etc. Faber concludes that this diversification and Trend Model produces better risk adjusted returns, as it allows the investor to fully participate in bull markets while staying in cash through the worst bear markets.  This Monthly Timing Model also reduces potential transactions costs as only monthly prices are used.

In my opinion, the major advantage of this Timing Model is that it provides a clear sell signal in a completely logical and unemotional manner. i.e. it allows you to take those small losses and thereby preventing catastrophic losses. However, the Trend Model may not be of much help in a sideways market as the whipsaw effect is common: when an stock  bounces above and below its 10 Month Moving Average, thereby giving false buy/sell signals and making you losses due to the transaction costs.

I have illustrated the Trend Model below using the last 15 years of the S&P 500 index ETF (SPY) to demonstrate the value of the Trend Model’s timing signals and the whipsaw effect: (click to enlarge)

Faber incorporates this Timing Modal in his book, The Ivy Portfolio. Along with the Timing Model, Faber details how Harvard & Yale manage their endowments and how ordinary investors can replicate their strategies by using a diversified set of ETFs. This strategy combined with the Timing Model allows investors to always be invested in the parts of the market that are performing well, while keeping the rest of their money in cash.  Also, Faber describes how investors can use legal disclosures find out what great investors, like Warren Buffer, are doing and replicate their portfolios.

Risk is not the chance of being down 10% or 20% – Risk is the chance of permanent loss of your capital.

 

You’re more than welcome to subscribe to JTT – Investing Approach here, as I continually rethink and update my approach on investing (updates will be infrequent but hopefully worth your while).

And that’s jus’ the tip.

 

References

The Alchemy of Finance  by George Soros

The New Paradigm for Financial Markets by George Soros

Security Analysis by Benjamin Graham & David Dodd

The Intelligent Investor by Benjamin Graham

A Quantitative Approach to Tactical Asset Allocation by Mebane Faber

The Ivy Portfolio by Mebane Faber & Eric Richardson