Ten Lessons For Investors: Lesson 1: The More Things Change, The More They Stay The Same

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CHAPTER 15
TEN LESSONS FOR INVESTORS

While the investment stories examined in this book reflect very different investment
philosophies and are designed for a wide range of investors, there are some lessons that can
be drawn by looking across the stories. In this chapter, you will see a number of
propositions about investing that apply across investment strategies. Hopefully, these broad
propositions about investing will stand you in good stead when you are subjected to the
next big investment story by an over eager sales person.
Lesson 1: The more things change, the more they stay the same
Each of the investment stories listed in this book has been around for as long as
there have been financial markets. Notwithstanding this reality, investment advisors
rediscover these stories at regular intervals and present them as their own. To provide a
façade of novelty, they often give these stories new and fancy names (preferably Greek).
Calling a strategy of buying low PE stocks the Omega or the Alpha strategy seems to do
wonders for its curb appeal to investors. In addition, as more and more data on stocks
becomes available to investors, some have become more creative in how they use this data to
find stocks. In fact, the ease with which you can screen stocks for multiple criteria – low PE,
high growth and momentum – has allowed some to create composite screens that they can
then label as unique.
Proposition 1: Be wary of complex investment strategies with fancy names that claim to be
new and different.
Lesson 2: If you want guarantees, don’t invest in stocks

No matter what the proponents of an investment strategy tell you, there are no stock
strategies that can offer guaranteed success. Stocks are volatile and are driven by hundreds
of different variables, some related to the overall economy and some arising as a result of
information that has come out about the firm. Even the most elaborate and best planned
strategies for making money in stocks can be derailed by unexpected events.
Proposition 2: The only predictable thing about stocks is their unpredictability.
Lesson 3: No pain, no gain

It is perhaps the oldest lesson in investments that you cannot expect to earn high
returns without taking risk, but it is a lesson that is often ignored. Every investment strategy
exposes you to risk, and a high return strategy cannot be low risk. If you are an investor
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who is uncomfortable with large risk exposures, you should avoid any high risk strategy, no
matter how promising it looks on paper. Why are some investors so willing to delude
themselves into thinking that they can earn high returns without taking much risk? One
reason may be that the risk in some strategies is hidden and shows up sporadically. These
strategies succeed most of the time and deliver solid and modest returns when they do, but
create large losses when they fail.
Proposition 3: If you cannot see the risk in a high returns strategy, you just have not
looked hard enough.
Lesson 4: Remember the fundamentals

The value of a business has always been a function of its capacity to generate
cashflows from its assets, to grow these cashflow over time and the uncertainty associated
with these cashflows. In every bull market, investors forget the fundamentals that determine
value – cashflows, expected growth and risk – and look for new paradigms to explain why
stocks are priced they way they are. This was the case in the technology boom of the late
1990s. Faced with stratospheric prices for new economy companies that could not be
explained by conventional approaches, investors turned to dubious models, where growth in
revenues substituted for earnings and cashflows did not matter. In the aftermath of every
bull market, investors discover the truth that the fundamentals do matter and that companies
have to earn money and grow these earnings to be valuable.
Proposition 4: Ignore fundamentals at your own peril.
Lesson 5: Most stocks that look cheap are cheap for a reason
In every investment story in this book, there is a group of companies that are
identified as cheap. Early in this book, for instance, companies were categorized as cheap
because they traded at low multiples of earnings or below book value. At the risk of
sounding like professional naysayers, it should be noted that most of these companies only
looked cheap. There was generally at least one good reason, and in many cases more than
one, why these stocks traded at low prices. You saw, for instance, that many stocks that
traded at below book value did so because of their poor earning power and high risk and
that stocks that traded at low PE ratios did so because of anemic growth prospects.
Proposition 5: Cheap companies are not always good bargains.
Lesson 6: Everything has a price

Investors are constantly on the look out for characteristics that they believe make the
companies they invest in special – superior management, brand name, high earnings growth
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and a great product all come to mind. Without contesting the fact that these are good
characteristics for a firm to possess, you have to still recognize that markets generally do a
good job of pricing in these advantages. Companies with powerful brand names trade at
high multiples of earnings, as do companies with higher expected growth. Thus, the
question that you have to answer as an investor is not whether having a strong brand name
makes your company more valuable, but whether the price attached to the brand name by the
market is too high or too low.
Proposition 6: Good companies may not be good investments.
Lesson 7: Numbers can be deceptive

For those investors who are tired of anecdotal evidence and investment stories,
numbers offer comfort because they provide the illusion of objectivity. A study that shows
that stocks with high dividends would have earned you 4% more than the market over the
last five years is given more weight than a story about how much money you could have
made investing in one stock five years ago. While it is sensible to test strategies using large
amounts of data over long periods, a couple of caveats are in order:
• Studies, no matter how detailed and long term, generate probabilistic rather than
certain conclusions. For instance, you may conclude after looking at high dividend
paying stocks over the last five years that there is a 90% probability that high
dividend stocks generate higher returns than low dividend stocks, but you will not be
able to guarantee this outcome.
• Every study also suffers from the problem that markets change over time. No two
periods are exactly identical and it is possible that the next period may deliver
surprises that you have never seen before and that these surprises can cause time-
tested strategies to fall apart.
Proposition 7: Numbers can lie.
Lesson 8: Respect the market

Every investment strategy is a bet against the market. You are not only making a
wager that you are right and the market is wrong but that the market will see the error of its
ways and come around to your way of thinking. Consider, for instance, a strategy of buying
stocks that trade at less than book value. You believe that these stocks are undervalued and
that the market is making a mistake in pricing these stocks. To make money, not only do
you have to be right about this underlying belief but markets have to see and correct their
mistakes. In the process, the prices of these stocks will be pushed up and you as an investor
will make money.
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While you may be justified in your views about market mistakes, it is prudent to
begin with a healthy respect for markets. While markets do make large mistakes in pricing
stocks and these mistakes draw attention (usually after the fact), they do an extraordinary
job for the most part in bringing together investors with diverse views and information about
stocks and arriving at consensus prices. When you do uncover what looks like a market
mispricing and an investment opportunity, you should begin with the presumption that the
market price is right and that you have missed some critical component in your analysis. It
is only after you have rejected all of the possible alternative explanations for the mispricing
that you should consider trying to take advantage of the mispricing.
Proposition 8: Markets are more often right than wrong.
Lesson 9: Know yourself

No investment strategy, no matter how well thought our and designed it is, will work
for you as an investor, if it is not match your preferences and characteristics. A strategy of
buying stocks that pay high and sustainable dividends may be a wonderful strategy for risk
averse investors with long time horizons who do not pay much in taxes but not for investors
with shorter time horizons who pay high taxes. Before you decide to adopt any investment
strategy, you should consider whether it is the right strategy for you. Once you adopt it, you
should pass it through two tests:
a. The acid test: If you constantly worry about your portfolio and its movements keep
you awake at nights, you should consider it a signal that the strategy that you just
adopted is too risky for you.
b. The patience test: Many investment strategies are marketed as long term strategies.
If you adopt one of these strategies but you find yourself frequently second
guessing yourself and fine tuning your portfolio, your just may be too impatient to
carry this strategy to fruition.
In the long term, not much that is good –either physically or financially – comes out of
these mismatches.
Proposition 9: There is no one best investment strategy that fits all investors.
Lesson 10: Luck overwhelms skill (at least in the short term)
The most depressing lesson of financial markets is that virtues such as hard work,
patience and preparation do not always get rewarded. In the final analysis, whether you
make money or not on your portfolio is only partially under your control and luck can play
a dominant role. The most successful portfolio managers of last year, all too often, are not
the ones with the best investment strategies but those who (by chance) happened to be at the
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right place at the right time. It is true that the longer you invest, the more likely it is that luck
will start to even out and that your true skills will show through; the most successful
portfolio managers of the last 10 years are less likely to get there because they were lucky.
As an investor, you should take both success and failure with a grain of salt. Neither
is a reflection of your prowess or lack thereof as an investor or the quality of your
underlying investment strategy. While you may not able to manufacture good luck, you
should be ready to take advantage of it when it presents itself.
Proposition 10: It pays to be lucky.
Conclusion
Beating the market is neither easy nor painless. In financial markets, human beings,
with all their frailties, collect and process information and make their best judgments on
what assets are worth. Not surprisingly, they make mistakes and even those who believe that
markets are efficient will concede this reality. The open question, though, is whether you can
take advantage of these mistakes and do better than the average investor. You can but only if
you do your homework, assess the weaknesses of your investment strategies and attempt to
protect yourself against them. If you have a short time horizon, you will also need luck as
an ally.

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413

TEN LESSONS FOR INVESTORS

Lesson 2: If you want guarantees, don’t invest in stocks

Lesson 3: No pain, no gain

Lesson 4: Remember the fundamentals

Lesson 6: Everything has a price

Lesson 7: Numbers can be deceptive

Lesson 8: Respect the market

Lesson 9: Know yourself

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