Know Thyself and Buyer Beware

Know thyself and buyer beware. These are phrases I not only preach but also practice, particularly when I make financial decisions each year. I have been talking about the importance of financial literacy with friends and also leaders in the Latino community. Here are a few thoughts.

I believe in self-honesty and knowing what you don’t know, self-education, and self-reliance. Let me take the last first, and tell you why and how they apply in becoming a financially literate individual.

Self-reliance. When I graduated from Harvard in the mid-1980s, I had no money, I was in debt, and I was about to enter graduate school at Yale, to assume even more debt and continue my education. I watched every penny. My bed for years was cinderblocks I found on the street covered by an old sheet of plywood and topped by a thick piece of foam. I saved money, even while at school, and opened my first money market fund.

Self-reliance and my cost-cutting ways were my methods of increasing the amount of capital even when I was earning small salaries as a teaching assistant. Yet even then, I knew that unless I made my savings grow, I would never go beyond a hand-to-mouth existence. So I also began investing in mutual funds. It was the beginning of one of the greatest bull markets in history, so I was also lucky.

Because I used my own investment money, no committee had to be consulted, no outside investor would ring my phone in the middle of the night to cry about losses, and I could choose out-of-favor or even unknown companies (except to me) and invest in them for the long-term. Self-reliance also meant patient money.

Self-education. As I invested, I also began to read. Benjamin Graham. Peter Lynch. Ralph Wanger. Warren Buffett. Barron’s and The Wall Street Journal. John Bogle. Jeremy Siegel. Philip A. Fisher. I am still reading books about investing, by investors and fund managers, and professors of finance. I also taught myself financial accounting, by reading accounting books. I wanted to be able to read and understand 10-K reports and annual reports, and how companies work to make profits.

But my education was not just book-learning. As I invested and learned on the fly, I saw how the financial press was manipulated by many mutual fund companies that trumpeted ‘stellar funds’ with great short-term records, only to have these same funds explode with assets the next year and the managers produce mediocre returns or leave for more money to other fund firms. These ‘stellar funds’ also carried high costs: win or lose, the fund managers still made money for themselves.

Costs matter. Costs are permanent. Invest in index funds, which are the lowest cost funds, particularly at a place like Vanguard. Index funds also have no prima donna fund managers. Buy three or four index funds that represent the stock and bond categories you want to be in, and that should be the plan for the majority of investors who are passive. Passive simply means you are not buying and selling individual stocks, you don’t have the time and inclination, and it’s better to know what you don’t know and invest in index funds. Investing is Socratic: those who don’t know who they are as investors will soon be ripped off by manipulators who appeal to the greed and vanity of the hapless.

Self-honesty. I made many investing mistakes. In my early years, I invested with ‘stellar stock funds,’ which soon tanked. Taco Cabana, another mistake. Stay away from restaurants and airlines. I know certain industries pretty well, but others are too difficult for me to understand, or too unpredictable as businesses. I stay away from what I don’t know, and if I want to know I do hours, even years, of homework.

I have not made many mistakes selling; I don’t know why. I do have a sense of when to get out when I have followed and invested in a company for years. But I have made mistakes buying early, a bit too high, for example. Over-enthusiasm. In a market rout, I don’t panic. I have thick skin, and I don’t report to anybody on my investments. Last March, the nadir of recent stock market valuations, I was indeed worried, yet I stuck to my individual stocks and index funds. I did nothing, which was the smartest thing I did all year.

Investing is about being efficient with the extra capital you have. Invest it well, learn who you are as an investor, and make saving money your constant priority. Then investing will be your path to independence.

Investment Character

I am reading the biography Snowball: Warren Buffett and the Business of Life, by Alice Schroeder, and thoroughly enjoying it. Years ago I read Benjamin Graham’s The Intelligent Investor; I teach parts of Graham and Dodd’s Security Analysis; each year I read Berkshire Hathaway’s annual report to understand some of what they are doing and why.

I would not consider myself a Buffettologist in the sense that I copy whatever stock investments Warren Buffett makes. But I do try to understand what he does and why, and apply those principles to companies and industries I am familiar with. Do your own homework, I say. Understand where your money is, and why it’s there. That’s the way to be an intelligent, independent investor.

As I’ve read this biography, I am not surprised to learn Buffett was/is good at math and calculating odds; I am not surprised to learn his friend Charlie Munger is much the same way. Ideas pour out from their heads; they are passionate about investing, and they believe they are right. ‘Didactic,’ is how they describe themselves. Other words that come to mind are ‘relentless,’ ‘iconoclastic,’ ‘anti-social,’ and ‘obsessed with details.’ They are also honest, self-critical, and loyal to those whom they think deserve loyalty.

When I have taught my summer course on Investment Analysis, I have always argued that number-crunching is only half the battle to becoming a good investor. The other half, and maybe even the most important part, is having the right kind of character to be a successful investor. I think you can train someone to understand and calculate the right figures from annual reports, 10-K reports, and 10-Q reports. I think you can teach someone to use discounted cash flow analysis to get a sense of whether the current stock price correctly values, or undervalues, future earnings.

(I’m not surprised Ben Graham did not give much weight to future earnings, because I also believe projections into the future are dicey figures easily manipulated to prove whatever you want to prove. Understand the nature of the business at hand, and how it can remain profitable forever, or be easily susceptible to margin pressures, inflation, taxation and so on, and that’s how you can truly value ‘future earnings.’ You won’t get an exact number, but you’ll get a sense of whether this business is worth owning. It’s better to be approximately right than exactly wrong. I think Buffett said that.)

But my point is that while number-crunching is largely teachable, having the right investment character is for the most part not. I don’t care what anybody else thinks, and I don’t look for others’ approval of my investment ideas, nor for my clothing, nor for my unorthodox political positions, nor my blog entries. I have always been that way. As a toddler, my mother called me ‘viejo Josisah,’ which was the name of a crotchety old man she once knew in Chihuahua. I was grumpy; I loved being alone; I was, in a word, ‘didactic.’ Now I am a rumpled, ornery man on Broadway, with what I consider to be a plain look on my face but which my wife Laura says looks like a permanent scowl.

That kind of investment character makes it easy to go against the crowd, to not panic when others are decrying the end of capitalism as we know it, or to not join the party when the champagne corks fly to the ceiling because of Internet stocks, China, or whatever the next new fad is. I also don’t like debt. I try to keep things simple. I try to see things as they are, not as I wish them to be, at least for my investments. The recent market meltdown, although painful, was not enough to change my ways; I had enough liquidity to survive.

So ‘Know Thyself,’ that Socratic maxim, is so important to me as an investor. If you know you don’t have the right kind of investment character, then lowering your costs with an index fund is about the smartest thing you can do. If you think you have the right math skills and character, and you start running your own individual stock portfolio, and then you panic when others head for the hills, or you slavishly follow the momentum of euphoria, then learn from that. Those that learn from clear-eyed self-reflection and analysis will be winners on Wall Street. Those that don’t will embody Mr. Market’s schizophrenia.

Investment Analysis

I am updating my syllabus and preparing to teach Investment Analysis at Yale this summer. I am an oddball who writes fiction and teaches investment strategy. I was an economist for a short period; I love writing short stories and novels and even teaching the occasional short-story workshop. Yes, perhaps I am a bit schizoid. But I became interested in investing the few dollars I had during and immediately after college, because I had relatively little money and I wanted more. I didn’t want the riches; I wanted the freedom. I love being my own boss, and that’s exactly what a fiction writer is, as well as an individual investor. I also love numbers. Go figure.

In my course on Investment Analysis, I have students read favorite investment practitioners like Ralph Wanger, John Bogle, Jeremy Siegel, Benjamin Graham, David Swensen, and of course, Warren Buffett. The Essays of Warren Buffett is perhaps my favorite book. I teach my students how to analyze income statements, cash flow statements, and balance sheets for different companies, by looking at actual 10-K reports and annual reports.

I believe in learning by doing. The more actual companies you look at, the better you will understand the industry, and which companies are well-run, and why, and which waste the company’s capital, your money. If you keep looking at companies year-round, when the right opportunity comes along, you can analyze it at lightning speed and make a decision about investing in it. ‘Toochis ofn tish,’ a Yiddish phrase for ‘ass on the table.’ Skin in the game. Put your money where your mouth is. These all mean the same thing: if it’s your money, you will take the risk and you will have the responsibility for the decision.

There is one way in which literary writing and investing are similar. The more you write, the more you can write. The more you live in the writer’s world. The more a certain type of focus becomes your normal state, rather than a special state for the weekends, for example. Paradoxically, the less you write, the less you will be able to write. The less you will be able to pounce on a set of ideas when they strike you, at the oddest moments. So writing, like investing, is learning by doing. You have to practice both to become adept. That’s one of the reasons why I started this weekly blog, to keep my literary motor hummin’.

I tell my Investment Analysis students that, yes, you need to love the detail of financial numbers, and you need to be infinitely curious about companies, their stories, why someone would take such a risk, against all odds, to survive and thrive amid brutal competition. But beyond having abilities in number-crunching, I tell them, being a good investor is also about character.

Certain character traits are excellent for an investor. Other traits work against you. You need to be an independent thinker, and not give a damn what the crowd thinks. Particularly the Wall Street crowd. You need to be able to check how you react emotionally to money, not too excited when your stock is going up, and not too depressed when it’s going down. This emotional distance is crucial for taking advantage of opportunities. Buffett: “Be fearful when others are greedy and greedy when others are fearful.”

People who invest in the stock market and are not self-aware, or acutely aware of what the crowd does and why, will be fools soon parted with their money. Crotchety. Detail-oriented. Fiercely independent. Industrious. Relentlessly curious. That's the makeup of a good investment character.

Human Nature and the Failure of Our Institutions

We start the New Year hopeful that it will be better than last year, but here is a suggestion: let’s go beyond ‘hope’ to examine one of the many things that went wrong in 2008, particularly in the financial sector, and how we can begin to fix the problems.

One of the fundamental, recurring problems, as I see it, is the assumption that human beings will act for their benefit and the benefit of others if they are acting out of self-interest. A corollary of this mistaken assumption is that people regulate each other, or that the market disciplines itself, and so the less interference you have in the marketplace, the better for everybody around.

Yet when investment banks were allowed to take on unprecedented debt, in 2004, not only did they do so, but they did it to the detriment of their shareholders. Again, when mortgage brokers were allowed to peddle subprime mortgages to those who did not understand them, or who were themselves riding the real-estate boom, on no or shaky documentation, these brokers did it enthusiastically. When politicians were allowed to accept millions from banks, brokers, and other financiers, to promote the “American Dream” of owning a home, these politicians took the money and ran to their bully pulpits to hawk what became an American Nightmare. When Henry Paulson was given $350 billion, with little strings attached from Congress, guess what Mr. Paulson did? Here a clue: he didn’t do what he said he would do, the banks that received this money kept it, and we are no closer to helping los de abajo, those at the bottom of the heap.

The Securities and Exchange Commission failed us. The Federal Reserve failed us. The United States Congress failed us. The President failed us. Many of our banks failed us. Mutual funds failed us, for charging us too much for mediocre returns. Moody’s and Standard and Poor’s failed us, for not rating risk the way they should have, for accepting money from the very institutions they were rating. Even the media failed us. Today, newspapers and TV shows are doing double time to expose the shenanigans which led to the debacle of 2008, but during the boom most of them were cheerleaders for the financial sector, for promoting mortgages to people who couldn’t pay them, for innocuous, celebrity-obsessed, simplistic reporting that eschews complexity, thoughtfulness, and precise criticism. The media were giving us the lowest common denominator, what produced the most ratings, and so in the end we failed ourselves, for not demanding something better when it mattered most, before 2008.

Human beings will take advantage of a situation, if they can profit from it, and if they don’t see it will affect others terribly and immediately, and if they are allowed to do so. So many large and small actors in our debacle performed in this way: why even think about the long-term, or the big picture, if I can get away with it, and if it brings me benefit, and if it’s strictly legal? Of course, millions of these selfish decisions, and a few of these selfish decisions worth billions of dollars, did corrode our general welfare, did damage our financial sector, and are now giving the world pause about whether they should keep lending us billions to keep us afloat.

The point is not to regulate for the sake of regulation, or to assume government will be immune from its own special brand of corruption. It won’t. But there is a crying need for common sense legislation or regulation that protects us from our own excesses, that forces upon us a sense of the general, long-term financial welfare of our country, that safeguards the consumer from predators, that encourages and funds the vigorous investigation of the powerful and well-connected to keep them honest, even when they claim nothing is wrong. Let’s not hope people do the right thing; let’s make sure of it.