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.

Business News Blather

I used to watch the TV for business news. But now Kudlow’s and Cramer’s shouting leave even more ringing in my ears than the express trains zooming past the local subway stop at 86^th Street. I have read the Wall Street Journal for decades, but I have noticed that after Murdoch took over more news stories have political slants and headlines are unnecessarily more pessimistic in the age of Obama.

I don’t get the parade of blond people at Fox News. Are they really trying to be that obvious about who is in their camp and who they could care less about? The CNN anchors who read Twitter responses: are they serious about that? That isn’t democracy, but stupidity, on display for the world to see.

I have become a full-fledged media skeptic. I do think that many of the quick and easy responses encouraged by modern media are often nothing more than rants. That’s one of the reasons I have not allowed comments on Chico Lingo. I read other blogs for years, and still do, and the comments are rarely thoughtful or interesting. I figured if someone wanted to comment on what I wrote they could send me an email, and I have received dozens. Or they could start their own blog.

I know I am in the minority, in more ways than one, on turning away from the flotsam of the news cycle. My only use for democracy-as-hyper-mediocrity is that I try to take advantage of the paranoia or euphoria through my investments. I ignored the doomsday scenarios of March, and kept my investments exactly the way they were. So I have benefited from the recent run-up in stocks. New money I have added to my short-term bond portfolio, simply to have more emergency reserves in case we return to the brink of depression. I am also paying off debt in advance, even if my debt levels were relatively small compared to my net assets.

I watch the crazy flamingos of speculation, the fast money, the lightning rounds, and I am happy to be patient and contrarian and independent. Investors should do their homework, and this knowledge will allow them to ignore the garbage advice that washes up on their shores.

One of the reasons, as I pointed out to my wife Laura, that I did not panic after the recent vicious bear market was that my mutual fund and individual stock positions were still mostly in the black, or with slight losses, at the bottom of the precipitous drop. I have invested patient money, for decades in some cases, and so a downturn cuts into my gains, but isn’t deep enough to even put me in the red.

Too often I hear of friends who invest to get rich quick. To me, that’s not investing, but speculating. I even had a close friend who would invest for a major appliance, for a month or two, score a quick profit, and buy the refrigerator he needed. It was ridiculous to me then, and is ridiculous to me now. But most media outlets encourage this kind of behavior. In yesterday’s Wall Street Journal, oil traders who invest in oil futures for quick bucks were labeled “investors” in paragraph after paragraph. That’s editorializing in news stories, and makes the point against Obama that he is against “investors” in this market when he or his administration considers putting limits on oil traders.

I don’t think we should expect much from CNBC, the Wall Street Journal or Fox Business News in terms of investigative journalism. They are promoters of Wall Street, and sometimes that’s good and too often it’s horrible. The best single article I have read about the current shenanigans in the finance industry came from the New York Times, about how subprime brokers have resurfaced as dubious loan fixers, by Peter Goodman.

The individual investor has to protect himself. But ‘Caveat Emptor’ only works if there is full disclosure in plain English, if abusive behavior is eliminated and illegal behavior prosecuted, if you are not lied to by whoever is selling you stock in a company, a bond, or a mortgage. That’s the proper role of government and what George W. Bush could never understand.

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.