Putting The Odds In Your Favour When Investing
When asked how he managed to be such a successful investor, Warren Buffet said it was all about putting the odds in his favour.
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That’s what we are trying to do. It’s imperfect but that is what it is all about.”
This explanation concisely describes the only rational approach to investing. It zeros in on the necessity of estimating the odds. Of course, some things are reasonably predictable and some are not. Most people have trouble distinguishing between the two.
We all overestimate our ability to predict what is going to happen. This is largely because humans underestimate the role of chance. We look for patterns – even when they do not exist. Random factors affect every event in our lives. Nevertheless, after the fact, we often believe that we should have expected the event, and we invent causes.
People are not very good at recalling the way an uncertain situation appeared to them before they knew the results. Many independent studies confirm the presence of this hindsight bias. For example, after the tragic events of September 11, 2001 (as unexpected an event as we can imagine), one in five members of the general public interviewed said they had fully expected something along those lines would occur.
Professionals are no better at near term forecasting. A distressing number of them enjoy speculating on macroeconomic matters such as foreign exchange rates, commodity prices and future interest rates. However, numerous studies have shown that short term forecasts in these areas are no better than would be achieved by chimps throwing darts.
Likewise, we are bombarded with predictions of the short term direction of the stock and bond markets. Yet, study after study has shown that the timing of near term market increases and decreases is entirely unpredictable.
Think of these pundits not as seers, but as entertainers.
Returning to Buffett’s advice to calculate probabilities, a good starting point is to avoid wasting time thinking about the type of unpredictable events described above.
Eliminate all macroeconomic predictions and all attempts to guess the direction of the markets over the short run. Focus on those factors that can actually put the odds in your favour.
There is one area that is completely predictable. You know with certainty that your net investment return is increased if you can reduce your cost of investing.
The principal cost of investing for most investors is income tax. Your after-tax return varies inversely with the amount of tax you pay. To minimize your taxes, begin by recognizing that deferring tax for the long run is the next best thing to eliminating it.
Capital gains tax is payable only if you sell your investment. Reduce the turnover in your stock portfolio by owning only companies with strong balance sheets that operate profitable, growing and relatively predictable businesses – and plan to hold them for the long run. Also, when possible, hold any dividend paying stocks (particularly non-Canadian dividend paying stocks) in your RRSP or RRIF.
After tax, your next highest cost is investment management fees and commissions. Most people should own only very low fee index funds, and hold them for the long run. This approach lowers your fees and the amount of tax you pay.
Moving from the certain to the highly probable, stocks have proven to be one of the best asset classes in which to invest over time. While short term price movements are unpredictable, returns from investing in publicly traded companies over a period of five or more years are likely to be highly satisfactory. Unless you have a short time horizon, there is a lot to be said for investing in stocks rather than bonds or other asset classes.
Also, numerous studies have shown that, for stock investors, value investing does work. Market multiples, for example, the ratio of price per share to earnings per share (the P/E ratio) will, over time, revert to a long term average. Investors who buy businesses at historically low valuations can expect to outperform the stock market averages over time.
If you want to engage an active manager to invest your capital, find a value manager that charges reasonable fees for the amount invested, has relatively low turnover in their portfolio, and thinks about allocating your investments between your taxable and tax-sheltered accounts in a tax-efficient manner.
As the Oracle of Omaha says, it’s all about putting the odds in your favour.
A version of this edition of The Long View was published in the Globe & Mail on October 20, 2016.