Putting the odds in your favour when investing
At a Berkshire Hathaway annual meeting, Warren Buffett was asked how he managed to be such a successful investor. He described his approach as nothing more than 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, this is not always possible. 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. Why is this? As Nassim Nicholas Taleb pointed out in his book, Fooled by Randomness, it is largely because humans continually 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 Sept. 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, future interest rate changes and impending recessions. 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.
You should think of these pundits not as seers, but rather as entertainers.
Returning to Mr. Buffett’s advice to calculate probabilities, a good starting point would be 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. You are then free to 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.
For a taxable investor, the principal cost of investing is income tax. Your after-tax return varies inversely with the amount of tax you pay. How do you 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. (Even then it is payable at a low rate, applied to only part of your sale proceeds.) 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 very 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, commissions, etc. Mr. Buffett has said that 95 per cent of people should own only very low-fee index funds, and hold them for the long run. This sensible approach lowers your fees and, because of the low turnover in index products, also materially lowers the amount of tax you pay.
Moving from the certain to the highly probable, equities have proven to be one of the best asset classes in which to invest your capital over time. While short-term price movements are entirely unpredictable, the return from investing in publicly traded companies over a period of five or more years is 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, such as the ratio of price a share to earnings per share (the P/E ratio) will, over time, revert to a long-term average. Investors who buy reasonably predictable businesses at historically low multiples of their normalized earnings 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.