The most famous investor of the world released his widely-anticipated letter to his shareholders last weekend.
I typically enjoy reading Mr Buffett’s letters as its sprinkled with bits of business wisdom and management tips allover, wrapped with his casual-like tone and occasional humour.
Here are some of my main takeaways from the CEO of Berkshire Hathaway’s latest letter:
(I) Emotional management is key to investment success:
“Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us…
During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.”
It is a widely-known fact that human beings are highly emotional creatures, and much neurological research has shown that many of the decisions that we make are highly influenced by our emotional state. Mr Buffett is simply emphasising the point that to be successful in investing, we need to be in control of our emotional state and be rational in sizing up the odds and opportunities in the markets during times of panics.
(II) Investing using an insurance perspective:
While commenting on Berkshire’s insurance businesses, Buffett writes:
“At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to talk away if the appropriate premium can’t be obtained.”
Although he was providing some advice on how an insurer should operate, there are some subtle and interesting insights that we as investors can distill. Firstly, we need to do our utmost to understand whatever we know of all possible risks that could hurt us. Secondly we need to cautiously estimate the true costs of those risks should they actualise. Thirdly, we must structure our investment positions to deliver positive expectancy over the long term given the risks of losses that we estimated earlier. Fourthly, we must be willing to by-pass and forgo opportunities if they have a negative expectancy profile (potential rewards are lower than possible losses).
To summarise in pointers:
- Know possible risk events and define your risk levels and tolerance ability (think survival first)
- Estimate the real costs of those risks as objectively as possible
- Make sure your investments have an asymmetric profile (potential upside higher than potential downside) to create positive expectancy over the long term
- Don’t unnecessarily take up bad risk-to-reward positions in markets
Here’s a great piece from Macro Ops that talks about expectancy in investing!
(III) Be wary of smoothed numbers and “short-terminism”:
“Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants…
Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.”
A great point to think about…
(IV) Do not mix your political views with your investing:
In a recent media interview, the legendary investor commented that it is a great mistake for people to mix up their political leanings with their investment decisions. He mentioned that for half of his life he had a president that he did not vote for, but that has “not taken me out of stocks.” Thus, in his latest letter, Buffett has stayed away from commenting on the political scene in the US.
Our jobs as investors is to size up the environment and invest accordingly, like what Jim Rogers says: “I cannot invest the way I want the world to be; I have to invest the way the world is.”
*image credits to https://fortunedotcom.files.wordpress.com/2016/02/rts49da.jpg*