The most important skill

That doesn’t mean to invest or trade money that you can afford to lose; that’s the definition of gambling, and that’s not how one develop wealth.  Trading and investing (meant for different purposes and different timeframes) are about turning 10 into 12, 15 or 20, with a high degree of probability for such outcome – not throwing 10 out there and “see what happens / hoping it will work”.  

At times, price will be disconnected from fundamentals – and it doesn’t matter how smart one is, if discipline can’t be used to execute the plan, one is taking more risks than it should.  The answer, in my opinion, is not to eliminate risks, but to learn how to manage them.  In today’s environment, saving is not enough to build wealth. One must invest (and / or trade) to grow their savings beyond inflation. So learning what trading or investing is about and learning how to mitigate risks, how the market works, is fundamental before learning how to buy and sell. Many choose to index – that won’t help if the market crashes, like it did in 2001 or 2008 or many other year, and one doesn’t have the required temperament and discpline.

During the Berkshire’s Annual Meeting in 2003, Buffett explains it best:

“If you focus on the price, you’re assuming that the market knows more than you do. That may be the truth, but in that case you shouldn’t own it. The stock market is there to serve you, not to instruct you.

Focus on price and value. If a stock gets cheaper and you have some cash, buy more. We sometimes stop buying when prices goes up.”

Charles Munger added: “What’s funny is that most big investment organizations don’t think like this. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can’t do it. Very few people have adopted our approach.”

Buffett concluded: “Ted Williams, in his book The Science of Hitting, talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way.”

In the following year, Buffett added the following when asked a similar question:

“The key is to have a “money mind,” which is not IQ, and then you have to have the right temperament. If you can’t control yourself, you’re going to have disasters. Charlie and I have seen it. The whole world in the late 1990s went a little mad in terms of investments. How could that happen? Don’t people learn? What we learn from history is that people don’t learn from history. Grade yourself on your temperament. Temperament is the ability to not be swayed by the market. See what you are supposed to see.”

So whichever strategy you choose to follow, be consistent. Discipline is part of the temperament to always execute the same plan regardless of what the market does.  When investing, it’s important to keep in mind Buffett’s words, given during a lecture on McCombs School of Business in 2008: “People want to make money fast, but it doesn’t happen that way. Graham’s philosophy doesn’t promise enough for many people. You don’t know when it will happen, but you just wait for the fat pitches within your circle of competence. It’s not as exciting as guessing whether the stock price will go up the next day. Most investors in internet companies didn’t know the market cap. They were buying because they thought the stock would move, but if you asked them to write “I would buy XYZ company for $6 billion because”, they wouldn’t get halfway through the sentence. It’s the classic tortoise versus hare, bound to work over time.”

Therefore, understanding what investing and trading entails also help with building the required temperament. Investing is meant for the long term, so one shouldn’t be investing if the plan is to cash out in the short term.  By long term I mean a very minimum of 5 to 7 years at least, because that’s the duration of one business cycle. And investing should be planned to last through several business cycles. Therefore, market gyrations in the short term don’t matter. Fundamentals do, so one should be monitoring earnings and cash flow on an annual basis to validate that a business continue to meet their goals.  Actually, thinking of your investment as a partnership of business helps tremendously with this process.  If you own an actual business, you wouldn’t sell if it the economy slows down. You wouldn’t sell it depending on who took office. You wouldn’t sell it if the market crashes.  This helps us to keep a cool head during these times. As an investor, we shall remember that our role is to simply deploy capital. The executives from the business that we invest on are well paid to run those business – their role is to react and adapt to different challenges. We just ride along. And we monitor their operating results to ensure that these businesses still meet our goals.

Trading is much harder than investing, because it requires luxuries not needed when investing: minimizing drawdowns and locking profits in the short term.  Hence my preference to algorithmic trading systems to minimize emotions when doing the regular buys and sells. Here too, temperament is required, since the rules not always will outperform the market.  Price can be driven by different components, and not every single component can be accounted for.  Therefore, the best trading and investing strategy are the ones with clear rules to buy and sell, through a well-thought process, and keeping consistency / discipline to execute them at all times – including when chosen style goes out of favor from time to time.

For these reasons, have a plan before you begin to invest or trade. Have the buy and sell rules defined ahead of time.  And if you believe that these need adjustment, do so AFTER exiting the position, to remove emotional bias into factor. When making a decision, ask yourself if it’s part of the original plan or if there’s an emotional component attached to that decision.  The 2 emotions that are associated with underperformance are fear (when the market crashes) and greed (when the market is euphoric).  The market will always be there so serve us, it won’t go anywhere.  Don’t pay more than you should due to fear of missing out. Be patient. Think as an owner of a business – you don’t want to overpay it.

Remember that investing and trading build wealth slowly. Even trading, meant for short term, is not a get-rich-quick scheme.  Overnight home runs are luck, not a byproduct of a strategy, since those can’t be estimated consistently overtime.  However, a well thought strategy that takes into account the elements that drive price up, those will  build wealth overtimme, with a high degree of confidence.

And lastly, remember that trading and investing are a business too.  And like every business, there will be losses. When they happen, it doesn’t mean that your strategy is broken.  It simply means that a low-probability event took place. As long as consistency is kept in place, success will happen more often than losses – and that will build a healthy and sustainable profitable portfolio.