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Only a few of them will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results. Doing so requires second-level thinking.
Your thinking has to be better than that of others β both more powerful and at a higher level.
What is second-level thinking?
First-level thinking says, βItβs a good company; letβs buy the stock.β Second-level thinking says, βItβs a good company, but everyone thinks itβs a great company, and itβs not. So the stockβs overrated and overpriced; letβs sell.β
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First-level thinkers think the same way other first-level thinkers do about the same things.
All investors canβt beat the market since, collectively, they are the market.
To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?
The problem is that extraordinary performance comes only from correct non-consensus forecasts.
The upshot is simple: to achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. Thatβs not easy.
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Asset prices immediately reflect the consensus view of the informationβs significance. I do not, however, believe the consensus view is necessarily correct.
To beat the market you must hold an idiosyncratic, or nonconsensus, view.
The efficient market hypothesis is its conclusion that βyou canβt beat the market.β
The greatest ramifications of the Chicago theory has been the development of passive investment vehicles known as index funds.
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If riskier investments could be counted on to produce higher returns, they wouldnβt be riskier.
The key question is whether itβs right: Is the market unbeatable? Are the people who try wasting their time? Are the clients who pay fees to investment managers wasting their money?
Second-level thinkers know that to achieve superior results, they have to have an edge in either information or analysis or both. They are on the alert for instances of misperception.
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Efficiency is not so universal that we should give up on superior performance.
Efficiency is what lawyers call a βrebuttable presumptionβ β something that should be presumed to be true until someone proves otherwise.
Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty.
For investors to get an edge, there have to be inefficiencies in the underlying process β imperfections, mispricings β to take advantage of.
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For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.
Buy at a price below intrinsic value, and sell at a higher price.
An investor has two basic choices: gauge the securityβs underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.
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Day traders considered themselves successful if they bought a stock at $10 and sold at $11, bought it back the next week at $24 and sold at $25, and bought it a week later at $39 and sold at $40. If you canβt see the flaw in this β that the trader made $3 in a stock that appreciated by $30 β you probably shouldnβt read the rest of this content.
Two approaches, both driven by fundamentals: value investing and growth investing.
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If value investing has the potential to consistently produce favourable results, does that mean itβs easy? No. For one thing, it depends on an accurate estimate of value. Without that, any hope for consistent success as an investor is just that: hope.
Itβs hard to consistently do the right thing as an investor. But itβs impossible to consistently do the right thing at the right time.
Being too far ahead of your time is indistinguishable from being wrong.
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Possible routes to investment profit:
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Dealing with risk is an essential element in investing. There are three reasons for this:
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Risk is β first and foremost β the likelihood of losing money.
The possibility of permanent loss is a risk to worry about.
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Only the things that happened, happened.
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The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.
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What the wise man does in the beginning, the fool does in the end.
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Β it takes analytical ability, objectivity, resolve, even imagination, to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk.
The oscillation of the investor pendulum is very similar in nature to the up-and-down fluctuation of economic and market cycles.
Extreme market behaviour will reverse.
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Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions.
The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing β these factors are near universal.
Inefficiencies β mispricings, misperceptions, mistakes that other people make β provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance.
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Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.
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To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.
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The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst.
The raw materials for the process consist of
(a) a list of potential investments,
(b) estimates of their intrinsic value,
(c) a sense for how their prices compare with their intrinsic valueΒ
(d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
The starting point for portfolio construction is unlikely to be an unbounded universe.
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Since bargains provide value at unreasonably low prices β and thus unusual ratios of return to risk β they represent the Holy Grail for investors.
Itβs obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.
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The marketβs not a very accommodating machine; it wonβt provide high returns just because you need them
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We have two classes of forecasters: Those who donβt know β and those who donβt know they donβt know.
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Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.
The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck.
A great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.
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IDEAS CURATED BY
CURATOR'S NOTE
Successful investing requires thoughtful attention to many separate aspects, all at the same time. The Most Important Thing by Howard Marks covers these key aspects in layman language and without a lot of finance jargon though it covers the concepts of investment theory.
β
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