The Secret Of Superior Investment Returns, In Two Charts

A data graph tracks the movement of stocks on the stock exchange in Germany. (Photographer: Alex Kraus/Bloomberg)

The Secret Of Superior Investment Returns, In Two Charts


If you are a believer in the Efficient Market Hypothesis, stop reading here. If, however, you believe that superior returns over the long term can be achieved, read on. If you need back-tested, empirical proof before you accept any hypothesis; again, stop reading. Because what follows is based on personal experience and self-analysis.

The Secret Of Superior Investment Returns, In Two Charts

The idea* is simple. There are three sources of superior returns; out-knowing, out-analysing, and out-behaving. When I say I out-know you I mean, I have more information than you. When I out-analyse you, that means I have analysed the same information better and when I out-behave you, it means with the same information and analysis, I behave better than you in my investing process.

Any superior long-term return will be 80% from out-behaving, 15% from out-analysing and if you want to be charitable, 5% from out-knowing.

Here’s where the empirical proof nuts will have a problem. How do you know it is 80% and not 75 %? Sure. But the point is that a large portion of long-term superior returns can be attributed to out-behaving.

And what does out-behaving really mean? We have dozens of quotes from highly successful investors that can become the Out-behaving Bible. Like Warren Buffett’s “Try to be fearful when others are greedy and greedy only when others are fearful” or Howard Marks quoting Lou Brock “Show me a guy who is afraid to look bad, and I will show you a guy you can beat every time.”

The second part of the hypothesis is that despite this truth about the source of returns, time spent by investors is the mirror-image of it. 80% is spent trying to out-know, 15% on out-analysing and if you want to charitable, 5% on out-behaving.

The Tiny Opportunity In Out-Knowing

The reason why out-knowing is such a short-lived source of return is that the arbitrage closes very quickly. The ‘superior information’ whether obtained legitimately or illegitimately, gives you only a small edge, and a lot of things have to go right for you to benefit from it.

But the pursuit of out-knowing is thrilling and even if for a fleeting second, being part of a privileged club stokes your ego. Once in a while, it may also lead to instant gratification and that makes you keep coming back for more.

For me, two hacks to guard against the out-knowing addiction have been useful. One, make this Paul Samuelson quote your screen-saver: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Every time you are tingling with excitement about knowing something, realise that you are deep in the out-knowing rabbit hole.

Two, always assume that the obscure article you read or whisper that you heard is already read or heard by everybody.

The Limits Of Out-Analysing

Detailed and complex analyses are generally thought of as being superior. Analysts pride themselves on the number of pages that their initiation reports have or the number of sheets in their excel models. Out-analysing is in fact the opposite of this. It’s not about complicating and expanding; it’s about simplifying and distilling and then being able to find commonalities with other sectors and disciplines to arrive at new insights. A way to nudge yourself to out-analyse is to be able to write your thoughts in a short, simple way such that it doesn’t ever evoke the millennial term TL/DR (too long, didn’t read).

This doesn’t mean being sloppy with your analysis. Think of it as a land survey drone flying really close to the ground for a long time but eventually gains altitude to not only get the big picture but also look further. I have seen some great investors spend weeks looking at a stock or sector but eventually invest based on three bullet-point rationales. The edge from out-analysing lasts longer than out-knowing, but not for a very long time as other smart investors catch on soon.

The DIY Way Of Out-Behaving

When it comes to out-behaving there is a lot of literature on what to do but not much on how to do it. I think that’s because the what is universal but the how is subjective. The question “how will you ensure that you are fearful when others are greedy” will need self-analysis and the answer will be bespoke. Knowing your biases and investing behaviour patterns is the critical fist step.

Personally, my recurrent investing mistake has been to hold on to cyclical stuff past its expiry date. By definition, a cyclical stock has made you a boatload of money and you tend to get attached to the darling. Sometimes, I have equated selling a stock with accepting intellectual defeat which is mixing your ego with investing. Over time, my hack for this has been to label a stock as ‘cyclical’ in bright lettering when I buy it. No matter how many secular growth reports are being published at the top of the cycle, I want to adhere to the ‘cyclical’ labelling. I have also tried to develop a circle of friends whose investing instincts I trust and whose conversation tone is “do you want to re-assess XYZ?” rather than “why are you still holding XYZ?” The former sounds like a well-wisher, the latter like an adversary and that helps me from getting all bull-headed about the stock.

Successful investors are also very good at doing nothing most of the time.

Charlie Munger has a colourful term for it: ‘sit-on-your-ass’ investing. The first step in cultivating this is observing how you respond to stimuli; the daily cacophony of breaking news, upgrades, downgrades, and talking heads. The next step is to try and reduce the stimuli you are exposed to and the third is to be able to insert some circuit breaker from whatever stimuli filters through. For me, it is ‘I will not buy a stock till I have written a hand-on-my-heart rationale’. I know of an investment team that, by rule, instructs trades only once a month and last I checked, they were doing exceedingly well. As long as you are aware of the action bias, what specific technique you use to curb it, is your choice.

All this doesn’t mean one will instantly achieve the investing Nirvana of perfectly aligning the sources of return with time spent. But even if we can nudge the latter a few basis points to the former, we will become better investors.

(*The idea germinated in a discussion with Rashesh Shah, Chairman and CEO of Edelweiss Group, in May 2019.)

Swanand Kelkar is an investor and former Managing Director at Morgan Stanley. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.

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