Friday, November 10, 2006

Basic to being a good stock picker (Part 1)

Before starting, it is important to attribute what is written are ideas from Charles T. Munger - whom personally I think is a better stock picker and thinker than Warren Buffett. In fact, he was the one who introduced and convinced Warren of the idea to buying businesses at a premium above book value if the moat is durable enough to validate the deal.
The carrot portion of this article is mostly about the general subject of worldly wisdom which forms the framework of this subject. After all, the theory of modern education is that you need a general education before you specialize, and to some extent, before you can be a good stock picker, you need some general education.
So to waltz through the framework of worldly wisdom, there are a few basic notions.
What is elementary worldly wisdom? The first rule is that you cannot really know anything if you just remember isolated facts and try to bang them back to use. If the facts do not hang together on a framework of theory, you do not have it in a useable and understandable form. So you have got to have models in your head through your experience which have to be displayed on this structure of models. If you noticed, students who just try to remember and throw back what is remembered, they failed in school and in life. Thus, you have got to hang experience on a framework of models in your head.
What are models? The first rule is that you have got to have multiple models - because if you have only a few models to use, the nature of human psychology is such that you'll torture reality so that the reality fits your models, or at least you will think your limited models fit reality. It's like the old saying, "To the man with a hammer, everything seems like a nail." So you have got to have a multiple of models.
And these models have to come from multiple disciplines, and thus, reading up a lot is extremely important if one is to gain any wisdom in life. No wise man can be really wise without reading a lot. By the way, being wise has nothing to do with intelligence. Wisdom of the world comes not from one little academic department, it is found in many, as diverse as from engineering to business to psychology and so on. Now you may say "Oh my god! This is getting way too tough." But, fortunately, it isn't that tough because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And of these 80 to 90, only a handful really carries very heavy freight.
So what are the models that constitute this basic knowledge that everybody has to have before they can become good at stock picking?
Firstly, there's mathematics. Obviously, you have got to be able to handle numbers and quantities which is actually basic arithmetic. The greatest model here is the compound interest or return which is so ungodly important in accelerating growth. Another great useful model, after compound interest, is the elementary math of permutations and combinations. This idea is probably taught in secondary or high schools. These are very simple algebra and not that hard to learn. What is hard is to get a person to use it routinely in life almost every day. These models are consistent with the way that the world works. It is really amazing to find that high school algebra actually works in life. However, by and large, many people can't naturally and automatically use this in their life because they complicate how it can be applied by making the models more complicated than it should be when it can be used simply.
So you have to learn in a very useable way this elementary math and use it routinely in life - just the way if you want to be a golfer, you can't use the natural swing that nature gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer. If you don't get this elementary into your blood, then you go through a long life like a one-legged man in an ass kicking contest. You're giving a huge advantage to all others.
One of the advantages like Buffett and Munger hold is that they automatically think in terms of decision trees and the elementary math of permutations and combinations.
The second notion is to know accounting. This is pretty obvious because it is the language of practical business life. It is one of the best gift that has been delivered to civilization. However good accounting may be, there are limitations to it. To understand the most important limitation is accounting is just a crude approximation of things. And it is not hard to understand its limitations. For example, everyone can see that you have to more or less have to guess the useful life of a jet plane, machinery or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.
The third model is to always ask "Why." You may ask why that is so important. Well, that's a rule of psychology. If you think about it a little more deeply, when you align knowledge on a bunch of models that are essentially answers to the question of "why, why, why", you will find people to understand and appreciate it better. If you always tell people why, they'll understand it better, they'll consider it more important, and they'll more likely to comply. Even if they do not fully understand, they'll be more likely to comply. So the iron rule here is for those who want to acquire worldly wisdom, they should start asking "why, why, why" in communicating with other people about everything. Even if it's obvious, it's wise to stick in the "why."
Besides the models aforementioned, which models are the most reliable? Obviously, the models that come from hard facts like hard science or engineering are the most reliable sources on earth because you can calculate and predict many outcomes. Here's a quote from Sir Isaac Newton, "I can calculate the movement of stars but not the madness of man." By the way, these models are very much based on elementary mathematics.
In such models, it gives you a model in a way that "it costs so much and you get so much less likelihood of it breaking if you spend so much." This is basic mathematics. Then also, the backup models of engineering are a very powerful tool. The idea of breaking point is a powerful tool as well.
All these mentioned have great utility in looking at ordinary reality and problems. You can actually apply the basic concept of it to solve some problems which elude others. Then there's all these cost-benefits analysis which is a great model and that's all so elementary. Just that many times it has been dolled up a little bit too much with big lingoes.
Then another great reliable model is from psychology. This is an ungodly important subject if you are going to have any worldly wisdom. It is important to understand that the mental or perceptual function of a man has shortcuts and shortcomings in it. Our brain cannot have unlimited connections in it. So for someone who knows how to take advantage of such shortcuts and cause the brains to miscalculate in certain ways can cause you to see things that aren’t there. So if you are being made to believe these people who know the shortcuts, you buy into ideas that aren’t in existence.
You can demonstrate this point quite easily. You can bet pretty much that there's not a person in a magic show viewing the work of a magician who see a lot of things happening that aren’t happening and do not see a lot of things happening that are happening.
Then when your fellow man starts to act like the magician and manipulates you on purpose by causing your mental function to dysfunction - you will be a victim.
Just as a man working with a tool has to know its limitations, a man working with his mental device has to know its limitations. By the way, this knowledge can be used to control and motivate other people.
Even though psychology is such a useful and practical model, it is very much neglected or ignored. In fact, I think this can be easily taught to any person with ordinary intelligence in a short time. Just that some of us are always too resistant to ideas that seem foreign to them. For me, I learnt it not too long back and it is extremely useful and I am still learning. When I realized how useful it is and how logical and practical it is to everyday life, I felt like a total fool.

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