Wednesday, November 20, 2019

Invest before you investigate

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I was reading a book entitled What Philosophy can Teach You About Being a Better Leader by Reynolds, Houlder, Goddard and Lewis and was pleasantly surprised that it turned out to be an above average read for investors.

The authors asked to resolve this paradox concerning two uber-investors Peter Lynch and Warren Buffett:

  • Lynch believes in hard work, but Buffett believes strongly that inactivity is much more intelligent behavior.
  • Lynch was quite an opportunist but Buffett was famous for his self-restraint.
  • Lynch makes thousands of decisions a year, Buffett only a few.
Although I think Peter Lynch is bad influence to retail investors because he seems to trivialize stock picking and made it seem to easy in his books, I find myself drawn to his behavior. One thing I do is to invest first and investigate later. A stock that is favorable to analysts and gives a high dividend should be invested into first before time is spent poring through their financial metrics. Generally, if I have a high yielding counter and I get confirmation from a blogger I respect, I would x10 to my holdings. Aggressively getting into a stock at a good price is better than waiting for others to pontificate and get in slowly after the fact.

I don't think there is a contradiction to Lynch and Buffett's approach. I think the unifying principle that determines how much effort you need to analyse the stock is the Kelly Criterion. 

If you reduce the Kelly Criterion into it's mathematical components, it basically means three things :
  • Take a larger position in a security that gives higher returns.
  • Take a smaller position in a security where the risk free rate is higher.
  • Take a smaller position in a security where volatility is higher. 
This should not be limited to position size - this can be applied to intellectual effort as well. 

But the rules are different - maybe intellectual effort is inversely proportional to position size.

  • Spend more time investigating a stock if you suspect that it may give lower returns.
  • Spend less time investigating a stock where the risk free rate is lower.
  • Spend less time investigating a stock where the volatility is lower.

Why does Lynch seem so hyperactive compared to Buffett even though their performance was equally stellar? My hypothesis is that Buffett has cheap financing in the form of insurance float so he does not need to think too hard to win when it comes to investing. He may also invest in less volatile stocks. Lynch has always been categorized as growth investor. 

I'm not a Buffett or Lynch scholar unlike many other financial bloggers so maybe I am wrong but I think there is credence to the idea that the Kelly Criterion can drive the amount of intellectual effort you put into portfolios as well.

A dividends portfolio consisting of 10-12 stocks can be designed to have a volatility about 2/3rds of the STI ETF. If you have such a portfolio, the intellectual energy you need to analyse this portfolio is going to be very small - so small that you may want to invest first, extract the dividend income and investigate incoming news through the Business Times later. I take these things one step further and even go as far to say that rookie portfolios need to have these mathematical qualities. 

If you go with a a few growth stocks and go in with leverage, then you've got a serious problem. Your volatility is high so the amount of intellectual energy is going to be humongous. You have to pore through every financial statement and think hard before you make a decision.  

What do you guys think ? 

Once this idea reaches maturity, I may do a more comprehensive article on the Dr Wealth website so I want my personal blog to showcase my more zany ideas. 

1 comment:

  1. Hi Chris

    Warren Buffet (in more recent periods) and Peter Lynch follow a growth at reasonable price philosophy rather than deep value investing, although they still look at deep value for certain stock positions. Both believe in concentration to a large extent.

    As Peter Lynch owns a mutual fund with portfolio allocation limits and a massive AUM, he is forced to buy large number of stocks to fit the fund mandate. As he invest in small caps, he needs to invest in a lot of them to generate sufficient returns to drive a large over performance. WB focuses on large cap in recent years due to AUM issue too.

    Your article on Dr Wealth regarding small cap underperformance is insightful. Black rock China ETF seems to exhibit underformance issue in small caps instead of large caps. It is good to not trust historical precedence blindly and to reexamine the validity of certain beliefs / myths!