Learning path

  • Learning Path : Phase I 0/29
    • Step 1: Investment Lesson: How Does The Stock Market Work
  • Learning Path : Phase II 0/35
    • Investment Guru: Howard Marks
  • Learning Path : Phase III 0/31
    • Book Summary : The Most Important Thing
  • Stockmarket Basics 0/4
  • Book Summaries 0/15
    • These are short summaries of the most valuable lessons taught from investing and trading books

  • Video Tutorials 0/7
    • These videos teach important topics that are relevant to the investment process and the stock market

  • Excel Video Tutorials 0/5
    • These videos demonstrate how to use Microsoft Excel to formulate basic spreadsheets, financial calculations and formulas for investment analysis

  • Stockeducate Library 0/5
    • These are the best stock market: Videos to watch, books to read, audio podcasts to listen to, and websites to explore

Book Summary : The Most Important Thing

Book Summary: The Most Important Thing Illuminated

 

Chapter 1: Second-Level Thinking

 

  • Investing does not rely on mathematically-complicated algorithms, statistics, or analytics.
  • Investors must realize that not one rule always works because the market environment is not controllable and is forever changing. Specific outcomes in the market rarely repeat themselves.
  • Investors must accept that human psychology impacts different markets all over the world.
  • Aspiring investors may take courses, read books, and receive mentoring from people familiar with the investing process.
  • Only a few will achieve above-average results in the market through superior intuition, value-creation, and awareness of human psychology.
  • To achieve above-average results, one must attain and practice a Second level of investment thinking.
  • First-level thinking is a characteristic of an average market participant. First-level thinkers frequently have an opinion about the future which forms their outlook on a company.
  • Second-level thinking occurs on a deeper level, which takes into consideration more complicated factors into account.

These factors include:

  • The likely range of all future outcomes?
  • Which outcome is most likely?
  • The probability of being correct?
  • What does the general consensus believe?
  • How do the investor’s expectations differ from the consensus’ expectations?
  • How does the current price of the security relate to the investor’s expectations and consensus’ expectations of the future?
  • Is the consensus belief too bullish or too bearish?
  • What will happen to the security’s price if the consensus is right? What will happen if the investor is right?
    • The difference in workload separates first-level and second-level thinkers, many individuals are capable of the former but not the later. First-level thinkers look for simple, easy answers for an investing problem.

Chapter 2: Market Efficiency

 

  • The Efficient Market Hypothesis declares that the majority of market participants share access to market-relevant information.
  • And as a result, all relevant company information is efficiently incorporated into the market price (stock price) of each asset, causing all market prices to reflect the true ‘intrinsic’ value of such assets.

However, many value investors believe that markets are in fact inefficient, supported by these following factors:

  1. Market prices are consistently wrong, and exhibit a price either above or below their relative intrinsic values.
  2. Some asset classes exhibit high or low risk-adjusted returns to similar asset classes.
  3. Investors can consistently outperform other market participants, due to differences in ability, information, and intuition.

Chapter 3: Value

 

  • Put simply, buy an asset cheap, and sell it at a higher price.
  • First, determine a security’s intrinsic value, then buy or sell once the market value deviates from the intrinsic value, and always base trading decisions on expectations of future price movements.
  • What creates value in a security or underlying company?
    • The basis of value investing relies on tangible factors such as assets and cash flows.
    • There are many forms of value investing, such as net-net investing, which is based solely on comparing current assets and total liabilities.
    • Value investing involves looking at financial metrics like cash flow, tangible assets, and enterprise value. Then attempting to determine the companies value so the investor can buy it when it appears to be cheap.
    • Growth investing involves identifying companies that have the potential of above-average future growth.
  • Value investors purchase stocks with the conviction that its current spot price (stock price) is below its intrinsic value.
  • Growth investors purchase stocks with the conviction that it (earnings, revenue, etc) will grow into the future.
  • Value investing is based on a company’s current worth and is argued as the most lucrative form of investing with more definitive results.
  • However, growth investing can be described as a punt or a gamble on a company’s future performance, which may or may not yield positive results.
  • Warren Buffett defines value investing as “buying a dollar for fifty cents,” but he asserts that such opportunities are scarce, and do not materialize immediately, especially if the market is acting in an inefficient manner.

Chapter 4: The Relationship Between Price And Value

 

  • Nifty Fifty’ was a group of stocks that were popular between the 1960s and 1970s.
    • These companies exhibited extremely high price/earnings ratios between 80 and 90, compared to an average stock which was in the mid-teens.
    • Within a few years, these extremely high price/earnings ratio companies dropped to around 8 – 9.
    • Despite being stalwart companies, many investors bought these stocks at a grossly inflated price.
  • A securities price will always be affected by short-term fluctuations, primarily influenced by human psychology and technicals.
    • Technicals are non-fundamental factors that affect market behavior.
    • Examples of technicals can be the forced selling of leveraged investors (those who have used debt to purchase stock) during a market crash, or the inflows of cash to mutual funds requiring portfolio managers to buy.
    • Both scenarios forced market participants into executing transactions without regard for price and valuation factors.
    • Being a forced seller is the worst-case scenario. Instead, investors should attempt to hold their stock during the bad times, this requires psychological willpower.
  • The key to understanding the price/value relationship involves achieving insight into the mind of other investors. In the short run, psychology can cause a security to be priced almost anywhere.
  • Psychology is arguably the most important investing discipline, as future price movements depend on the number of investors who like the security.
  • Investing can be similar to a popularity contest, the most harmful action is purchasing a security at the peak of its popularity.
  • Because of the presence of other factors, such as technical and psychological influences, fundamental value is not the only factor that determines a security’s price.
  • During stock market bubbles, investors purchase attractive investment opportunities at an inflated price, with the belief that a fully priced security will continue to rise.
  • The most dependable way to make money involves buying something for less than its intrinsic value, then reaping the rewards as its price moves towards its true value, or when the market becomes aware of the price inefficiency and corrects the price.

Chapter 5: Understanding Risk

 

  • According to financial theory, most people are risk-averse.
  • When evaluating an investment opportunity, investors should assess the risk to return because it makes sense to be compensated for pursuing larger amounts of risk with the chance of achieving greater return.
  • Skilled investors can estimate the amount of risk present in each investing scenario.
  • When the outcome of an investment is less certain, or the probability distribution of returns is wider, it exhibits greater risk.

To compensate, riskier investments should expect:

  1. Higher expected returns
  2. The possibility of lower returns
  3. The possibility of losses (in some cases)

Chapter 6: Recognising Risk

 

  • When investors are risk-loving, they tend to buy shares at higher price/earnings ratios, and private companies at high EBITDA multiples.
  • Some of the falsehoods told over the last few years regarding global risk reduction include:
  1. Skillful central bank management had eased the risk of economic cycles
  2. Globalization has spread risk worldwide rather than concentrated geographically
  3. Risk has been distributed to a variety of market participants due to secularisation and syndication
  4. Risk has been distributed to investors who are better able to bear it
  5. Leverage has become less risky because of more lenient interest rates and debt terms
  6. Leveraged buyouts have become less risky because companies are stronger fundamentally
  7. Risk can be hedged through the use of derivatives, long/short and absolute return investing
  8. The markets are better understood by participants
  9. Markets are less risky through technological improvements in computers, mathematics, and modeling
  • Risk derives from the actions and behaviors of market participants, therefore risk will be low if investors behave rationally.
  • These aforementioned falsehoods are infeasible; risk cannot be eliminated but can be transferred and spread.
  • People overestimate their ability to identify risk and incur it unknowingly, therefore second-level thinking is essential to successfully identify risk.
  • Risk arises through investor behavior, accelerating asset prices to artificially high levels, and lowering potential returns
  • As more people take particular risk, the reward for incurring the incremental risk shrinks.
  • Increased investor confidence creates more risk, demanding compensation through wider risk premiums. This is known as “perversity of risk.”

Chapter 7: Controlling Risk

 

  • Long-term investment success relies upon an investor’s ability to control risk, more so than their assertiveness.
  • Long-term investing results are determined by the number of losses and how bad such losses are, compared to the number of winners and how profitable each win is.
  • Skillful risk control is an essential quality of any successful investor and must be considered before making any all investment decisions in the stock market.

Chapter 8: Being Attentive To Cycles

 

  • Two rules investors should remember:
    • Almost everything proves to be cyclical
    • Some of the greatest opportunities for profits present themselves when market participants forget the first rule
  • The involvement of humans creates the cyclical swings in the market because it is driven by human emotion and inconsistency.
  • There are some objective factors that play a role in cycles, but psychology causes market participants to overreact or underreact, causing the amplitude of such fluctuations.
  • When people are generally optimistic, their behavior involves: spending more, saving less, borrowing more, and most importantly are willing to spend more.

The credit cycle involves:

  • The economy moves into a period of strong growth
  • Capital providers thrive and expand their capital base
  • Risks have seemed to diminish
  • Risk adversity diminishes
  • Financial institutions expand and provide more capital
  • Financial institutions lower credit standards, cut interest rates and provide more capital to compete for market share
  • Risk aversion rises, along with interest rates, credit restrictions and covenant requirements
  • Restricted capital market; less capital is available to borrowers
  • Companies become restricted in accessing capital, and borrowers are unable to roll-over debts. This will lead to widespread defaults and bankruptcies.

Chapter 9: Awareness Of The Pendulum

Markets around the world follow a pendulum-like motion:

  • Between jubilation and despair
  • Between fixating over positive developments and fixing over negatives
  • Between overvalued and undervalued
  • When a crash does occur, risk aversion keeps investors from buying even when prices are extremely low due to pessimism.

Three stages of a bull market:

  1. A select few forward-looking investors who believe conditions will improve
  2. The majority of investors realize the conditions are improving
  3. All investors conclude that conditions will be perpetually better into the future
  • The short-term variations in market valuation and stock prices are caused by changes in investor psychology, which also moves like a pendulum.
  • It takes a few daring bargain hunters to act against the herd and buy when conditions look bleak. When the market begins to appreciate upwards, it encourages other investors to buy.
  • Then most investors start to buy; observing the profits made by other investors who bought early while ignoring the markets cyclical nature, concluding that such conditions will continue perpetually into the future.
  • At the end of the bull market, market participants are willing to pay exceedingly high prices for stocks, and they assume the good times will continue forever.

Stages of a bear market:

  1. A few forward-looking investors believe good conditions will not continue into the future.
  2. The majority of investors realize that conditions are deteriorating.
  • One could assume that the pendulum will reside at the midpoint between the two extremes of fear and greed, but it doesn’t last for long, due to investor psychology.
  • Also, the pendulum cannot stay fixed on an extreme forever, despite appearing to be permanently fixated there.
  • Investor psychology forces the market into one extreme; however, the swing back to the other extreme is usually more rapid, caused by the build-up of energy, similar to a pendulum.

The presence of this pendulum-like motion in market phases depends on a large variety of factors. We never know:

  • How far the pendulum will swing in one direction
  • What might cause the pendulum to reverse and swing the opposite direction
  • When this reversal will occur
  • How far the pendulum will swing the reverse direction

Chapter 10: Combating Negative Influences

 

  • Inefficiencies such as mispricings are caused by mistakes market participants make. This presents potential opportunities for investors, as long as the investor is on the right side of such mistakes.
  • These opportunities occur through human psychology; investors may collect and analyze all the relevant data, but their ultimate conclusions and decisions are deeply affected by human emotion; the primary source of making incorrect decisions.
  • The most influential emotions affecting investor behavior include:
    • The first emotion is greed and can be strong enough to overcome/ignore risks, logic, caution, past lessons, and other crucial elements that are essential in making prudent decisions. Greed is manifested by the pursuit of profit and the prospect of large monetary gain; however, an investor operating under such emotion will eventually become undone.
    • The second emotion is fear, which tends to incite the opposite of greed, leading to exaggerated concern, overdone risk aversion, panic, and inaction.
    • The third factor is an individual’s propensity to dismiss history, norms, and logic. This tendency makes the individual more likely to engage in actions that have been seen to fail throughout history, leading to catastrophe as it has done in the past.
    • Emphasis is placed on “thoughtful investors” who are able to experience long-term wealth creation by avoiding risky behavior, controlling their ego, and exhibiting prudence.
    • These thoughtful investors are better able to identify profit-making opportunities; when already overpriced stock prices move up even further, they sell, and when already under-priced stock prices move down even further, they buy.
    • As hard as it might be to grasp, the vast majority of investors fail to act upon opportunities, they have strong tendencies toward self-doubt and refrain from ‘going against the herd’

Weapons that will help the investor succeed:

  • Strong sense of intrinsic value
  • Acting with conviction when the price diverges from the true value
  • Gaining knowledge from veteran investors, and then validate from personal experience
  • Understand that human psychology plays an important role in market cycles
  • Realize that when things seem to be too good to be true, they usually are
  • Take a contrarian position against the prevailing market if the investor believes such a market has become irrational
  • Surround yourself with like-minded friends and colleagues for support

Chapter 11: Contrarianism

 

  • Second-level thinking, and engagement in more complex and intuitive thought, separates an investor from the majority of investors; who happen to be natural trend followers. By definition, such second-level thinking is not practiced by the majority of investors, and certainly holds the key to success.

The logic behind crowd psychology occurs when:

  • The Market swings considerably between bullish and bearish and from overpriced to under-priced
  • The Market swings are determined by ‘the herd’; who depend on whether the majority of market participants are buying or selling
  • When market extremes are bound to reverse, this can be defined as an ‘inflection point’
  • The market will start to reverse when the first person sells
  • These extremes are caused by what ‘the herd’ believes, and the herd is usually wrong
  • The key to success and profits involves doing the opposite to the crowd; through taking a contrarian approach to investment
  • One must recognize that contrarianism won’t yield success all the time, as great market excess isn’t always present. Just because a security is overpriced, doesn’t mean it will correct and depreciate tomorrow; the markets can stay irrational for extended periods of time.
  • It can be very stressful and expensive when the trend moves against you.
  • Contrarianism must be based on sound reason and analysis; you must know that the herd is wrong to take such positions.
  • If the majority of investors like an idea, it has usually achieved strong past performance. This doesn’t mean it will experience strong performance into the future, in fact, usually, the opposite is true.
    • The price has appreciated to a level which leaves little room for further appreciation and gains. There’s a strong risk that if everyone likes the idea, it will reverse as soon as the herd changes its mind.

Two elements of intelligent investing:

  1. Seeing quality or value that others don’t
  2. Having such a principle turn out to be true
  • Contrarian investing relies on the premise of measuring intrinsic value; if practiced correctly, this is the investor’s path to superior performance and reward, with the least amount of incurred risk.

Chapter 12: Finding Bargains

To build a portfolio, one must:

  • Compose a list of potential investments.
  • Find the intrinsic value of such potential investments.
  • Compare the intrinsic value to market prices.
  • Understand the risk involved with each investment, and how each investment would affect the risk in the portfolio itself.
  • Why do some securities/assets sell at a cheaper price or exhibit a greater turn relative to their true value and risk respectively.
  • Bargains usually have an obvious, objective downfall or weakness which drives the price down further than it should.
  • Bargains occur through human irrationality and inexperience.
  • A potential bargain in the market is usually neglected or discredited by media outlets.
  • Investors believe that past results determine future results, concluding that falling prices of such an asset will continue.
  • Potential bargains are generally disliked and remain under-owned.
  • Bargains exist because the general consensus perceives the asset as worse than it actually is in reality. Therefore the best bargains are usually found by contrarian investing which is acting against the herd.
  • Bargains can provide the greatest reward for investors, which provide the greatest amount of return per unit of risk.

 

Chapter 13: Patient Opportunism

 

  • The GFC was a great opportunity for investors to sell greatly overpriced assets before the crash, and buy greatly underpriced assets after the crash. These opportunities are rarely realized.
  • We emphasize that bargain opportunities are not always available; therefore an investor must be shrewd and patient.
  • When operating in a market with low returns:
  • Do not expect traditional returns
  • Invest: Try for the most satisfactory returns possible in the current market conditions
    • Focus on the long-run
    • Hold cash
    • The best buying opportunities manifest themselves when investors are either forced to sell or when selling occurs in large quantities.
  • Such asset holders may be forced to sell because of portfolio or fund losses, violation of investment guidelines, or finally margin calls; which require investors to deposit additional money into their margin account.

 

Chapter 14: Knowing What You Don’t Know

 

  • The macroeconomic future is hard to predict, and people rarely possess such information that would help them profit from large, systematic market movements.
  • Are the forecasts accurate?
  • Are the forecasts valuable?
  • What was the source(s) used in creating the forecast?
  • Have the forecasters been correct in the past?
  • If the forecasters have been correct in the past, why should an investor remain opposed to such forecasts?
  • People tend to predict a future similar to the recent past.
  • The future does seem to exhibit a similar trajectory of the past
  • The general market also assumes a future that is similar to the past
  • Sometimes, the future can be very different from the past
  • Accurate predictions are scarce and hard to find but will prove to be very valuable
  • Such forecasters who make accurate predictions are not likely to do so consistently
  • To conclude, forecasts are normally of little value

Ego-fueled investors:

  • Believe that knowledge of the macroeconomic factors (such as interest rates) are essential for investor success.
  • They are confident they know how to exploit any form of knowledge.
  • They believe they will be successful no matter what
  • Opinion on future movements sculpt their investing behaviors
  • They are happy to broadcast their views with other investors
  • And they are rarely critical of their past performance
  • In investing, overestimating your ability or knowledge is dangerous, and to avoid this, an investor must acknowledge the limitations and boundaries of their ability and/or knowledge.

 

Chapter 15: Having A Sense Of Where We Stand

 

  • Market cycles consist of random peaks and troughs. which impacts investor returns. This demonstrates the unpredictable nature of market cycles.
  • Instead of trying to predict market swings, try and stay alert in detecting a market that has reached an extreme, then adjust your decisions based on this.
  • Investors need to determine what is going on in the market and use such information to form investment decisions.

 

Chapter 16: Appreciating The Role Of Luck

 

  • Sometimes investors experience superior returns through luck or courage, not skill; especially in the short term. The key to investment success is skill, timing, and assertiveness. An example of this is during a boom when the most assertive investors, who take the most risk, end up making the most profit, regardless of their investing ability.
  • Investors can be right for the wrong reasons, which is not due to their skill or knowledge, but they are willing to take credit anyway.
  • Decisions cannot be evaluated based on certain outcomes, as in the short-run randomness can generate a range of different outcomes.
  • It is important to gather and analyze a large quantity of data before evaluating an investor or manager’s ability; as their success could be due to such short-run randomness.
  • We should make decisions and act on parts of the market that we know best (such as individual companies), rather than macroeconomic factors or broader movements which are harder to predict.
  • Use the value investment approach when making investment decisions, as no investor can be certain about the future
  • Survival is the key in the market, only risk money that you can afford to lose.
  • Acting in a contrarian fashion to the broader market as it reaches an extreme will improve investor’s chances of strong returns.
  • Due to the imprecise nature of predicting outcomes, we must exhibit skepticism and suspicion of the potential strategies that an investor decides to employ in the market.

 

Chapter 17: Investing Defensively

 

  • A diversified portfolio will limit overall risk and exposure to market crashes
  • Concentration and leverage, increases both upside and downside risk, by either magnifying potential profits or losses, which has the potential to greatly threaten or benefit an investor’s portfolio.
  • Invest with caution! Visualize how much you could potentially lose through investing, and despite making greatly informed decisions, outcomes can still go awry. This will keep you on your toes; encouraging you to employ a margin of safety in making investing decisions.
  • Be prepared for things to go wrong; all investors experience a multitude of failures and losses over their careers.

 

Chapter 18: Avoiding Pitfalls

What we should be learning from a crisis:

  • Too much capital circulating the market creates allocation inefficiencies and money flowing to the wrong places
  • When capital flows to inefficient places, things go wrong
  • When capital is in large supply, investors accept low returns and thin margin of errors to compete for investments
  • The apathy of risk creates risk
  • Incomplete and poor due diligence leads to large losses
  • In a market upswing, capital can relocate to new types of investments, which often fail
  • High correlation of assets within portfolios can lead to large losses
  • Human psychology and momentum factors can override fundamentals
  • Models used for previous markets can become outdated, making them invalid
  • Using leverage as a tool may magnify outcomes, but does not create value
  • Market irrationalities, such as bubbles, correct eventually

Investors should, when suspecting of an impending crisis:

  • Observe the careless behavior of other market participants
  • Prepare for a downturn; sell assets, reduce leverage, convert assets into cash, adopt a defensive portfolio stance.

 

Chapter 19: Adding Value

 

  • Investors should aim to do better than what the market expectation is
  •  ‘Beta’ measures a portfolio or stock sensitivity to overall market movements.
  • ‘Alpha’ measures the ability of a portfolio or stock to generate performance that is not related to overall market movements.
  • An active investor makes the decision to be offensive or defensive, and how much they want to deviate from the index.
  • Risk-adjusted return is the key. Investors must determine how much risk they want to take, in order to run the chance of gaining a potential percentage return, in the form of profits.
  • The process of style adjusting involves the investor deciding whether they are going to approach their investment decisions in a defensive or offensive manner.

 

Chapter 20: Reasonable Expectations

 

  • No investment will be successful unless the goal of return is obvious to the investor and within reason of the absolute and relative risk of the investment.
  • In order to attain higher returns, stocks should be bought in an extremely depressed environment.
  • Unrealistic expectations played a significant role in the Global Financial Crisis. Many investors leading up to this market crash held the expectation that 30% of returns year on year were possible to attain; this was true for some years, but the expectation should not be held long-term as it once was.
  • It is true that this thought pattern leads to greater risk-taking in order to gain greater returns.
  • If expectations were in check, then various investors would have capped their expectations much lower, thus limiting the amount of risk taken.

 

Chapter 21: Pulling It All Together

 

  • Closing ideas that the author has left the reader with:
    • Find value in the market. This can be done by being inquisitive about aspects other market participants are overlooking; see the broad spectrum differently to other investors, and analyze situations better than other market participants.
    • Find the relationship of difference between price and value, which is a result of perception – this serves to limit downside risk.
    • The relationship between price and value is influenced by psychology and technicals, which can lead to a lack of transparency of fundamentals.
    • Trends (market being bullish or bearish) often become overdone; this is a great opportunity on both ends to make substantial gains.
    • The margin for error is of great importance when investing defensively.
    • No one can predict the future prospects macro environment, and what stocks will be affected, this should always be remembered when style adjusting your investment portfolio.

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