How to Become a Better Investor and Privacy Policy

A few months ago, I read Malcolm Gladwell's Outliers and Geoff Colvin's Talent is Overrated. Both books explore what it takes to become an expert, or even the best at something. Examples such as Tiger Woods, Grandmaster Chess Players, Steve Balmer and Bill Gates, fill the pages of the books. Did you know when Tiger Woods was an infant, like 6 months old, his father would sit Tiger in his highchair and then proceed to hit hundred of golf balls in front of Tiger - Tiger would be fixated on his father and somehow, maybe that exercise, helped begin to wire the fundamentals of a golf swing into Tiger's head.

Both books draw heavily from the research of K. Anders Ericsson of Florida State University. He is the thought to be the world's expert on expertise. Most of what Ericsson postulates (there is a enormous body of his research on the web via Google Search) comes back to the fact that expertise comes from something he refers to as dedicated practice. This is a very specific type of work that is repeatable, offers quick feedback, and adjustments can be made. Again drawing on Tiger woods, when he was 15 years old, his father would pick a target for Tiger to swing at. Maybe this target was 150 yards out. Tiger then had to meticulously hit each of his clubs ranging from driver to pitching wedge that exact distance. Then, he had to do the same exercise, but this time each time he swung he had to hit the ball with a low fade, then a high fade, then a low draw, and finally a high draw. He did this for hours on end. Constant repition, with measurable results, and quick feedback.

I began to think, how can this exercise of dedicated practice be applied to investing. I began to try devising techniques to improve my investment instincts and feel. And you know what? I came up short. I then read a quote somewhere that Warren Buffett generally reads the financials of a company, and then tries to guess its stock price. I wondered if this could be turned into some repetitive exercise and again I fell up short.

I then came across a very specific piece of research that Ericsson penned. It is entitled: The Enigma of Financial Expertise: Superior and Reproducible Investment Performance in Efficient Markets. You can read the article yourself (I very much enjoyed it). One of the big take-aways comes from the abstract: "...data suggests that financial expertise is highly specialized (e.g. by sector) rather than general." Of course, this flies in the face of Warren Buffett's The Superinvestors of Graham-and-Doddsville. Actually, maybe it doesn't.

Now for the record, I think the efficient market hypothesis is just something that keeps economists busy between their 6 hour a week class load, golf, flirting with undergrads, and summer vacations on Martha's Vineyard. It's like CAPM: Assume not taxes, transaction costs, etc. What world are we living in? So, I for one think that markets are wholly inefficient due to the random variable that is human emotions (loosely behavioral finance).

In the paper, Ericcson point out that: "Expertise is the final reslt of the gradual improvement of performance by additions of new patterns acquired during extended experience in a domain, and thus is attainable by highly motivated, normal and healthy individuals without any requirement for innate talents. These finding have lead to the "10-year" rule sggesting that winning at an international level in many if not most domains occurs only after at least 10 years or 10,000 hours of deliberate practice." Further, Ericcson throughtout a lot of his research, refers back to an expert identifiying patterns and making decisions based on them. If you throw a bunch of random chess pieces on a board, a Grandmaster will see his skill diminish greatly versus having an actual game piece positioning, where his performance will skyrocket.

Maybe this is why Warren Buffett and Seth Klarman are so good at what they do? They have seen the patterns and playbooks before. It is said that Warren Buffett reads multiple annual reports a day - maybe after reading so many, his brain has somehow made the connection that this combination of factors, combined with this valuation, leads to superior investment performance. Maybe Seth Klarman has seen so many bankruptcies and reorganization, he can accurately predict the probability of XYZ occurence, its payoff, and therefore his potential gain vs downside risk.

Further down the paper, Ericcson postulates some other reasons how investors can get superior market beating returns. Fund managers have abnormal returns for stocks that they are geographically near (attributed to better contacts and information). Maybe this is why the Burkenroad Reports seem to always outperform (fantastic reading there by the way). And the one that I find most fascinating, managers who concentrate on stocks in a few industries exhibit superior investment performance (vs. diversified managers). In depth (insider) knowledge about specific companies also produces superior investment performance.

What do the three of these all have in common: They share the link of better, more specific information about a certain company. When Warren Buffett was younger, he focused a lot of his attention on companies that were near Omaha. In addition, and I may be reaching here, but WEB has seen the most success out of three industries: Insurance/Financial Institutions, Consumer Products, and Utilities.

Over the past year, I have taken on one industry in particular, and focused on it greatly. This has been outside my duties at my job where I cover a number of industries (including this aforementioned one which I have covered loosely for over 5 years now). I have focused on the domestic companies only which number somewhere nearly 100 companies with market caps over $5M. In addition, many companies in this industry tap the debt markets across the rating spectrum, allowing me to bring my experience in high yield and distressed investing to the forefront.

And to what end? Many people that have spoken with me in the past, know I want to eventually get seeded and run my own show. While I sometime have thought in the past that limiting your investment universe in any one way can hinder long term performance, I believe a long/short, up and down the capital structure, industry (assuming its broad enough) focused fund could produce outsized returns for investors with low volatility. If you need any examples, look at Healthcor or any of the niche specific Tiger Cubs.

If you have any thoughts on methods of dedicated practice as it relates to investing, leave a comment or send me an email.

As a quick aside, a reader asked about our privacy policy: Unless you tell us otherwise, we treat the email address, name, physical address, and/or phone number of those submitting information and content (hedge fund letters, research, etc) as confidential and will never share it with third parties.


Sami 8/25/2009  

Drucker always argued that the time and energy it takes to build a new competence or to eradicate a weakness is wasted because you can spend fraction of that time and energy to further enhance your current skill competence yielding greater benefit for the job at hand.

Max 8/25/2009  

Eddie Lampert once said that analyzing merger arbitrage deals at Goldman Sachs was like shooting free throws over and over again. For every deal that was announced, he would have to quickly come up with different outcomes and assign a probability to each.

I would guess that after a while you would get a pretty good intuitive feel for whether a certain deal is a good investment. It would also help with the ability to value a wide range of companies.

Anonymous,  8/25/2009  

I am actually reading "Buffett" right now, and what struck me last night (before reading this) is that Buffett actually spent several years just reading annual reports and trying to figure out investment strategies before he truly got started. There was some comment about when some opportunities arose (I think it was a bank) in the late 60's, he had been reading that company's annual report for 7 or 8 years, and had read hundreds of other bank annual reports as well. So he had a huge knowledge base to rely on. Furthermore, since he has almost photographic memory, it seems as though that information is much more readily accessible than to the rest of us who have to construct patterns to remember information better.

VISHNU 8/26/2009  


I enjoy your articles much. I agree with all of your points except the one where you say "concentrate on stocks in a few industries". Because you will never know when / where the pricing discrepancy will occur ( Ex: Technologies companies after 2000 , Even Seth Klarman mention about Isreli Tech company “Radvision” in Security Analysis -Introduction during dot com bubble burst)

I believe that basic trait of any value investor is to uncover the pricing discrepancies (and reduce the pricing discrepancies if he can).

Good example is Buffet’s investment in Sanborn map. I don’t think Buffet has any specific insights in geospatial maps and products. He just uncovered a company with pricing discrepancies.

Atlast some excerpts from the book "Margin of safety"

David Dreman recounts “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the Signs... .’ The stock fell from a high of 53 to 11”.

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar.

(May be it will be a great help if you are working in Hedgefund as Industry expert)


Anonymous,  8/26/2009  

speaking as someone who day-trades futures contracts, i completely agree with this idea of "deliberate practice". having spent several months developing a single strategy, a set of rules, and a set of performance metrics, then actually *executing* the plan, i can understand how most people lose money in the futures markets, since it seems that most of the traders i talk to are woefully underprepared / under-practiced.

i have no idea what kind of environment you're in, but i recommend that you try to choose an area that gives you lots of chances for practice. for example, you cite tiger's constant practice. do the same thing - pick an area where, every day, you have *lots* of chances to hit the ball.

stated another way, you want to pick an environment where you can hit that 10,000 hour mark as fast as possible.

you know...you should check out Brett Steenbarger's "Enhancing Trader Performance" book. it sounds like you don't "trade" per se, but a lot of the concepts in there can be applied to longer-term investing types of strategies.

drop me a line if you want to chat a little more (stephen at stephenarehart dot com). take care, and good luck!


Anonymous,  8/28/2009  

Great blog and great post...
FYI Daniel Coyle's The Talent Code is another interesting book drawing on yet more of Andersson's research.
I read the paper and I found it fascinating. I agree with your assessment that he seems unduly beholden to the ridiculous efficient market theory.
He also seemed to focus too much attention on the impact of transaction costs. In the age of discount online brokers do transaction fees really adversely impact performance to the extent that he suggests?
The paper also doesn't (and maybe can't) address the ability of an indivudual investors to allocate across the capital structure generally, whether specializing in an industry or not.

I suspect beating the stock market may not be as difficult as the paper suggests if one is not always fully invested in it (a la some mutual funds) and holds other asset classes.
One's chances may improve greatly by having a diversified portfolio that is heavily in cash when conditions warrant it (as Klarman and Buffett are both known to do)


Jeff 12/21/2009  

I'm going to comment on this old post because I just came across the blog recently - hopefully you still care!

"It is said that Warren Buffett reads multiple annual reports a day - maybe after reading so many, his brain has somehow made the connection that this combination of factors, combined with this valuation, leads to superior investment performance. Maybe Seth Klarman has seen so many bankruptcies and reorganization, he can accurately predict the probability of XYZ occurence, its payoff, and therefore his potential gain vs downside risk."

My only issue with this statement is that there are lots of other highly "experienced" investors who have read a million annual reports, but are not nearly as good as Buffett or Klarman. So in my opinion, it can't just be the repetition, but the repetition plus something else - I'm not sure exactly what, but one can draw some conclusions if they think about it. I also think this "something else" is attainable, not some birthright, but as you've sort of alluded to here, it's hard to say exactly what it is.

I think your industry concentration idea is a good one. Course, it depends on how broadly you define an "industry." As an extreme example, I'm not sure you could have a whole fund based around health insurers, but you could easily build a fund around financial institutions.

(Of course, now I'm curious what industry you've chosen, hah.)

Here's an interview you might like where a small fund manager echoes your thoughts: http://cornerofberkshireandfairfax.ca/?p=12

" 'Having taken a relatively unconventional approach, how would you suggest an aspiring fund manager start?'

I would suggest that you pick a niche (small local banks, local manufacturing cos. etc.). Whatever is the popular product or service in your area or region and become the expert. I mean own it. Talk to everybody associated with it (management, suppliers, customers etc.) and learn everything about it. Then ask those same people who helped educate you (the bankers, directors, customers etc.) to pool their money together and let you manage it (do the leg work) by investing in those types of companies."


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.