stocks the game of calculated risk, fear and greed

Overconfidence
Several psychological studies have pointed out that errors in judgmentoccur because people in general are overconfident. Ask a large sampleof people how many believe their skills at driving a car are above average,and an overwhelming majority will say they are excellent drivers.Another example: When asked, doctors believe they can diagnose pneumonia with 90 percent confidence when in fact they are right only 50 percent of the time.

I came to the psychology of misjudgment almost against mywill; I rejected it until I realized my attitude was costing me a lot of money.CHARLIE MUNGER, 1995

Investors have the following characteristics:
• True investors are calm.
• True investors are patient.
• True investors are rational.

Ben Graham, as we know, fiercely urged his students to learn the basicdifference between an investor and a speculator. The speculator, he said,tries to anticipate and profit from price changes; the investor seeks onlyto acquire companies at reasonable prices. Then he explained further:The successful investor is often the person who has achieved a certaintemperament—calm, patient, rational. Speculators have the oppositetemperament: anxious, impatient, irrational. Their worst enemy is not the stock market, but themselves. They may well have superior abilitiesin mathematics, finance, and accounting, but if they cannot mastertheir emotions, they are ill suited to profit from the investment process.

Success in investing doesn’t correlate with IQ once you’reabove the level of 125. Once you have ordinary intelligence,what you need is the temperament to control the urges thatget other people into trouble in investing.1WARREN BUFFETT, 1999

It is a complex, puzzling, intriguing study. Few aspects of humanexistence are more emotion-laden than our relationship to money. Andthe two emotions that drive decisions most profoundly are fear andgreed. Motivated by fear or greed, or both, investors frequently buy orsell stocks at foolish prices, far above or below a company’s intrinsicvalue. To say this another way, investor sentiment has a more pronouncedimpact on stock prices than a company’s fundamentals.

To make his point, Buffett asks us to imagine what happens if youbuy a $1 investment that doubles in price each year. If you sell the investmentat the end of the first year, you would have a net gain of $.66(assuming you’re in the 34 percent tax bracket). Now you reinvest the$1.66, and it doubles in value by year-end. If the investment continuesto double each year, and you continue to sell, pay the tax, and reinvestthe proceeds, at the end of twenty years you would have a net gain of$25,200 after paying taxes of $13,000. If, on the other hand, you purchaseda $1 investment that doubled each year and never sold it until theend of twenty years, you would gain $692,000 after paying taxes of approximately$356,000.

Focus investing is necessarily a long-term approach to investing. If wewere to ask Buffett what he considers an ideal holding period, he wouldanswer “forever”—so long as the company continues to generate aboveaverageeconomics and management allocates the earnings of the companyin a rational manner. “Inactivity strikes us as intelligent behavior,”he explains.

As a general rule of thumb, we should aim for a turnover rate between20 and 10 percent, which means holding the stock for somewherebetween five and ten years.

You can see why Buffett says the ideal portfolio should contain nomore than ten stocks, if each is to receive 10 percent. Yet focus investingis not a simple matter of finding ten good stocks and dividing yourinvestment pool equally among them. Even though all the stocks in afocus portfolio are high-probability events, some will inevitably behigher than others, and they should be allocated a greater proportion ofthe investment.Blackjack players understand this intuitively: When the odds arestrongly in your favor, put down a big bet.

THE FOCUS INVESTOR’S GOLDEN RULES
1. Concentrate your investments in outstanding companiesrun by strong management.
2. Limit yourself to the number of companies you can trulyunderstand. Ten to twenty is good, more than twenty isasking for trouble.
3. Pick the very best of your good companies, and put thebulk of your investment there.
4. Think long-term: five to ten years, minimum.
5. Volatility happens. Carry on.

“We just focus on a few outstanding companies. We’re focus investors.”WARREN BUFFETT, 1994

“The market, like theLord, helps those who help themselves,” says Buffett. “But unlike theLord, the market does not forgive those who know not what they do.”

Great investment opportunities come around when excellentcompanies are surrounded by unusual circumstances that causethe stock to be misappraised.WARREN BUFFETT, 1988

few timeless financial principles:
• Focus on return on equity, not earnings per share.
• Calculate “owner earnings” to get a true ref lection of value.
• Look for companies with high profit margins.
• For every dollar retained, has the company created at least a dollar of market value?

Warren Buffett gives us some valuable tips:33
• “Beware of companies displaying weak accounting.” In particular,he cautions us to watch out for companies that do not expensestock options. It’s an obvious red f lag that other less obvious maneuversare also present.
• Another red f lag: “unintelligible footnotes.” If you can’t understandthem, he says, don’t assume it’s your shortcoming; it’s a favoredtool for hiding something management doesn’t want youto know.
• “Be suspicious of companies that trumpet earnings projectionsand growth expectations.” No one can know the future, and anyCEO who claims to do so is not worthy of your trust.

Expand your reading horizons. Be alert for articles in newspapersand financial magazines about the company you are interested in andabout its industry in general. Read what the company’s executives haveto say and what others say about them. If you notice that the chairmanrecently made a speech or presentation, get a copy from the investorrelations department and study it carefully. Make use of the company’sweb pages for up-to-the-minute information. In every way you canthink of, raise your antennae. The more you develop the habit of stayingalert for information, the easier the process will become.