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Clarify Your Investment Goals
THE MASTER INVESTOR KNOWS WHY he’s investing: He finds intellectual stimulation and self-fulfillment (Habit No. 20). He knows his purpose. To be successful, you must first clarify yours.
You could be investing for your retirement, so perhaps your underlying goal is security. Perhaps you’re like Charlie Munger and seek independence. Or your primary goal could be the welfare of your children.
As you think about your reasons for investing you’ll put your financial goals in their proper context, and realize they are secondary: a means for supporting some “higher” purpose.
Then ask yourself whether you’re dedicated to achieving those goals—or whether they are just dreams.
The difference is motivation. A dream is something you’d like to have but are not really motivated to achieve. A goal is something you’re willing and often happy to work toward. For the Master Investor there is no doubt: He lives and breathes investing twenty-four hours a day. It is his life (Habit No. 22).
Unless you see yourself following in Buffett’s and Soros’s footsteps, you’re unlikely to go to quite this extreme. And you don’t need to. What you do need to do is commit the time and energy it takes to achieve your investment objectives, whatever they may be. Only through dedication will you achieve them.
It should be immediately obvious that losing money will only make it harder for you to achieve your underlying goal. How can losing money possibly help you achieve security? Will you be more secure or more independent with less money? Clearly not.
That’s why, like the Master Investor, your first financial goal must be preservation of capital. Keeping what you have—however much or little it is (Habit No. 1).
By the same token, spending more than you earn will eat into your capital (or send you farther into debt). Only by living below your means can you build capital in the first place, keep what you have—and then add to it (Habit No. 19). Preserving capital and living below your means are the mental attitudes to money that set the wealthy apart from the poor and middle-class. They are the foundation of wealth. Adopting them is the only certain road to wealth.
What’s Your Investment Niche?
One of the little-known and usually overlooked secrets of the successful investor is that he specializes. Even investment elephants like Buffett and Soros occupy a small fragment of the multitrillion-dollar investment marketplace. Not having billions of dollars to invest, your niche can be even smaller and more focused than the Master Investor’s.
What defines your investment niche is your circle of competence. Like the Master Investor, you should only act when you know what you are doing. That means keeping within the limits of what you know—and never straying into the unknown (Habit No. 7).
So it’s essential you define your own circle of competence. To do so, simply ask yourself:
• What am I interested in? What class of investments and what aspects of investing fascinate me?
• What do I know now?
• What would I like to know about, and be willing to learn?
The more detailed and specific you can be, the better. And don’t be put off if everyone laughs at the area you have chosen.
For example, how would you like to specialize in investing in rent-controlled real estate in New York? Sounds insane, doesn’t it.
But a friend of mine has made millions doing just that and little else. How? He knows the New York rent control laws backward, forward, inside, and out. He knows how to make minimal improvements to a property so that rents can be increased—which naturally hikes the resale value of the properties he buys. In fact, most New Yorkers aren’t even aware that it’s possible to increase the rent on a rent-controlled apartment. So my friend has the last laugh—and has that profitable little niche pretty much all to himself.
A doctor I know leverages his medical knowledge by investing exclusively in health-related stocks. A friend of mine now uses the skills he learned as a floor trader to support himself by day-trading stock index futures—usually from a beach somewhere in the world via the Internet.
There’s bound to be something that you do or know that you can build into your own personal investment niche. Just as important is to be aware of what you don’t know and don’t understand. As Warren Buffett says: “What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”1
Defining your circle of competence is an essential step—but it’s not enough. The hallmark of the true Master Investor is that he is never tempted to step outside the boundaries of his investment niche (Habit No. 8).
Saying no to that temptation can be one of the more difficult disciplines for the novice investor.
But if you’re truly fascinated by the class of investments you have selected, like the Master Investor you’ll be focusing on the process of investing rather than the investments themselves (Habit No. 21). This is one shield against straying into the unknown.
Another powerful antidote to temptation is success. As one of my clients put it: “Now that I know how to make money, those ‘greener’ fields look decidedly brown.”
Of course, for the beginning investor success is something to look forward to, not to rely on today. What you can do today is create, as the Master Investor has done, an investment philosophy that will anchor you within your circle of competence (Habit No. 3).
What Moves the Market?
You probably have some beliefs about the nature of the market. But have you ever made those beliefs explicit? Have you ever examined them to see if they’re valid and noncontradictory? Do they, in fact, guide the way you have invested?
Just as goals drive our actions, so beliefs govern them. If you are a devotee of the efficient-market hypothesis and believe that markets are rational and the price is always “right,” then you believe that it’s impossible to beat the market. The only strategy that is consonant with that belief is to invest in an index fund.
As we saw in chapter 5, the Master Investor believes that the market is sometimes or always wrong. He has developed a theory about why that is the case and a method of profiting from it.
A successful investment system needs to be built on the foundation of an investment philosophy that’s consonant with reality. An investment philosophy is a set of beliefs about:
• the nature of investment reality: how markets work, why prices move;
• a theory of value, including how value can be identified and what causes profits and losses; and
• the nature of a good investment.
Buffett’s Shortcut
When Warren Buffett first read The Intelligent Investor he was hooked. Benjamin Graham gave him everything Buffett had been looking for in a complete package: an investment philosophy, a proven investment method, and a complete and well-tested system. “All” he had to do was learn how to apply it.
Graham became his mentor. Buffett studied with Graham, worked for him, and became a Graham “clone.”
Buffett, of course, was not Graham. So eventually he departed from Graham’s system. Nevertheless, by modeling himself on Graham, Buffett took a huge leap along the learning curve towards becoming a Master Investor. “A few hours spent at the feet of the master,” Buffett recalls, “proved far more valuable to me than had ten years of supposedly original thinking.”2
George Soros also chose a mentor: Karl Popper. But Popper’s theories weren’t directly applicable to investing. It took Soros years to build a successful system based on Popper’s philosophical foundation. Years that Buffett didn’t have to spend. “The best thing I did was to choose the right heroes,”3 Buffett said.
Think about what you believe moves markets. Do prices reflect fundamentals? If so, in the short-term or the long term? Or both?
“Fundamentals” is a broad term. Do you focus on general economic conditions? Changes in the money supply and interest rates? Levels of supply and demand in a commodity market? Or would you prefer to look at the characteristics of an individual company? Or, perhaps, a specific industry?
Or maybe you believe that prices have little or nothing to do with fundamentals at all, that what moves prices is investor psychology. Or the balance between the number of shares of a particular stock being offered for sale and how many buyers are interested in it at any particular moment.
If you’re a technical analyst, you might believe that all of this is irrelevant and everything is “in the chart.”
The best way to clarify your beliefs is to write them down. This may seem like a daunting prospect—but you don’t need to devise a theory as complex as Soros’s. Your belief about the nature of the markets can be as simple and straightforward as Graham’s and Buffett’s belief that market prices eventually reflect the underlying fundamentals but often deviate wildly from them in the shorter term.
Soros’s Protégé
George Soros was to Stanley Druckenmiller what Benjamin Graham was to Warren Buffett.
After reading The Alchemy of Finance Druckenmiller sought Soros out. “George Soros had become my idol,” he said. When Soros offered him the job of managing the Quantum Fund, Druckenmiller needed little convincing. “I thought [working for Soros] was a no-lose situation. The worst thing that could happen was that I would join Soros and he would fire me in a year—in which case I would have received the last chapter of my education.”4
Once you have clarified your beliefs about why prices move the next step in establishing your investment philosophy is to define what you mean by “value.” You may agree with Graham and Buffett that an investment has a measurable, “intrinsic” worth. Or you may take Soros’s view that value is a continually moving target determined by the changing perceptions and actions of actors in the marketplace. Or you may think that value, while measurable, is also contextual in the way that a glass of water to a man in the desert dying of thirst has a far greater “intrinsic” (or life-supporting) value than the same glass of water to you or me.
The Good Investment
By pinpointing what you think represents value, you can now create your definition of a good investment. You should be able to summarize it in one sentence. Consider these examples:
Choose Your Mentor
The fastest way to master anything is to study with a master of the art.
If someone has already perfected the method of investing that appeals to you, why reinvent the wheel? Seek him out. If necessary, offer to work for him for nothing (as Buffett offered to Graham).
If that’s not possible, you can still adopt your mentor by long distance. Read and study everything you can about him and his methods. When you’re thinking about making an investment, always ask yourself: “What would he do?”
Putting yourself in somebody else’s shoes helps your subconscious mind take on some of that person’s natural behaviors and characteristics that you wouldn’t necessarily notice by simply reading about and consciously copying his actions. Before filming started on Rain Man, Dustin Hoffman spent three weeks literally shadowing the person the story was based on. At one point in the filming he was crossing the street when the lights changed. Though not in the script, Hoffman stopped in the middle of the road. They later discovered that that’s exactly what the original character would have done in the same situation.
Even if you later modify the method you have adopted from your mentor, modeling yourself on him you will make it easier for you to acquire most of the 23 Winning Investment Habits of Warren Buffett and George Soros.
As Warren Buffett observes: “The key in life is to figure out who to be the batboy for.”5
Warren Buffett: a good business that can be purchased for less than the discounted value of its future earnings.
George Soros: an investment that can be purchased (or sold) prior to a reflexive shift in market psychology/fundamentals that will change its perceived value substantially.
Carl Icahn: a company with no controlling shareholder trading below its breakup value that’s a potentially appealing candidate for a takeover.
Benjamin Graham: a company that can be purchased for substantially less than its intrinsic value.
There are hundreds of other possibilities. A few more examples:
The Corporate Raider: companies whose parts are worth more than the whole.
The Technical Analyst: an investment where technical indicators have identified a change in the price trend.
The Real Estate Fixer-Upper: run-down properties that can be sold for much more than the investment required to purchase and renovate them.
The Arbitrageur: an asset that can be bought low in one market and sold simultaneously in another at a higher price.
The Crisis Investor: assets that can be bought at fire-sale prices after some panic has hammered a market down.
Coming to your definition of a good investment is easy—if you’re clear about the kinds of investments that interest you and have clarified your beliefs about prices and values.
What’s Your Investment Personality?
Perhaps you share Buffett’s definition of a good investment. Does that mean you should model yourself on him?
Not necessarily. For example, you could follow Buffett’s rules for buying investments but use trailing stops, as some traders do, as your exit strategy.
A handful of successful investors invert Benjamin Graham’s investment strategy. They pinpoint companies selling far above their intrinsic value—and sell them short.
In addition to deciding what kind of investments to focus on, you also need to select your investment strategy. One way to select the method that suits you best is to decide whether you’re primarily an Analyst, Trader, or Actuary (the three investor archetypes introduced in chapter 15). By now you have probably already realized which investment personality fits you best. If not, you need to think about whether your investment horizon is long, short, or medium term. Are you planning to buy and hold; go short as well as long; trade in and out; or take a purely actuarial approach like the professional gambler?
A related consideration is your talents, skills, and abilities. Are you mathematically inclined? If you are, it doesn’t mean you’ll necessarily follow in Buffett’s footsteps. You might prefer to develop a mathematically based, computerized trading system to select a class of investments that, on average, has a positive profit expectancy—a purely actuarial approach.
“Arbitrageurs Die Young”
When George Soros was offered a job by F. M. Mayer in New York, his application for a United States visa was knocked back on the grounds that no twenty-five-year-old could be an expert in anything.
Mayer consulted the legendary Franz Pick, who monitored free (i.e., “black”) gold and currency markets around the world and published the annual Black Market Yearbook.
“Pick submitted an affidavit in support of Soros, saying that the position of arbitragist was very taxing and that the risks that such people constantly assumed took a dreadful toll on their health and nerves and consequently they tended to die young.”6 Pick’s letter got Soros the visa he needed.
Though he didn’t die young, Soros eventually burned out, as Pick had forecast in his admittedly overdramatic letter. Twelve years later his protégé, Stanley Druckenmiller, suffered the same fate.
By comparison, it’s easy to imagine Buffett running Berkshire until he reaches his preferred retirement age—somewhere north of Methuselah.
Stress is a factor you should consider when choosing your method and building your investment system. Successful traders deal with stress with a variety of tools, including keeping fit, meditation, taking complete breaks—or by altering their system to reduce or eliminate the level of stress.
Or maybe you’re a “people person” and would find it easiest to dig up investment ideas by talking to managers, competitors, retailers, suppliers, and others in the business. Or perhaps your element might be reading the emotions of traders on the floor of the exchange.
The key is to adopt the method and strategy that best suits your personality and best uses your skills and abilities. One shortcut is to study different investors and traders until you find the approach that resonates most with you. Once you have done this, you’ll be ready to start building your investment system.