9
Stick to the Knitting
“Know what you are doing.”
—BENJAMIN GRAHAM1
“The market, like the Lord, helps those who help themselves. Unlike the Lord, the market does not forgive those who know not what they do.”
—WARREN BUFFETT2
“Don’t do anything until you know what you are doing.”
—JIMMY ROGERS3
AT A DINNER ONE NIGHT, I met an investor named Larry who is basically a one-man venture capital fund. He doesn’t even have a secretary.
Larry arrived in New York penniless at the age of twenty, landed a job on Wall Street, and two years later had $50,000 in profits from his investing. A couple of years after that, he quit his day job and began investing full-time for himself.
Now a multimillionaire, he specializes in getting in on the ground floor of promising biotech start-ups.
The secret of Larry’s success is that he has found his market niche. He is fascinated by the biological sciences. He has a powerful underlying motivation: he wants to live a very long life. He’s an avid reader of Nature and other science journals. His research starts with the science, not the companies. He lives and breathes biotech.
So when, during the dinner, he was asked a question about investing, he proceeded to tell us all why the greatest profits were to be had in biotech.
The woman I was sitting next to, Mary, said to me: “I’ve been thinking I should do something on the stock market. Maybe I should look into biotech.”
I could tell from the one of her voice that she was far from convinced. So I asked her: “What have you invested in before? Tell me about the profits you have made.”
A few years ago, she told me, she had bought two condominiums, which had since more than doubled in price. All her friends, and everyone she knew in the real estate business, had urged her not to buy them. The condominium association that ran this building was involved in litigation, internal disputes, was running out of money—a hornet’s nest, she was advised by all and sundry, that she should stay away from.
As proof, they pointed to the low prices these condos were selling at. “Obviously,” they would only go lower.
Mary, who had been in the real estate business for many years, knew differently. To her, these condos were a steal. She knew that eventually the association problems that had depressed the prices of these apartments would be sorted out, one way or another. At worst, their prices would come back to the market level.
I said to her: “Why do you want to know about biotech? Why should you even look at the stock market? You already know how to invest and make money. Why not do what you already know?”
The Penny Drops
For a moment, she sat there in a kind of stunned silence. And her face, her whole demeanor changed. It was like a blinding lightbulb had gone on in her mind. For her, the penny had dropped.
Mary is the exact opposite of Warren Buffett, who once said: “Why should I buy real estate when the stock market is so easy?”4 For Mary, it’s “Why should I buy stocks when real estate is so easy?”
Mary already knew her investment niche. She just didn’t know that she knew. Awed by the success of people like Larry, she discounted her own knowledge and expertise in real estate as being worthless. Under the virtually universal notion that the grass is always greener on the other side, she looked for the secret to investment success everywhere except the one place she was sure to find it: in her own backyard.
What’s His Niche?
Every successful person has a clearly defined niche. For example, I’ll bet you can name, instantly, what John McEnroe, Michael Jordan, Babe Ruth, and Tiger Woods are famous for—even if, like me, you have almost no interest in sports whatsoever.
And you know intuitively that John McEnroe on a basketball court or Babe Ruth at Wimbledon would flounder around like fish out of water.
In exactly the same way, every successful investor has his own niche. If you have been in the investment arena for even a short while, chances are you can also associate each of these investors …
Benjamin Graham
Warren Buffett
George Soros
Peter Lynch
John Templeton
Jimmy Rogers
Jesse Livermore
with an investment specialty or a certain investment style.
It may seem strange to say that investment “whales” like Warren Buffett and George Soros occupy a tiny niche. Yet even Buffett’s Berkshire Hathaway, with $77.6 billion in net assets, is only a medium-sized fish in the $32.3 trillion pond of all the world’s listed companies.5
Different species of whale occupy specialized environments and rarely cross paths with each other. Similarly, Buffett and Soros inhabit different ecological niches in the investment ocean. And just as the whale’s ecological niche is related to the food it can eat, the investor’s market niche is determined by the kind of investments he understands.
“I Want to Double My Money”
Unfortunately, I’ve met hundreds of investors who simply refuse to believe that the investment world is no exception to the general rule that specialization and success go hand in hand. For example, many years ago I asked an attendee at one of my investment seminars why he had come.
“I want to learn how I can double my money in the next twelve months,” he replied.
This man had built a multimillion dollar fortune by spending twenty years putting in twenty-four-hour days to build his business. He knew what it took to make money, yet he didn’t believe me when I said he would need to put in the same kind of effort to invest profitably.
Too many investors believe, thanks in part to the marketing put out by investment newsletters and mutual funds, that to make money by investing is easy, rather like buying a lottery ticket but getting a winner every time.
That was certainly my attitude when I bought my first stock. I was about nineteen, and I rushed out to buy some stock that a broker I’d met at a party the night before was touting. While I can’t recall the name of the company, I do remember that I bought it within a few cents of its all-time high.
To this day, I have no idea whether the broker believed what he was saying or was simply trying to dump his own shares. Whichever was the truth, it doesn’t matter. What does matter is that this same scenario is repeated daily in brokers’ offices around the world.
The belief that investing is easy underlies every one of the Seven Deadly Investment Sins. Consider the time and energy devoted to just the first of these sins: that prediction is the key to investment success.
By turning to the stock market page of your daily newspaper, or tuning your TV to a financial program you’ll immediately notice that the underlying theme is: What is the market going to do next? Even most investment professionals are devotees of the first Deadly Investment Sin.
And then there are the myriad ways people have attempted to codify this belief. The search for chart patterns, or indicators such as relative strength, moving averages, and momentum that, it is hoped, will help forecast the market’s direction. There are cycle theories like the Elliott and Kondratieff Waves, each based on the idea that there’s some regularity in the markets that, once detected, will ensure profits effortlessly. All these cycle theories have one thing in common: blurry vision and 20/20 hindsight.
I even know one investor who’s certain that astrology is the secret to investment success. His only problem, one that’s dogged him for nigh on twenty years, is that every astrologer he’s tried has cost him money. But that hasn’t dented his faith, and I’m sure his search will continue to the day he dies or goes broke—whichever comes first.*
The investor who believes that investing is easy will dismiss out of hand the idea that understanding is the real secret. The getting of understanding is hard, he might respond. It takes time and effort … overlooking the time and effort, not to mention the money he’s lost trying to find the shortcut to easy street.
Circle of Competence
It’s no accident that every successful investor narrows his focus to a small segment of all possible investments and specializes in those and those alone.
The very act of developing his investment philosophy defines the kinds of investments the Master Investor understands. This becomes his circle of competence, and as long as he invests within that circle he has a competitive advantage that enables him to do better than the market as a whole.
“Understanding” versus “Knowledge”
You can put knowledge in a bottle (or a book) and sell it like candies. But not understanding.
To understand is to combine knowledge with experience. Not someone else’s experience: your own. Experience only comes from doing, not from reading about what someone else did (though that can add to your knowledge).
As the word “knowledge” (or “know”) is often used in the sense of “understand,” it pays to grasp what both words really mean:
Knowledge n. 1 a awareness or familiarity (of or with a person or thing) (have no knowledge of that) b person’s range of information.
2 a understanding of a subject (good knowledge of Greek) b sum of what is known (every branch of knowledge).
Understand 1 v. perceive the meaning of (words, a person, a language, a subject, etc.) (understood you perfectly; cannot understand algebra).
2 perceive the significance or cause of (do not understand why he came).
The meanings of these two statements …
“Marion has a good knowledge of Greek”
“Peter understands Greek”
… are clearly different.
Does Marion speak Greek well? Or can she only read Greek? Or does she just know a lot about Greek (for example, its grammar, history, word derivations, linguistics, and so on)? It’s hard to say.
By comparison, it’s safe to assume that Peter speaks Greek pretty well, if not fluently.
Similarly, if you say “she knows a lot” maybe all you mean is she’s good at Trivial Pursuit. “She understands nuclear physics” is, qualitatively, a very different statement.
Knowledge usually means a collection of facts—a “person’s range of information” or the “sum of what is known.” But “understanding” implies Mastery—the ability to apply information and get the desired results.
That competitive advantage is his ability to measure whether an investment has a positive average profit expectancy. The moment he looks at any other kind of investment, his “tools of measurement” no longer work. Unable to measure it, his ability to know whether such an investment is likely to be profitable is no different from the average investor’s.
The Master Investor doesn’t set out to occupy a particular “ecological” market niche. That’s just a natural result of what he understands and what he does not understand; and the distinction between the two is crystal-clear in his own mind.
In Warren Buffett’s words: “The most important thing in terms of your circle of competence is not how large the area of it is, but how well you’ve defined the perimeter.”6
By viewing the investment world through the lens of his investment criteria, he literally only sees those investments he can understand.