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Robert Abbott
Robert Abbott
Articles (795)  | Author's Website |

Book of Value: Noise, Luck and Choice

Are you a gambler or an investor? Two routes to potential returns

March 04, 2020 | About:

Anurag Sharma used a simple, one-word title for his introduction to “Book of Value: The Fine Art of Investing Wisely”: Noise.

Why that word? Well, it made the point that it’s difficult to make good investment decisions when the world around you is full of chatter, opinions, expert views and much more. Wherever you turn, from social media to newspapers, you find lots of speculation about the future of market prices. Today it’s the effect of the coronavirus, soon it will be something else.

But that’s not all. There are not only external distractions, but also internal voices that in Sharma’s words, “cloud the mind.” He added that fear, hope and greed are always present and when they become active, we engage in behavior counter to our own interests.

In this, I’m reminded of thoughts from James Montier’s book, “The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy." He warned us against what he called “siren stories” that can lead us away from facts and evidence. Stories are emotionally warm and appealing, while facts are emotionally cold and unappealing. It’s not hard to know which way an undisciplined mind will head.

Sharma’s solution is for all investors to develop their own methods, systematic approaches that will help them analyze information, focus attention and offer consistency in decision-making. That said, different investors will develop different methods and “Fitting your method to your personality is particularly important.” He provided Warren Buffett (Trades, Portfolio)’s method as an example, describing it as “tactfully developed analytical approaches consistent with a mental orientation of extreme patience and steadfastness.”

I would add here that, for value investors, a method will several have core elements. They include a commitment to business analysis, the “facts and evidence” on which rational decisions can be made. Buying with a margin of safety is also a must, meaning the price we pay must be less than a fair valuation of the company. And we need to believe in reversion to the mean since that’s the mechanism by which the prices of undervalued but solid companies become fairly priced or overvalued in time.

And, of course, we need to manage our emotions and think clearly when doing our analyses. Which brings us back to Sharma, who noted that financial markets are incredibly noisy and filled with all sorts of bad ideas. He added that our perceptions are susceptible to distortion and no investing lesson would be complete without showing how the distortions might be corrected.

As part of the process of getting to that conclusion, the author noted that gamblers look for low odds with a high payoff; for example, they might bet on one-to-nine odds in hopes of doubling their money. On the other hand, investors want more favorable odds for decent returns, as in nine-to-one odds for a 15% return. And if the odds are roughly even, as in 51 to 49, gamblers would jump in while investors would jump back.

Volume and time also factor into the differences between investors and gamblers (speculators). Sharma told us that the “math of marginal odds” means that gamblers need large volumes of transactions and, thus, trade a lot—in short-term positions. Investors, on the other hand, work to reduce their dependence on luck, which they can do by developing skills and enhancing their knowledge. The author summed up: “Gamblers want to take chances; investors want to make good choices.”

I think Sharma has framed the issue quite effectively since one of the enemies of good choices is noise, whether it comes from outside or inside our own minds. It’s a subject he pursues in subsequent chapters, but for now, I’d like to develop these ideas in my own way for novice investors.

When we make investment choices, we are choosing between at least two visions of the future. For example, I might ask myself whether Coca-Cola (NYSE:KO) or PepsiCo (NASDAQ:PEP) would be a better investment over the next five to 10 years (a long-term position). If I think one or the other has superior taste and, therefore, should be more popular and, therefore, more profitable, I’m letting noise make my decision. My taste preferences are emotions.

On the other hand, if I were to compare discounted cash flow analyses for the two companies, I would have some facts (assuming I made the same assumptions about the future when doing both analyses). Using the default settings provided by the GuruFocus Discounted Cash Flow calculator, this is what we see for Coca-Cola:

GuruFocus Coca Cola DCF

A negative growth rate and a negative margin of safety are a couple of facts that would prompt me to avoid this stock. Things don’t look any brighter for PepsiCo, which also has a negative margin of safety and growth rate:

GuruFocus Pepsico DCF

Having this information about the DCFs is having facts. Not that these facts by themselves constitute enough data or information to make a decision. However, doing the exercise has pushed back what might have been an emotional decision, of deciding on one or the other based on my taste preferences.

Incidentally, avoiding these stocks might be a good idea based on another set of facts: The GuruFocus list of trades involving the gurus it follows. This chart shows why:

GuruFocus  Pepsico trades

Bars colored red indicate guru stock sales and green bars indicate guru stock purchases in the first chart, while red bars in the second indicate the volume of guru sales and green bars show guru buys. All things considered, this doesn’t look like a good time to buy soft drink companies.

Now, my point wasn’t to make a decision about a beverage stock, it was to illustrate two different approaches to investing. One, based on noise or emotion, would have seen me select a soft drink based on my taste preferences. That would have been a gamble. The other would have been based on facts, albeit a small set of facts, and that would have been a rational choice.

Conclusion

“Noise” was the word Sharma used to title his Introduction to “Book of Value: The Fine Art of Investing Wisely.” Noise is the avalanche of information and data that come at us every day, and much of it is unhelpful or even misleading. That avalanche can come from inside our minds or from external sources, but noise is noise, regardless of its source.

Sharma made a point of distinguishing between a “gamble” and a “choice.” A gamble is speculation, the idea that is based on low odds and high payoffs. It is often based on emotions, including hunches. A choice is a rational determination, which involves searching for favorable odds and reasonably profitable outcomes. It should be based on facts and a method or system.

Finally, I tried to help new investors distinguish between the two types by giving the example of an investment decision I might have made based on two approaches.

Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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