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Be Aware of the Good Ideas

It's important to recognize the limiting conditions of good ideas

June 19, 2020

During an interview with CNBCs Becky Quick, Warren Buffett (Trades, Portfolio) said the following about good ideas:

My old boss Ben Graham told me very early on that you can get in more trouble with a good idea than a bad idea because the good idea works. Its a good idea to buy a home, for example. And then people go crazy sometimes. A good idea works and it works and it works. Stocks work better than bonds most of the time. And after a while, people forget that there were some other limiting conditions. With Edgar Lawrence Smiths book it was that when bonds yield the same as stocks, which was the case then, that stocks are going to outperform because they have this retained earnings. So stocks started going up in the 20s. And all of a sudden they were selling at five or six times the prices as when he bought the book. And the original correct perception on his part had experienced changing conditions. But people got their confirmations for the stock price. And thats what happened in bull markets. People start out thinking stocks are cheap and then they start thinking stocks have gone up.

The above quote was the best part of the interview in my opinion. Its a counterintuitive and refreshing reminder for investors that we should always be aware of the limiting conditions of good ideas.

What are some of the current good ideas?

  1. Stocks are better investments than bonds.
  2. Growth stocks are better investments than value stocks.

Lets take a look at the first good idea stocks are better investment than bonds. It has generally been the case that stocks outperform bonds, but a stock can be a good buy or a bad buy, and so can a bond. It depends on the price. In the present situation, stocks are better buys than bonds because the long-term bond yields are so low. Buying a bond is equivalent to paying a high multiple for an investment where the earnings dont grow for many years. Here the limiting condition is low yield on long term bonds. That can and probably will change. If the 30 year bond yield were to change from 2% to, say, 5%, the calculation changes dramatically. Stocks may still look attractive compared to bonds, but not as much as they do today.

Now, lets take a look at the second good idea growth stocks are better investments than value stocks. This has certainly been the case since the financial crisis. The trend has accelerated during the past five years. A lot of traditional value investors have vastly underperformed the index, while many growth investors outperformed the index. The question one should ask is what are the limiting conditions of this good idea? In other words, why has growth outperformed value? Historically, there are periods when value stocks vastly outperformed growth stocks. We can say that during these periods of time, it was a good idea to buy value stocks. But again, what are the limiting conditions of value stocks outperforming growth stocks?

Above are just two current good ideas. There have been many other good ideas that worked for a while but eventually turned out to be extremely dangerous if they were clung to for too long. During the recent market turmoil, we have seen many good ideas suddenly fail to work, causing financial losses for many investors.

For example, a recent Wall Street Journal article describes the story of a college professor who invested his and his spouses life savings into leveraged ETN. This professor had earned comparative excess returns for many years due to the high leverage, until March of this year when the ETN collapsed from $14 a share to 25 cents a share.

Another investor had also earned 18% a year by investing in the leveraged ETNs, only to become bankrupt in just two weeks. Hes 67 years old and lost it all.

One other individual poured money into a risk-parity hedge fund. He didnt understand what risk-parity meant, but the hedge fund had generated consistent high returns until March.

Such is the peril of good ideas. People either dont know the limitations of good ideas or forget that there are limiting conditions of good ideas. With a legitimate need for income, as a consequence of the low interest rate environment, its understandable that many investors would invest in the good ideas. When conditions change, many of the investors who follow these short-term strategies while only focusing on the upside are wiped out.

How do we avoid such follies in investing? Fortunately, Buffett has answered it for us. We can do it by recognizing both the limiting conditions and changing conditions of good ideas.

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About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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