"Investors operate within what is, for the most part, a zero-sum game," wrote Seth Klarman (Trades, Portfolio) in a letter to investors of his hedge fund, The Baupost Group, back in 2005.
He was referring to the notion that in the stock market, there is always a buyer for every seller, and one person's loss is another person's gain.
It is a zero-sum game because someone is always winning and someone is always losing. For the most part, the average investor is the loser while Wall Street wins, taking commissions and fat fees from offering its services. This is particularly true in the small-cap segment of the market where more companies than not rely on issuing shares to keep the lights on, transferring wealth from investors to company employees, managers and brokers.
But Klarman views these actions as an opportunity -- not an opportunity to profit, but an opportunity to learn from the mistakes other investors are making. His letter went on to say:
"While it is true that the value of all companies usually increases over time with economic growth, market out performance by one investor is necessarily offset by another's under performance. Consequently, you keenly watch your competitors to see not only what they are doing right, but what they are doing wrong. You observe carefully to identify their investment constraints and limitations, their time horizon and liquidity requirements, areas that they ignore and areas that they avoid."
By studying the actions of others and avoiding their mistakes, not only can you improve your own investment process, but the areas other investors avoid may be fertile hunting grounds for unloved and undervalued investments:
"It is in these areas that opportunity is often greatest; that is where bargains regularly surface, with your best competitors not only failing to compete but sometimes serving as the seller. It is here, where others panic, sell mindlessly, neglect, or fear to tread that investors have a chance to develop and sustain an edge."
Klarman isn't the only well-known investor who advocates learning from the mistakes of others to improve their investment process. Charlie Munger (Trades, Portfolio) has also stated that this is a fantastic way to develop:
"We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so that we could avoid them."
And on a similar note he has also previously said:
"I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart…"
People fail at investing for many different reasons and far more people fail than succeed over the long term. This is good news for those willing to learn because it gives us a rich encyclopedia of mistakes to study and make sure we avoid. Using the inversion principle, or as Munger likes to say, "Invert, always invert," is a helpful way to boost knowledge using real-world case studies.
For example, the primary reason companies and individuals tend to go bankrupt is leverage. By knowing this, we can make sure we stay away from overleveraged businesses and avoid taking on personal debt. It is not a complicated lesson to understand, but it is a valuable one.
The inversion principle is one of the reasons I like to study company failures and success stories. If we know the reasons a company failed or succeeded, we can look for similar traits in other investment opportunities.
It is all part of the continual investor improvement process. In this zero-sum game, we all have to have an edge over other players if we want to succeed.Â
Disclosure: The author owns no share mentioned.
Read more here:Â
Seth Klarman on Why Cash Is Vital for Investors
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