The best time to sell a stock is when the opportunity cost of holding it higher than the expected return of holding it.
If you are asking yourself this question, you are asking yourself the wrong question. At the very least, I would propose you implement a minor tweak to it: How would Warren Buffett be investing if he were in your shoes?
The thing is that the investing style of Warren Buffett has changed immensely over time. That’s just because he is extremely smart and extremely adaptable. And you wouldn’t want to mimic Buffett’s investments today, for the simple reason that he is severely disadvantaged compared to yourself.
If Buffett were in your shoes, he most definitely wouldn’t be looking at Berkshire Hathaway for copycat ideas. You see, one of the things that is not talked enough about, when people are discussing Buffett is that he has been extremely adaptable.
There are assets worth a total of $788 billion on the Berkshire Hathaway balance sheet. If the company would want to deploy 1% of its assets base to one investment, that investment would have to be valued at $7.8 billion. By comparison, the smallest company in the S&P 500 index has a market cap of $1.5 billion.
Therefore, if Buffett wants to make an investment that actually moves the needle today, his universe of available investment opportunities is actually tiny.
The Buffett Partnership
So, how did Buffett invest early in his career, when he was a much smaller fish in a much bigger pond? This question brings you to the the Buffett Partnership, which Buffett managed from 1956 to 1969. When Buffett dissolved the Partnership in 1970, he kept his stake in Berkshire Hathaway, which the Partnership had had a controlling shareholder in. The rest is history, I guess.
First of all, during the Partnership years, Buffett invested in smaller, less liquid companies. Secondly, Buffett was a relatively concentrated investor, focusing on a few high conviction ideas. Nonetheless, this does not mean he didn’t try to diversify the Buffett Partnership Portfolio. The way he did it was not through quantity of exposure, but through the quality of exposure.
By quality, I don’t mean that the stocks he chose were of higher quality than the stocks in the general market. But rather that he managed the stock portfolio by allocating its capital into three buckets that each had exposure to qualitatively different factors.
The Three Arrows of Buffett’s Capital Allocation
His objective, as I understand it, was to be able to keep his options open and be flexible under different market conditions. For example, if the overall market went up, he would be able to allocate capital to the bucket of stocks that were not driven by the overall market, and vice versa if market sentiment was overly pessimistic.
But you don’t have to take my word for it. Here is Buffett’s explanation of the three qualitative areas that he allocated capital to. The following is taken from the 1961 Buffet Partnership Letter Shareholders:
Our Method of Operation
Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors.
The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.
Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.
The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.
Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies.
This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development.
I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.
The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it.
These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.
In this speech by Peter Thiel, he says the following when talking about how to detect patterns when trying to recognizing entrepreneurs as a venture capitalist:
“You always want to invest in the ones where they speak in definite future tense. You sometimes have to be careful they’re not totally crazy people, but that’s the sort of person you want to invest in. You do not want to invest in people who are talking too much about probabilities or risks or things like that because my experience has been that the people who think they’re involved in some sort of lottery ticket-like dynamic are already setting themselves up to already somehow get the probabilities wrong and invariably lose.”
“There is a similar version of this that I experience as an investor in these ventures. There’s always this very tricky question of the role of luck and chance in these things working. There certainly is this external truth perspective that there is a certain amount of luck that is built into the nature of the universe and you try to model it. You try to account for it. You try to get the probabilities right, as you assess these things. So, when people say that luck is involved, this is a statement about the deep nature of our universe.”
“And then there is this sort of internal truth version. Whenever we have thought that it is a matter of work. Psychologically I can say that this has often been a very bad sign. Where you say, “well, we don’t know if this is going to work. Maybe it works. Maybe it doesn’t. So, let’s just invest a slightly smaller amount for our lack of knowledge.” And as a pattern, I would say, those are investments that have generally gone very badly wrong.”
“If I had to sort of explain why. When you think you are multiplying a small probability by a big payoff, you sort of psycho yourself into playing the lottery and you psych yourself into losing. Because you somehow are being sloppy and not doing that much work.”
I think these thoughts do a great job of highlighting the inherent differences between entrepreneurs and investors. The entrepreneurs Peter looks for speak of the future through a deterministic mindset. They have a clear sense of the future and how they are going to shape it. Peter himself, on the other hand, as a venture capitalist does not invest his all his funds in one company. In his role he needs to have a more probabilistic mindset, even though he bets big once he has a high conviction on particular investments.
The World According to…
|The Entrepreneur||The Investor|
|Deterministic mindset||Probabilistic mindset|
|Risk is endogenic||Risk is exogenic|
|High Conviction||Risk Management|
One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.
Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.
The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).
Analytical vs Statistical Approaches
For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.
The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.
The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.
The Limits of History
But what is data? Data is history.
Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.
The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.
I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.
We don’t seem to ask ourselves how we come up with these number, do we?
Do We Even Know What Inflation Is?
The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”
In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).
If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?
How to Measure Inflation?
This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.
Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?
What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches?
And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.
So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.
In 1916 Robert Frost published his poem The Road Not Taken. It is a narrative poem, where the narrator describes a moment when he comes to a fork in the road while taking a walk through a forest. After mulling it over, the narrator decides to take the road that seems to be less travelled.
The poem is by many regarded as one of the most misunderstood poems in history. It is often quoted when expressing views of individualism and not conforming to general convention.
At the end of the poem, the narrator sighs as he tells the reader that he took the road less taken and that it made all the difference. But the sigh is left open to interpretation by Frost, as the reader does not know if the sigh is from relief or regret.
The Misinterpreted Message
“You have to be careful of that one; it’s a tricky poem — very tricky,” Frost is known to have said about the poem. The story has it that he wrote it to tease a friend of his, Edward Thomas, who often had problems with coming to a decision over choices that were offered to him. Frost describes him as a person who, “whichever road he went, would be sorry he didn’t go the other”.
An economist would tell you that the problem that Edward Thomas – just as the narrator in the poem – was battling with was the Opportunity Cost of the choices that he had.
The Opportunity Cost of a decision basically equals the benefit of the best alternative option that you have to choose from. This means also means that the opportunity cost is dependent on the situation that you find yourself in at any given time. Furthermore, it means that your opportunity cost is not the same as my opportunity cost.
The concept of opportunity cost is well known in economics and finance, where it is relatively easier to measure the potential outcomes. The Opportunity Cost of Capital, for example, is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
Mistakes of Omission
In The Road Less Taken, the narrator has two choices. Therefore, his opportunity cost is whichever road that he will not take. If he picks the wrong road, he will have made a Mistake of Omission. When asked about their biggest mistakes at the Berkshire Hathaway 2011 annual meeting, the legendary investors Warren Buffett and Charles Munger highlighted specifically about their Mistakes of Omission.
The Road Less Taken
Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;
Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,
And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.
I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
How to Value Stuff is a website dedicated to thinking about the value of everything and nothing. What us to value something? Let us know.
All investments have to be made by taking into account the objectives of the portfolio, the allocation of assets, and the need for the new investment into the overall investment strategy. Hence, before investing in gold it is best to carry out a basic review of the portfolio goals and then make a choice.
The start of 2016 featured dull economic growth and feeble energy prices which caused the share market to open at its worst. This resulted in an increased demand for gold and its price soared. However, as the year progressed, the share market outperformed gold and by the year ending it was 3 percentage points above the yellow metal.
You may go through the below-listed pros and cons of gold before investing in it.
Advantages of investing in Gold
- It is a great hedge against inflation and currency: Gold and other precious metals are a good source of hedging any risks such as a possible decline in the US Dollar or other major currencies. Price of gold tends to rise with the weakening of a currency. It is argued that high inflation is marked by increased prices of gold, which safeguard purchasing power. However, there are many who debate this argument. Additional information about the relationship between inflation and gold prices is provided below in the article.
- Portfolio diversification: One of the major aspects of a good portfolio is diversification wherein there is no correlation between different classes of assets in the investments. This means that the different asset classes fluctuate in their own unique way thereby offering some protection during times of volatility. Over the past 5 years, the price of gold has differed from the different share indices and the movement of each is independent of one another. Thus, gold and other precious metals are a great way to diversify the portfolio.
- Hedge against economic collapse: Gold and other precious metals can be a great source of barter when the world economy is in turmoil. Over the course of history, it has been observed that people purchase gold as a hedge against uncertain times. When the world appears to be in a state of disarray, investors like to buy and own gold. For example, in 2008, during one of the worst global financial crises in recent times, there was an appreciation of gold by 5 per cent while stocks tanked by nearly 40 per cent. Gold gained over 7 points against stocks in 2011 when it seemed that the United States may default and the credit rating of the country dropped.
Disadvantages of investing in Gold
- The returns in the long-term are low: As compared to shares, the returns offered by gold have historically been low. It thus makes a bad investment selection for the long term.
- No revenue in form of dividends: Investment in gold does not offer interest, dividends, or any other type of income. Hence, one of the most renowned investors in the world, Warren Buffet, is against investment in gold or other precious metals. Currently, the interest rate is low, and hence in such a scenario lack of income will play a smaller role as the opportunity cost with regards to investment in gold will be lower.
- The worth of gold is determined by what a buyer is willing to pay for it: Gold does not have an intrinsic value. Thus, it’s worth can drop if people decrease their investments in gold. Also, it would not be of great value in a barter market as people may consider something like toilet paper or other true consumables to be worth more than gold which does not really take care of any human needs on its own.
The relationship between gold and inflation
It is said that gold does not offer any yield. The definition, however, states that increased interest rates will offer some yield to gold investors. On the other hand, if the FED detects inflation and increases the interest rates, then people will sell gold and purchase Treasury notes for better returns. This will cause the price of gold to drop.
President Trump has stated that he will begin a public works program amount to $1 trillion. Such fiscal stimulus may cause the inflation to rise sharply and making the FED increase the interest rates. This may eventually result in a drop in gold prices.
The above example has to be read in context with what happens in reality and not in theory. It is important to note that the FED does not increase interest rates haphazardly. It wants the inflation to be under control, but its main aim is to keep negative real rates wherein inflation is higher as compared to nominal rates. Raising the interest rate will not offer any positive effect unless there is a faster rise in inflation. This is the scenario where its job of wealth preservation is done by gold.
In the late 1970s, the United States was on the brink of hyperinflation, the gold price was about $130, and Treasury notes dived under 7 per cent. By 1980, gold reached its peak price of over $800, while the ten-year Treasury returns were over 10 per cent. To avoid a worldwide run on the dollar, the FED chief took anti-inflation steps in October 1979. The price of gold kept rising till it reached its peak, but the stranglehold kept on by the FED eventually yielded results and gold prices started to dive.
The current Fed chief, Janet Yellen, may not strangle inflation as in the above example. In the late 70s, the FED had hiked up the interest rates above the inflation rate. However, in 2018, the FED is most likely to increase interest rates but keep it under the rate of inflation.
Different financial issues across the world like persistent unemployment, the European debt crisis, and a hangover of the housing crisis, etc., have created an environment that is fraught with a probable collapse of the global economy. Hence, hedging in gold will offer stability and protect your ability to continue trading for varied goods and services.
The cryptocurrency market has experienced tremendous growth over the last decade; especially in the case of Bitcoin as opposed to other altcoins; Bitcoin is a digital currency that came into the market early in the year 2009.
What is Bitcoin?
Bitcoin’s operations are purely decentralized with no entity given the responsibility of controlling it. Apart from Bitcoin, there are several other cryptocurrencies available in the market today; the most common ones include Ethereum, Litecoin, Tether, Stellar or BitcoinCash.
- Learn more about Bitcoin: Bitozi: Crypto Research Compendium
Since December 2017, Bitcoin’s value has escalated up to about $1900. However, its value has experienced volatility since then, despite the prediction of digital analysts of financial showing the value will increase to $50000 by 2025. This looks quite confusing whether to or not to invest in Bitcoin? Before making a judgment let’s check over some fundamental aspects of in relation Bitcoin investment;
Is Bitcoin Safe?
There has been a hot debate over the years whether Bitcoin is a safe investment. Regardless of the negative stories on bitcoins that people hear, Bitcoin has proven to be more secure compared to other financial systems.
Firstly, the Bitcoin’s operations are decentralized such that over ten thousand nodes are responsible for keeping track of Bitcoin ledger and validate all the transactions in the network to ensure the security of investor’s money. On the other hand, the centralized system can be easily compromised by hackers or third party. Also, Bitcoin uses proof of work to enhance security and prevent any possible failures in the system.
Moreover, the transparent transaction done using bitcoin is also an indication of its safety. Additionally, a customer does not need to provide confidential information when using the Bitcoin Wallet and thus are not a risk of revealing their identity to possible malicious people.
Is Bitcoin Legal?
The question of the legality of any currency is understandable. Unlike the traditional currencies controlled by a single entity, in most cases the central bank, Bitcoin is unique. The Bitcoin is decentralized and primarily under nobody’s control. Generally, the legality of the Bitcoin currency entirely depends on what are you doing with it, where are you in the world. Nevertheless, is essential to be always updated on the recent regulations that may arise with regards to digital currency.
An Investment or a Currency?
Currency can be defined as a unit of account and store of value or a medium of exchange. On the other hand, Bitcoin as per definition can be termed as an asset. In this case, an asset can be used to serve various purposes. A currency should be trustworthy, convenient and stable. Bitcoin has experienced volatility and fluctuation in value over a long period. Its instability, therefore, cannot qualify it as a currency but rather an asset or a commodity. The value of commodity usually surges. It creates an exchange value that is affected and modified by underlying marketing expectations.
How do I value Bitcoin?
There are several ways of valuing cryptocurrencies. One of the best methods of determining the value is by evaluating the market that the cryptocurrency trades in. In this case, the value of Bitcoin can be determined by assessing the supply and demand in the market. In other words, the price of Bitcoin depends on the interaction between the sellers and buyers. A Bitcoin trader who believes that its rate will increase in future will be willing to purchase it at a more expensive than the existing one.
The rising demand for digital currency has got the attention of many people in the financial industry. Some of the advantages of investing in bitcoins include protection fraud, minimized risk of identity theft, direct transfer lower fees of transactions as well as the access to difficult-to-access markets. However, some of the limitations are the uncertainty of its legality, high volatility and high risks of loses. Conclusively, based on the above discussion, investing in Bitcoins might be a risk worth taking, having in mind the demand is growing tremendously, and the number of users is doubling yearly.
Investing in today’s economy has evolved tremendously over the last decade. With advancements in financial technology and the growth of the Internet in general, the financial markets have become more accessible today than ever before.
Exchange Traded Funds (ETFs)
Growing financial markets entice new product creation and one of the more recent products is an ETF or an Exchange-Traded Fund. Having many of the same characteristics of a mutual fund, this is traded on the exchanges and behaves similarly to a stock with minute by minute price movements.
Difference Between an ETF and a Mutual Fund
As stated, an ETF has similar characteristics to that of a mutual fund in that it mimics an index or underlying asset. However, some of the differences include how it works. With a mutual fund, some funds require a minimum investment amount and only let you enter and exit as described in the prospectus. With an ETF, there are no minimum requirements and you can enter and exit how you see fit.
Secondly, when trading an ETF you are actually trading shares, whereas with a mutual fund you are contributing to the pool of assets and your money is being used to rebalance the portfolio. Some mutual funds will limit when you can enter due to frictional costs.
Lastly, mutual funds are typically priced at the end of the day whereas, with an ETF, the price is changing constantly like a stock.
Are ETFs a Better Investment Than Stocks?
Many individuals ask if an ETF is better then a stock, while it varies on an individual level, here are a few benefits that an ETF will have that equities do not. The first one is that company-specific risk is limited. When you invest in an individual equity, you add company specific risk to your portfolio, but when you add an ETF that tracks a sector or index, you have a limited company-specific risk.
Another benefit to an ETF is it is managed with a fund manager. This ensures that your ETF products are reacting and performing as it should. With a stock, you have to watch the company’s performance yourself and be willing to study and understand what you are investing in at the company level.
It’s difficult to have a flat statement saying one is better than the other because everyone has different investment objectives. Each has their own benefits and it is up to you to understand what your portfolio requires.
Are ETFs Safe?
As a general rule, yes, ETFs are a proven product that appears to be safe and sturdy. However, you cannot take for granted that an ETF is safe, even the popular ones such as the SPY. It is prudent that you as an investor to complete your own research and understand if the ETF is aligned with your financial objectives.
Overall, ETFs are a wonderful way to access certain areas of the market without taking on risks such as company-specific risk. You can find ETFs that track an index or market sector, allowing you to diversify portions of your holdings. ETFs should still be researched and reviewed like any investment and should you still have questions, contact your financial advisor.