Clear Thinking principles for investment success

The investment profession is so endlessly fascinating partly because of the way that it mixes analytics and psychology. Most great investors are also keen observers of the human condition. And a few have a special talent for putting these thoughts into words. Buffett and Munger certainly fall into this camp, but in my mind, Christopher Davis is right up there with them. 

Here’s a story Davis told on the Masters in Business podcast:

I had a meal with Danny Kahneman quite a while ago, at an investor event, and we’re talking about investing, and he said, “As far as I can tell, you’re in the manufacturing business, right? 

And I said, “We’re not. What are you, an academic? We’re not in the manufacturing business.” He hadn’t yet won the Nobel Prize at this point. So he said, “Oh, you’re in the manufacturing business.”

I said, “Well, what do we make?”

“Decisions.” He said. “If I were you, I would break down the process of making a decision into as many measurable steps and inputs as possible, and over time rally look at where the value is added, and where the value is taken away.”

So when we start with thinking about investing, we think about from the point of view of decisions. We break down the process into these big areas.

If Daniel Kahneman says that investing is the business of manufacturing decisions, I’m not going to argue with him. It’s actually a pretty clever insight. 

As investors, then, we should spend more time analyzing our process for making decisions. And when it comes to thinking about thinking, one of the first people that comes to mind is Shane Parrish. Shane has just released Clear Thinking, which is a concentrated compendium of some of the best insights he has collected over the past decade-plus of writing Farnam Street. 

Reading the book, I found a few insights that link up well with the Low Risk Rules ethos that I thought I’d highlight. 

Liquidity as positioning

One of the concepts covered early in the book is the idea of positioning. That is, your odds of success go up or down based on how good or bad your starting situation. And so putting yourself in a position to succeed is an important consideration. 

Anyone looks like a genius when they’re in a good position, and even the smartest person looks like an idiot when they’re in a bad one.

I repeatedly talk about the importance of staying liquid in your investment portfolio. Committing too much of your capital to private investments, real estate, or illiquid funds can put you in a poor position. You will find your hands tied at the exact moment you want that liquidity for other investment opportunities. Being locked into a great investment is not a bad thing, but the law of averages tells us that you’re more likely to be locked into a mediocre or (God forbid) poorly performing investment. 

I find that far too many investors, especially in the “high net worth” realm, fail to appreciate the value of liquidity. Shane’s coverage of the idea of positioning clearly explains why I encourage investors to maintain as much liquidity as possible. It’s all about positioning. 

Safeguards and rules

Shane describes a number of safeguarding strategies - think of them as guardrails to keep you on course. 

One of these strategies is the use of rules. 

He writes: 

Why not bypass individual choices altogether and create an automatic behavior—a rule—that requires no decision-making in the moment?

And so creating a set of rules for yourself might help you avoid making unwise investment decisions at times when you might otherwise be driven by emotion. 

I don't speculate on short-term trades.

I don’t mess around with shorting stocks.

I don’t buy companies that aren’t profitable. 

These are all a good start. 

Every time an investment decision goes wrong, you can add to your library of rules. In this way you can refine your strategy, and make sure that you are actually learning from your mistakes. There is nothing more frustrating than making the same mistake over and over, and if we operate without a framework for learning from our mistakes, we doom ourselves to be victims of our own biases and shortcomings over and over again. 

Know yourself, and stay within your circle of competence

Shane tells the following story:

I witnessed a powerful display of self-knowledge recently, at a group dinner with a very successful friend who’d made a fortune in real estate. A savvy investor at the dinner pitched him on a company he was taking private. The idea was one of the most compelling I had heard in years.

After hearing out the pitch, my friend paused for a second, took a sip of water, and said, “I’m not interested in investing.” The entire table sat in silence, wondering what we had missed. Someone finally broke the silence by asking him why he was passing.

“I don’t know anything about that space,” he said. “I like to stick to what I know.”

As we left the restaurant, the conversation continued. He admitted that the pitch sounded great, he trusted the person, and thought investors would make a lot of money on the deal. (They did.) Then he told me, “The key to successful investing is to know what you know and stick to it.”

I can’t tell you how many times I’ve seen a successful entrepreneur lose big on an investment that happened to be in an area they knew nothing about. Too often people get excited about the upside in a hot new idea or industry, and let greed take control. They end up committing capital to an investment they don’t fully understand, which so often leads to failure. 

Most striking about this particular story is the individual’s complete lack of FOMO. It’s a level of stoic self awareness we should all strive for. 

Do you really understand? 

This one is really good. Shane makes the important distinction between real knowledge and abstractions. 

Real knowledge is earned, while abstractions are merely borrowed.

Have you done the work necessary to really understand this investment decision, or have you just accepted what you’ve been presented at face value? 

A detailed investment pitch highlighting all of the best aspects of an investment can be hard to resist. It’s easy to create a pitch deck that identifies the risks while downplaying them (equivalent to the job applicant who says that their perfectionism is their biggest weakness). 

When your only source of information on an investment is from the person who is selling you that investment, you are at risk of making a decision based on abstractions.

By nature, (abstractions) are designed to serve the interests of their designers. If those designers don’t have the same interests as you, their abstractions aren’t going to give you the information you need. Similarly, any information you may get from a secondhand source has likely been filtered through that source’s interests. Since your interests are likely different from theirs, their summaries, highlights, and descriptions are likely to leave out relevant information that could help you with your decision.

When evaluating a pitch deck, what is the motivation behind its preparation? What is the side of the story you’re not being told? 

Who wrote the article you’re using to form your own opinions? Who are the “experts” consulted by the author? Do they have an agenda? Do they have any blind spots? 

When it comes to macroeconomic commentary, are “facts” based on past observations being used to back up “opinions” about the things that are sure to happen in the future? 

Are the analysts you’re relying on playing the same game as you? Do they have the same time horizon and risk tolerance? 

Returning to the core principles of prioritizing liquidity, transparency, and simplicity is a good way to build an enduring investment portfolio that serves you and your family, taking the power out of the hands of an investment industry designed to serve itself first. These clear thinking principles are important to keep in mind. The book is a recommended read for everyone, but for anyone not yet familiar with Farnam Street, it’s essential.