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My recommendation: 09/10

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Summary of notes and ideas

Investment skill consists not in knowing everything, but in judicious neglect: making wise choices about what to overlook.

Most investors would have better performance if they thought more and did less. One of the great tricks in investment is learning to be happy doing nothing.”

Monitoring changes in market psychology helps in understanding where you are in the cycle. “A market doesn’t peak until the majority is convinced it is going to move higher, and it doesn’t bottom until the majority believes it must go lower.”

I believe that when an individual stock seems cheap, one should buy and ignore whether general market movements might make it 10% cheaper next week.

If you think Armageddon is coming, what are you actually going to do? Sell all your shares and hide under the bed with a crate of whiskey? In that scenario, if Armageddon is averted, then with hindsight shares will have been a massive bargain. And if Armageddon materialises, you would have bigger worries than your share portfolio.

After half a century, he thinks that there are “only two keys to long-term investment success: common sense and patience. Value will always come through in the end

He thinks successful investors tend not to follow the orthodox paradigm of seeking advice about unfamiliar subjects, but instead have “a psychological predilection towards figuring things out for themselves.”

Kelly betting are that investors are better off maximising expected logarithmic return, not expected return, and that this often implies lower leverage than casual intuition suggests. For example, an investment which either rises 25% or falls 20% with equal probability in each period has a positive expected return of 2.5%, but an expected logarithmic return of zero. If you then leverage this investment 2x, as would be common in spread betting, it will rise 50% or fall 40% in each period. This leverage increases the expected return to 5%, but reduces the expected logarithmic return to less than zero at -0.0527. Compounding over the long term, the negative expected logarithmic return means that the leveraged investor will almost surely go broke, despite having a positive expected return in each period.

This lack of ego is perhaps his main comparative advantage as an investor. He combines Livermore’s ability to “be both right and sit tight” with an ability to change his mind quickly and completely on new information.

But the story is only one side of an investment decision: the other side is the price, and the price of good news is often high. Buying bad news might be a better strategy, if the price is low enough.

The most common type of glitch is a profit warning (see panel). A profit warning often induces a dramatic change in investors’ perception of a company. Some investors seem to regard any profit warning

He is conscious of the trade-off between thorough knowledge of the sectors he invests in, and not missing new opportunities. Focusing on a limited number of sectors leads to “economies of scale in knowledge production” – that is, learning about one company in a sector helps you to understand others in the sector. On the other hand, if you spend all your time looking at a few sectors, you “risk getting stuck at local optimal.”

He also made the point that it is not worth knowing everything about a company: every investigation has a time opportunity cost. Your aim is not to check all possible hygiene factors, but to check enough to reduce your error rate to a time-efficient acceptable level: a low, but probably not zero, rate of error.

Asked when he sold stocks, Vernon said “when they become popular”. Elaborating on this, he said that selling was conceptually a more difficult decision than buying. In principle you should always think about selling as a switch to an alternative investment. You should sell if the prospective returns on the alternative investment – which might be a cash deposit – are sufficient to compensate for the tax and other costs of switching. But that is impossibly difficult in practice, so you need heuristics, that is rules of thumb.”

The ease of online dealing makes many people act as if investing was positively scored, but the arithmetic of compounding dictates that it is really negatively scored. Success in investing consists mainly of avoiding big mistakes.

He also highlighted the particular importance for an investor of avoiding mistakes. He drew a distinction between activities with ‘positive scoring’, where success is defined by gaining wins, and activities with ’negative scoring’, where success is defined by avoiding faults.

Time is a limited resource with strongly diminishing returns. The first hour you spend researching a company is much more important than the tenth hour.

To limit the time resource applied to any one company, he reminds himself of psychological research which suggests that in many contexts decisions are best made with no more than five to seven points of information.

To limit the time resource applied to any one company, he reminds himself of psychological research which suggests that in many contexts decisions are best made with no more than five to seven points of information. Any more information beyond that does not significantly improve decisions, and may even degrade them.

Directors often initially don’t want to speak to me, but I always persevere. I find it helps to put something in writing. I get the company secretary’s email from the advisors, then I get the directors’ contact details from the secretary and I write to the directors. I express my views, I refer to the directors’ fiduciary duties and I ask them to call me. Once there is a paper trail, the directors can get into trouble if anything goes wrong, so they have little option but to communicate with you.”

Generally speaking, a larger percentage shareholding means greater influence. Peter regards a 25% shareholding as a particularly important threshold. This is because the Companies Act requires major corporate actions such as new issues of shares to be approved by 75% of the votes cast at a company meeting. A 25% shareholding therefore guarantees ‘negative control’ in the sense that one can veto these decisions. In practice, because some shareholders (particularly those with nominee holdings) neglect to cast their votes at company meetings, a somewhat lower percentage than 25% is often sufficient to give effective negative control.

Positive working capital. Most businesses need to maintain a stock of finished products ready for sale, or pay employees for their work before the business invoices clients. For example, a house-builder needs to maintain a stock of completed or near-completed houses for marketing to potential house-buyers. The house-builder has to pay all the costs of building the houses many months before any sale proceeds are received. The house-builder needs capital to bridge the time gap between payments and receipts – that is, the business has a positive working capital requirement.

Please consider buying Free Capital: How 12 private investors made millions in the stock market.

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