There are many things I wish I'd known when I started investing and in this blog I look at five of the lessons I've learned from some of the world's most successful investors.

Top investors such as Warren Buffett, Charlie Munger, Ray Dalio and Jim O'Shaughnessy are not only extremely amusing but they also have a deep insight into how to harvest the best possible return from the markets.

Using their quotes as a backdrop, I look at how the data supports their views and why you might want to listen to what they have to say.

If you would like to arrange some financial coaching with Ramin to discuss investment in more depth, then why not check out our Power Hour page. Power Hours are conducted via a one-to-one confidential video call and are tailored to your specific needs, to help you become a better investor.

Investing Advice Lesson 1: Avoid Overtrading

If you're going to invest you want to avoid trading too often. 

Top Investor Warren Buffett has a beautiful analogy for overtrading, that compares calling someone who actively trades an investor, to calling someone who repeatedly engages in one night stands a romantic.

Clearly in Warren Buffett’s eyes if you're a proper investor then you just shouldn’t trade that often.

Warren Buffett Quote Avoid over trading

In the quote below he extends this birds and bees analogy to go on to say that he doesn't think many others will achieve long-term investment success if they flip from flower to flower..... In other words if they're always switching investments.

Jim O'Shaughnessy, another top investor, takes this idea one step further. He came up with this brilliant twitter thread below, in which he says "Often in investing, the best thing to do is nothing…."

Avoid Overtrading - The Facts

The company Dalbar does an analysis of investor behavior which they publish every year.

They show that over a 20-year period from 1996 to 2016, the S&P averaged an annual return of about 8.2%, yet the average investor return over the same period was much lower at 4.67%.

The reason the investors didn’t do so well was because the average holding period for equity funds was very short, at just three to four years, and during periods when markets turn downwards the investor holding period became even shorter.

If the investors had simply held onto their funds for longer they could have reaped more than a 8% return!

So the message here is not to react to short-term market conditions. Don't sell when markets fall and buy when everyone else is buying because this leads to bad decisions.

If you want to learn more about behavioural investing then check out our blog Animal Spirits Rule

Investing Advice Lesson 2: Don’t Chase Returns

Another type of bad behavior can be to chase returns. An alternative way of thinking about this is you should try to avoid following the herd.

In the quote below, Warren Buffett describes fear and greed as being like super contagious diseases. He says he never tries to anticipate their arrival. But when they do arrive he simply attempts to be fearful when other people are greedy, and greedy when others are fearful.

This means he sells when prices are too high and everyone is buying, and he buys when prices fall and other people are selling.

Don’t Chase Returns - The Facts

One way to tell whether people are greedy or fearful is to look at valuations. 

In the graph below we've got the valuations on the S&P 500 going back 20 years. This is the forward 12-month price to earning (P/E) ratio which divides the price of the index today by the forecast 12-month earnings. 

Another way to think about this is how many dollars people are willing to pay for every dollar of forecast profit.

When markets are overpriced, as they were in the dot-com bubble, people were willing to pay about $23 for every dollar of earnings. But during the global financial crisis people were only willing to pay $8 for every dollar of earnings.

You can see from the right hand side of the graph that currently markets are expensive. This is because people are paying a lot more than usual for every dollar of forecast profit.

Investment Advice Lesson 3: Be Cautious Of Active Management

Active managers aim to select stocks that outperform the broad market.

It's pretty surprising given that Warren Buffett's probably the world's greatest stock picker that he is quite negative about active management.

You can see from the quote below that one of the things he dislikes most is high fees. Consequently he thinks that it's better for large and small investors to stick with low-cost index funds rather than those that are actively managed.

Warren Buffett gives a really simple example to help you understand why low fees are important.

He says passive investors achieve average results before costs, because by definition they just buy the whole market. Consequently, active investors that form the rest of the market must also achieve, on average, average results before costs.

He then goes on to point out that whichever group has the lowest costs is therefore going to win.

Now this doesn't mean that no active managers can ever outperform the market, it just means that as a group they will not outperform. The consequence of this is that the great majority of managers who attempt to over perform will fail net of fees

Be Cautious of Active Management:- The Facts

Below is the S&P Index Versus Active (SPIVA) report for Europe.

If you look at the far right column you can see for the last ten years the vast majority of funds are outperformed by their benchmarks.

For example in the top row for European Equity, over three-quarters of the funds were outperformed by their benchmarks. For US Equity, on the bottom row, only 3% of the funds beat their benchmark.

This represents a catastrophic failure of the entire active fund industry. It also explains why many people are taking Warren Buffett's advice and shifting to passive funds.

If you want to read more about Active vs Passive Performance then you can take a look at my interview with S&P’s Andrew Innes on his Index vs Active Report

How Can I Find A Good Active Fund Manager?

Even if there are fund managers which can outperform the benchmark, how can we find them?

Warren Buffett points out that this search is complicated because some investment professionals, just like amateurs, will simply be lucky over short periods of time. 

He says that if a thousand managers make a market prediction at the beginning of a year then it's very likely that at least one of them is going to be correct for nine consecutive years.

He then say, rather unkindly, that a thousand monkeys would be just as likely to produce a seemingly all-wise prophet. With one difference the lucky monkey would not find people standing in line to invest with him.

This reminds me of the twitter thread by Robin Wigglesworth about a Norwegian TV program pitting some professional stock pickers against an astrologist, some beauty bloggers and some cows pooing in a field. The cows selected their stocks by pooing on a grid.

So who do you think outperformed over this three-month period?

The astrologist came bottom and in fact he underperformed the whole Norwegian Stock Market.

The professional investors drew neck and neck with the defecating cows - the star bovine fund manager was called Gullros.

The team that won were the beauty bloggers!

Investing Advice Lesson Four: Diversification Is Important

It's very important to keep a handle on the risk of your portfolio. One way to do this is to diversify your investments.

Ray Dalio has described achieving good investment returns while taking very little risk as the Holy Grail.

He produced the graph below for a video called Ray Dalio breaks down his "Holy Grail"

The graph shows the risk of the portfolio on the Y-axis, with high risk at the top and low risk at the bottom. The number of assets in the portfolio are along the bottom.

The key thing here is that as you add more assets, going from left to right on his graph, the risk gradually drops until it reaches a plateau.

Notice when the correlation of assets is higher the lowest level of risk is higher too. Whereas if you combine assets with low correlation, the overall level of risk that you can achieve is much lower.

You can see from this graph that the probability of losing money in a given year, if you don't diversify at all, is about 40%, but it's dramatically lower if you do diversify.

What this means is when you choose multiple assets you never know which one is going to outperform. But by diversifying it reduces your risk while you wait for at least one of the assets to generate an income.

So the goal of diversification is to increase the number of units of return you receive for every unit of risk you take.

 In finance speak this is described as maximizing your risk adjusted return 

Creating a Diversified Portfolio

When I look at what I would like to include in my portfolio, because there are so many Vanguard funds I want to compare, it would be impossible to make sense of them in a correlation matrix as there are just too many numbers. 

The tree below represents how correlated each of the funds are with one another. So this tree is a simple and low-dimensional way to see those relationships.

If I have two funds which are close together on the tree, then they're highly correlated. If I have two funds which are far apart on different branches, then they have a low correlation and they would diversify one another better.

You can see that the tree splits quite nicely into bond funds at the top and equity funds at the bottom. 

I represent bonds and equity as being like characters in Scooby-Doo: Velma is quite boring and studious so she represents the bonds, Scooby-Doo is kind of crazy and exciting so he characterizes the shares. 

To have a balanced portfolio you'd have a bit of Velma and a bit of Scooby-Doo. But if you want to achieve a good balance then you don't want too much of either one.

In practice I cut the tree at some point and below I've cut it into three branches. Then I simply choose the funds I like best from each of those branches. 

The important thing you need to know from this is however you decide to choose your funds, to maximize your diversification, you have to choose funds which are uncorrelated.

Investing Advice Lesson Five: Be Wary of Forecasts

Generally you should be wary of forecasts. Definitely don’t ignore them, but just take them with a pinch of salt.

Charlie Munger, who is Warren Buffett's long-term associate, puts this very memorably in the quote below.

Jim O'Shaughnessy amplifies this point of view in his tweet below.

He starts with a quote from Warren Buffett and then later in the tread went on to point out that “People tend to take recent events and forecast similar returns into the future, which is a mistake.”

Be Wary of Forecasts:- The Facts

Jim OShaughnessey also tweeted about David Dreman's book “Contrarian Investment Strategies: The Psychological Edge”.

For this book David Dreman studied analyst and economist earnings growth estimates over a 30-year period. When he looked at the average annual percentage error in those estimates over this period, for the analysts there was a huge 81% error and for the economists it was a 53%.

Dreman also looked at a survey which was conducted at large international conferences of institutional investors, such as pension and hedge fund managers, between 1968 and 1999. This survey regularly trawled-up a rogue's gallery of stocks.

The favorite stock in 1999 was Enron. Enron later went on to be the biggest bankruptcy in corporate history in America.

Jim O'Shaughnessy summed up his thoughts about this in his tweet below, where he seems to think some of these professional forecasters were using a rather unusual cutting-edge technology to make their forecasts!

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