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There are businesses that may remain good (earning return on capital greater than cost of capital) for some time, maybe a long time, but you must not attach infinite values to them.

This is because high returns attract competition, generally causing return on capital to move towards the cost of capital. While such companies may still earn excess returns, but the return trajectory is down.

The good thing about high-quality stocks is that you can pay up for them (never overpay), expensive looking prices, and still do well till the underlying businesses remain good.

With poor quality, most probably, you have no hope.

As Charlie Munger says –

Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.

Somewhere, right this very moment, an investor you know of is having more fun than you. He has made a lot of money – more than you – in the stock market surge of the past few months. And you missed out on it.

In fact, you may even know of someone who owns all the stocks that are rising, and you are cursing yourself for not being that person, plus envying him.

Not just that, looking at your portfolio you realize that somewhere, something isn’t right. There’s one stock, or maybe more, that hasn’t done much even when other stocks you don’t own have skyrocketed.

I know this affects you, annoys you. And that’s a normal emotion to have, and one you have no control over, which is also normal. Your lizard brain – part of the brain that is responsible for primitive survival instincts such as aggression and fear – is hardwired to behave that way.

So, even when you own more assets and privileges than you could have imagined by this age, and are reasonably happy in your life outside stocks, you feel terrible because you missed out on a few stocks that have done wonders for other investors you know of.

[Read more…] about The Biggest Killer of Investment Returns

In his book, Skin in the Game, Nassim Taleb runs an interesting thought experiment where he talks about two cases of playing the casino.

Equate the first case with ‘stock market trading’ in general –

…one hundred people go to a casino to gamble a certain set amount each over a set period of time, and have complimentary gin and tonic. Some may lose, some may win, and we can infer at the end of the day what the “edge” is, that is, calculate the returns simply by counting the money left in the wallets of the people who return. We can thus figure out if the casino is properly pricing the odds.

Now assume that gambler number 28 goes bust. Will gambler number 29 be affected? No.

You can safely calculate, from your sample, that about 1 percent of the gamblers will go bust. And if you keep playing and playing, you will be expected to have about the same ratio, 1 percent of gamblers going bust, on average, over that same time window.

[Read more…] about A Cheat Sheet To Avoid Stock Market Ruin