Are you comfortable travelling by air after hearing news about a recent air plane crash? Do you like person simply because they dress well? Do you want to buy a share which has been purchased by an investor you admire?

The answers to above questions are probably “yes”. It is just because of how our mind works. The moment we hear a question, our mind throws out some thoughts instantaneously, builds a story around it, and jumps to conclusion.

This instantaneous working of mind leads to miscalculation of the situation and affects our judgment. Psychologists call these reactions - the biases, and this whole phenomenon - an Illusion of Knowledge.

Though, it is very important for everyone to know the above phenomenon, but it is especially critical for an investor. An investor deals with the future, which is uncertain, and has to continuously make judgments. So, the obvious question that comes to the mind is how should we judge the situation and make predictions?

Philip Tetlock and Dan Gardner in their book, Super Forecasting, gave a manual for thinking in an uncertain world. They say, “Collect forecasts, judge their accuracy, and add the numbers. That’s it.”

What they are essentially saying is that the measurement is the key. The only way to know if something is working is to measure it.

They further say, “The first step in learning what works in forecasting, and what doesn’t, is to judge forecasts, and to do that we can’t make assumptions about what the forecast means. We have to know.”

Let’s understand the above statement using an example. A weather forecaster may say that there is 70% chance that it is going to rain tomorrow from 3 pm onwards. Here, there are three important things mentioned, a) the timeline of an event (tomorrow); b) the specifics of an event (rain from 3 pm onwards); and c) the probability of happening of an event (70%).

These three things clarify the forecast. Now, we know what the forecast is.

Also, when a forecaster says there is 70% chance that the event will happen, she also says there is 30% that the event will not happen. So, the only way to know for sure about her forecasting skills would be to run the forecast hundreds of time.

If we are serious about forecasting, we must a) clearly define the forecasts in terms of its specifics, timelines and, probability; b) measure its accuracy; and c) doing it for the very long term.

Let’s apply this to investing.

In investing, trying exactly this can improve our performance. Here, by defining we mean the probability of which stock, going up by how much, and within what time frame. By measuring we mean comparing the performance with the benchmark, the broader market index.

But, investing is not as precise as forecasting. It is a rough endeavor. Defining a probability to a stock going up is difficult. Defining by how much the stock is going to up is even more difficult. Doing it consistently for the very long time is even more difficult.

Our article #4 and #5 is based on defining the forecast based on probability and continuing it for the long term, respectively.

Now, let’s go one step upstream on what methods are we using to define the forecast. There are several ways or styles to invest like momentum investing, pattern trading, growth investing and many more.

Li Lu, an investor and businessman, in one of his talks said that he realized there are only few long term track records and practically, all were value investing. In other words, value investors are the only ones who are beating the broader market index.

Warren Buffett has also said similar thing in his article “The Superinvestors of Graham and Doddsville”. He has indeed shown the long term track record of some of the investors who has beaten the broader market index in the longer term.

From what we have learned above, if there is only value investing that is working for the very long term, then it must be the true kind of investing. Thus, learning about it can improve our performance. There are only four principles of value investing.

First, stocks are not just pieces of papers to buy and sell. Stock represents a part ownership in the company. When we invest in a stock, we are investing in a company. As the company grows, value of our investment grows.

Second, market is there to serve us. It gives us many opportunities to buy a share of a company for many different prices. But, we should not act on it every time. We should not let it become our master; instead we should use it as a tool to serve ourselves.

Third, While investing we should leave a large buffer to accommodate our errors. This is called margin of Safety. It means we should purchase the stock at a price less than our estimation of value of the company. We should act only when the market offers us our desired price.

Since, stocks are the part interest in the company and the company has an intrinsic value. We should wait for the market to take the price below that intrinsic value and, then act. How to calculate the intrinsic value? That’s where the next principle comes in.

Fourth, gaining the deep understanding of the company and the industry in which it is working to better estimate the future performances. This way we can calculate the intrinsic value of the company. It is called the Circle of Competence. It takes a lot of time and efforts to build and expand circle of competence.

We have to remember one thing. The above principles are the roadmap to the investing. There are several ways of value investing. It can range from pure quantitative ways of Benjamin Graham to great businesses style of Warren Buffett.

Now, that we know what path to follow, there are few more things we should be aware of to improve our judgment skills. The authors of the book, psychologists, conducted a project in which many experts were divided into two groups. One beat the benchmark, but other didn’t. They write, “Why did one group do better than the other? It wasn’t whether they had PhDs or access to classified information. Nor was it what they thought. The critical factor was how they thought.”

So, it is the temperament of the investors that let them beat the benchmark and makes them great. We should use many analytical tools (or what Charlie Munger calls many big ideas, a multidisciplinary approach) to face the problem. We should read and read to collect as much information as we could. We should think in terms of probabilities, not certainties. We should be flexible enough to accept when we are wrong and change our mind.

We shall further think about the details of these topics later.

Let us conclude this discussion by jotting down the few simple and big ideas that we have learned.
1. Stick to one simple, tested idea and stick to it for long term.
2. Don’t be ideological, be flexible in thinking.
3. Have many analytical tools in your arsenal. Be multi-disciplinary.
4. Think in terms of numbers and probabilities.

Disclaimer: The above learnings are from the book Superforecasting by Philip Tetlock and Dan Gardner. We try to apply these learnings to our investment operation. We can be wrong in our thinking or that our thinking can change in the future as we learn more. So, let's move forward with a sense of skepticism.