Markets And Intuition 2

I emailed the book reviewer mentioned in my last post and received the following back from him:

I would like to emphasize a key point I made that still sticks in my mind like a sliver and makes me wonder why anyone needs a human to tell them which stock to invest in if intuition is so unimportant in the long run. Here is part of my post which I would like you to consider in a little more depth and let me know what you think…

“If all it took was simple number crunching to pick good companies to invest in, then a mindless computer could make each of us millionaires and pick the companies for us. No more gurus, no more tedious analysis.”

You are still saying that your book tells people how to analyze a company objectively and with the same information available to the experts, yet if successful long term investing did not take a severe dose of intuition or luck, then a computer could analyze the market for us, tell us which companies suck and which to invest in, and whadda ya know, we’d all be millionaires 20 years down the line. Well, plenty of financial data is available for a computer to analyze and make the same decisions and conclusions that you hope people will make by following your formulas, so I still see a major contradiction here. Why are humans still involved in the process if successful investing is merely the result of analyzing objective, freely available, computer analyzable information? That makes no sense.

The short answer is that successful investing is NOT merely the result of objective analysis. I never claimed that it was. However, success in stocks does require some number analysis along with judgment.

While a computer cannot analyze numbers and spit out a list of winners, it can certainly help you choose winners by running the numbers and spitting out a list of companies that fit your basic criteria. For example, companies that: are profitable, carry no debt, have a P/E under 20, and are trading below their 52-week averages. Will every stock on that list succeed? No. How can we find the winners on the list? With further research and, yes, judgment.

The raw numbers analysis is a good start. Even if you have poor judgment, your odds of succeeding are better from a small universe of carefully-screened, high-quality stocks than from an open pool of good, bad, and ugly stocks.

But let’s look at the judgment portion of success, as that seems to be the reviewer’s main qualm. The purpose of my books is to help you find good stocks. Part of that involves teaching ways to acquire good judgment. Reading what management has to say helps. Hearing the opinions of other investors helps. Reading information about competitors helps. Thinking long and hard about what a company is really worth helps. We need to think ahead to what kind of free cash flow a company will generate in the future, then discount that back to today’s dollars and decide how much we’re willing to pay for it. Is it possible that after running those numbers, arriving at our own assessment of the company, and then patiently waiting to buy at a price that’s reasonable to us, we could still lose money on the stock? You bet it is! I mention that more than once in my book. However, we greatly increase our odds of success when we invest after walking a path such as the one I just outlined.

The whole point of careful investing is to reduce risk. The goal is not to eliminate risk. If we must eliminate risk then we should just hold cash. But to seek the higher returns of stocks, we must take on risk. To achieve the highest return possible with the lowest exposure to risk is our ever-present challenge. Meeting the challenge requires good numbers analysis and careful judgment. Computers can help, but they can’t do it all.

On a final note, so what if it takes judgment? So what if it takes skill? Are we incapable of developing good judgment and fine skill? I don’t think so. We must practice at everything we do, investing included. Some people have more talent than others. Does that prevent us from trying to improve our golf swing, our singing, our painting, our poker game, or indeed our investing? No, it doesn’t.

Having a good set of golf clubs won’t guarantee your success at golf, but it will help, and moreover, it’s necessary. Knowing how to analyze numbers won’t guarantee your success at investing, but it will help, and moreover, it’s necessary.

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