This idea is interesting in light of the work of behavioral finance professionals. What we have learned is that by and large we humans are terribly overconfident. We think we are above average even when the evidence points to the contrary. In his book the Black Swan, Nassim Taleb sites a study by Paul Slovic that suggests that with more information we gain more confidence. Slovic “asked bookmakers to select from eighty-eight variables in past horse races those that they found useful in computing the odds. … The bookmakers were given the ten most useful variables, then asked to predict the outcome of races. Then they were given ten more and asked to predict again. The increase in the information set did not lead to an increase in their accuracy; their confidence in their choices, on the other hand, went up markedly.” Because we are more confident doesn’t mean we are more right. We can deceive ourselves that with more information our analysis of a company is better.

This may be part of the reason some more mechanical investing strategies can outperform active management investing strategies. The mechanical nature reduces our reliance on our foibles such as over confidence.

Do you use confidence as part of your investment strategy, if so, how do you ensure that it is not overcofindence? Any thoughts on this subject, please add a comment.

Related Posts:

• Investing Styles for Beginning Investors: Philip A Fisher
• Why You may Want to Invest for Yourself
• 20 Things You Need to Know about Value Investing
• 3 Must haves for your Value Investing Notebook
• Mutual Funds – Beginning Value Investor Terms

But what is back testing? It is a process where one takes an idea like investing in low price to book stocks. You formulate a method, for example, that you will buy only price to book stocks in the lowest quintile (20%) on the last trading day of the month and rebalance your porfolio quarterly. Then you test this idea in past period of time. These are usually tested over longer periods. In my post last month about Ben Graham’s Stock Selection Criteria, Oppenheimer back tests the strategy from 1974-1981. In the post on Buying Low Price to Book stocks, Ibbotson back tested from 1967-1984.

I have used these and other academic studies to form the basis of an investment strategy that underpines this website. In fact, it was some of this same back tested research that sparked the idea of 80/20 investing, which I am still developing. But I am not an academic, I am a small time investor. And like many of you, I am really only interested in real returns. So I am keenly aware of some of  the practical limitations of back testing. When I began my research on Graham, years ago, I was puzzled by something. Graham had developed a set of investing criteria. And someone set up a fund that set out to capitalize on this method. The studies show that it should have worked. But it didn’t. The fund had to disband a few years later. Why? What was the disconnect?

So what is the Problem with Back Testing? It turns out there are several Problems for the practical investor.

1) Friction- Friction are the Brokerage Commissions, taxes and bid-ask spread issues that Damodaran referred to. Broker commissions and taxes you can calculate, but because many of the value investing approaches studied deal with small cap stocks that are often illiquid, the difference between the bid for a stock, the amount an investor is offering to buy the stock at, and the ask price, that is the price the seller of that stocks is asking for, can often be quite large, sometimes 10% or more. This cannot be easily calculated in an academic study.

2) Buying on an arbirtrary time frame- For academic research you must attempt measure results over a given time , with specific criteria, but the best deals will not always occur on the end of the month, or once a year.  Rebalancing at mechancial intervals, may also limit your profits, by telling you exit a position too early or too late.

3) Survivor bias- Taleb speaks about this as  a general problem with the investing community in general, and economists in particular. Is the back testing incorporating the number of companies that fit the strategy but failed or when bankrupt?

4) Portfolio limits- If you have a limited investing portfolio such as $5,000, you cannot know going into a year knowing how many opportunities you will have. With such a small portfolio you cannot possibly invest in every opportunity that arises. But that is the very assumption you supposed accept. If 40 opportunities arise, you buy all forty, and if five arise then buy only five. In what proportions? Do you leave everything else in cash?

Are their any solutions to these problems? Some. But not neccessarily solutions that you will be happy with.

1) Friction- There are several ways of dealing with the friction issues. Some I have written about before. For brokerage commissions, select a good discount broker or one that doesn’t charge fees for maintaining a certain balance. Tradeking, my primary broker, charges just $4.95 a trade. Taxes can be controlled by  investing in tax advantaged accounts like ROTH or traditional IRA’s. But bid-ask spreads are a little trickier.  My favorite strategy is to sell on good news. I have noticed that the volume on thinly traded stocks tends to go up when there is good news and investors are trying to buy the equity. Since value investing is also a contrarian strategy, good news is often a catalyst for a price rise and a good opportunity to exit a position. Another tactic is simply patience. Set up flags when a stocks price reaches a certain price. Then put in a limit order. And wait.

2) Buy when opportunities present themselves. Don’t be afraid of cash. It is a better alternative than losing money. I think Graham’s idea of holding for a 50% gain or two years is a good starting place for parameters to frame your investment horizon. But you shouldn’t completely exit a position just because you have reached a 50% gain, if your analysis suggests  a larger upside. Perhaps, in that instance you take a portion of your profits off the table. Two years should be the outside to hold an investment that is not performing. Maybe. If you discover a much better investing opportunity, two years could be too long.

3) Surviving Survivor bias. Look for tools to minimize the chances of a company failing. The most important thing is preservation of capital or as Buffett says, “Rule number #1 is don’t lose money. Rule #2 is don’t forget Rule #1. ” These tools may include the Altman Z score, the Piotroski F score and other more simple financial metrics such as the acid test.

4) Portfolio- Decide how many companies you are willing to invest in. Invest in great investment opportunties when they arise. Keep a Focused Investment strategy. It is possible that if you chose to invest in 8 companies, that after a price drop, one of the companies you have already invested in is the best value, and you should add to your position.

This does not mean a simple approach to investing cannot work. But I am more suspicious of mechanical investing that I was before.

Related Posts:

• Why You may Want to Invest for Yourself
• 20 Things You Need to Know about Value Investing
• Value Investing Ideas – Companies Passing my Custom Screens
• Value Investing Criteria that Works- Low Price to Free Cash Flow (FCF)
• 3 Must haves for your Value Investing Notebook

Simoleon Sense takes a psychological and behavioral approach not just to investing but to finance and the world at large. Miguel Barbosa’s site is a terrific for more than beginning investor’s. Reading his site regularly can help experienced investor’s to take a look at a perspective that is essential but also, often neglected.

Greenbackd takes terrific research and draws detailed analysis of the companies he covers from a deep value perspective, most often those companies that have a catalyst to help extract value. And when available, often he highlights Net Net stocks. The most interesting thing for me about this interview was hearing about Greenbackd’s influence’s. Many of his inspirations I shared but he extended past me into a philosophical school of Economics called the Austrian School. Nassim Taleb has referred often to Hayek, who was part of this movement. Greenbackd also recommended others including  Bastiat and Hazlitt. Over the next week I will try to outline some of the Austrian view. It seems very promising and philosophically satisfying.

Related Posts:

• What is Value Investing?
• Value Investing Criteria that Works- Low Price to Free Cash Flow (FCF)
• Beginning Value Investor Terms – Exchange Traded Fund (ETF)
• Top 5 Value Investing Tips
• Greenblatt, Ackman & Value Investing Masters speak at the Value Investing Congress

If you are the kind of small time or beginning investor that I am hoping is reading this blog, then I didn’t just throw you into the deep end of the pool, I dropped you into the ocean. So consider this another swimming lesson. Investing 101. Beginning Investor class. More like a list of Investor tips.

Since you are at my blog, I will tell you what I think is important. This is not a complete list. These ideas are not listed in any particular order. You didn’t go to Gray investing. This is Chroma Investing. Hopefully I can bring a little color to what everyone else seems to think is black and white. There are hundreds of blogs about investing and many have not just different but contradictory ideas. Which is correct?

Figuring out what  is right and what is a load of crap takes time. If you don’t  understand the basics of investing, you will have to learn them. Hopefully that is part of why you are here. And that you like sarcasm.

1) Take it slow.  You didn’t learn to drive in a day. You won’t learn how to invest in a week. There will still be good deals whenever you are ready. Don’t invest with real dough until you have worked through the fundamental investing ideas enough so that you know how you want to invest. That means if someone says they have a great tip, you better get in before the market closes in fifteen minutes. Pass. Run away. They may be right. But you won’t be able to figure it out that fast. Unless have already done research on that particular company.

2) as Graham said, you need to make sure you are protecting your capital before you are earning on it. O.k. that is a paraphrase.  And not a very good one, but the idea is right. There many ways to lose your money. Don’t jump off the bridge, unless the bungy cord is properly connected. Make sure are not taking unnecessary risks or being rewarded too low for the risks you are taking.

3) Get out of debt. This is an easy one. Unless you are the next Warren Buffett you will not be making more money from investing that you are paying on credit card debt. Unless you have been able to secure some incredible deal on a loan, you will be burning cash until you get out of debt. That said, even the master Buffett has used leverage ( a fancy word for borrowing) on occassion. If you know what you are doing, leverage is not a bad thing. Used sparingly and fully understanding the risks. Even many of the financial professionals seem to misunderstand the risks involved with leverage. Just ask Nassim Nicholas Taleb the master of explaining risk and probability and how stupid we really are in understanding it. Taleb is at least a week of posts given the importance of his work in understanding down side risk. (Taleb has two great books that are must reads for humans and doubly so for investors. They are The Black Swan  and Fooled by Randomness).

4)  Have fun. Seriously. If you are not having fun investing for yourself, you will probably cut corners on your research, or fail to update your spreadsheet or valuation tools. If you aren’t having fun, drink good wine instead.

5)  Be comfortable with the fact that you will never, ever have perfect information about anything you invest in. I am not kidding. This is one of those facts that most people missed in the course of college, or grad school, or kindergarten, whenever they got the best info in their life. You will need to embrace the unknown. If you understand the Macro side of economics, you will miss the Micro side. Many professionals will have a problem with this point. Ignore them, this isn’t their blog.

6) Don’t be afraid to keep your money in cash. If you don’t know what to do, or no good deal presents itself to you- Do nothing. Remember Benjamin Graham- preservation of capital first. Be Patient and be confident in your choices.

7) There are always deals to be had. Sometimes they are good, sometimes they are great. Sometimes they suck donkey. Go for the great ones. If you can’t find anything that looks great to you see point Six again.

And I was trying to keep these posts to a couple of pages. Don’t be afraid of annual reports. Annual Reports are like Security Analysis , everyone says they read them, but few people do. Apart from the numbers most of the good stuff is the gems that tell you to run the other way. Good info and sometimes they put right there for everyone see.

9) As I mentioned earlier in the week,  you should develop an investing strategy. Listen to everyone you can read. I will expose you to a bunch of great sites and books and investors. Take it all in. Then figure out what makes sense to you. If it doesn’t make sense you dump it. It doesn’t matter if your neighbor Tom has made a killing in Apple stock. If you don’t understand how he did, or if you understand but, it doesn’ add up some how, then find another strategy.

10) Know what your edge is. Warren Buffett has said stay in your circle of competence. To me this means that we all have special knowledge and talents. Get some self knowledge and decide how that gives you an edge. Low volume penny stocks for example can be an edge for small time investors over mutual funds.

11)  if your investment has a looming cataltic event or person, or group. Pat yourself on the back. Greenbackd.com, one of my favorite stock blogs, specializes in asset driven investments with a catalyst. Smart. I like catalysts like liquidation. It helps develop a time frame for your stock investment.

12) Make sure you have an Roth IRA. Remember if you do well in investing you want to keep. I love the USA, I just don’t want them taking all my hard earned investment profits.

13) a disagreement with Warren note. Buy and hold is a great strategy for Berkshire Hathaway, the corp that Buffett runs. They are huge and you can’t move ships that big very quickly. But the nimble small time investor needs to be clear when an investment is good to buy and when it is good to sell. Buffett didn’t follow his own advice when he was younger and had hedge fund like partnerships. See tip ten again. What is good for Buffett is not necessarily a good deal for a beginning investor.

14) Don’t deworseify your investments. Peter Lynch coined the term. Stick to your good ideas. No small time investor should own 40 stocks. You don’t have time to track that many companies actively.

15) Do not dollar cost average. This is an idea so patently stupid it must have come from the same geniuses who gave us the Effecient Market Theory. Why would anyone invest in anything when it is clearly overvalued? Bet big when the deal is good, stay out when the deal is bad.

16) Research companies in advance. Have a watchlist of companies you might be interested in buying at the right price. Have a buy in price. If the price drops unexpectedly, you will be ready like a vulture to swoop in for the kill.

Oh good I think I said everything I needed to say with this blog. I guess I can retire.

Related Posts:

• 20 Things You Need to Know about Value Investing
• Mutual Funds – Beginning Value Investor Terms
• What are your Investing Goals?
• What is your Investing Edge?
• The Chroma Investing Small Investor Portfolio