The role of an active investor is to compound return at a rate higher than the market over the long-term. To achieve that, you have to be right and non-consensus. Both require making good decisions. And good decisions comes from learning how to think well.
Good thinking can only be achieved through lifelong learning. These are the books I’ve read that I believe can help you to become a better thinker. Reading is only the beginning. Apply what you learn is where knowledge meets wisdom. Make them part of you.
The Signal and the Noise: The Art & Science of Prediction by Nate Silver
How do we differentiate the signal from the noise in data? If a company decided to venture into a new business, is that an indication of high future growth or is it a sign of management complacency?
Silver looks into the nature of weather, earthquake, economics, and disease to understand what makes them unpredictable. In part, they are dynamic systems that can create butterfly effect; a small changes can lead to large effects. And there’s 2 levels of complexity. Weather is complex but we can improve our forecast as our tools get better. That is level 1. The stock market falls under level 2. Similarly, it has many variables but unlike the weather, which doesn’t care about our predictions, market learns and adapts. The act of forecasting it changes the outcome. But there’s hope.
Silver offers Bayesian thinking as a way to get closer to the truth by constantly updating our view. Apart from learning how to avoid common mistakes in making a prediction, you’ll come away from this book with an appreciation on uncertainty and the advantage of thinking in systems, which, to me, are essential in investing. Check out Superforecasting if you like this book.
Psychology of Intelligence Analysis by Richards Heuer Jr.
In investing, we can be right for the wrong reason. Our return, or the outcome of an investment, is heavily influenced by the role of luck. Therefore, using it as the basis of judgment whether you have made the right decision can lead to wrong feedback and more mistakes down the road. A better way is to focus on the thought process – how you come to a conclusion by evaluating the logic and reasoning behind it.
Drawing from studies in political, social sciences and clinical settings, this book looks into the psychological aspects of how we make decisions. The limitation of the mind, cognitive bias, and tools for better thinking. It then introduces a systematic framework to develop hypotheses, examines evidence and draws tentative conclusions. While most of the examples are associated with intelligence analysis in the political landscape, they are practical for any work concerning the analysis of information. If this is good enough to be the manual guide for CIA, it is certainly good enough for investors. If you like psychology, check out Thinking, Fast & Slow, Predictably Irrational and Misbehaving.
Most would be familiar with Howard Marks. Read his memos if you have the time. Otherwise, this book is a good place to start. It encapsulates all the key concepts that are critical to become a successful investor. You probably heard of Pareto Law or the 80/20 rule. In short, the rule shows that a few things tend to determine the bulk of the outcome. So, it can be a few stocks that explain the return of a portfolio or a few activities that determine the success of an investor.
In investing, you have to get the big things right. Or in Mark’s words, the most important thing. The 20% that drive 80% of the result. Trying to find the next profitable stock matters the least if you don’t get the big things right. From a total of 20 chapters, Howard Marks spent 5 chapters on market fundamentals; 6 on risk and not losing money; and another 5 on psychology. That tells you a lot what are the big things in investing and where you should put your time into. Ironically, they are also things that not many talks about.
Joan Magretta’s book distills the essence of Michael Porter’s work on competition and strategy. It gives you an overview of how to analyze competitions and understand what is strategy. Two reasons why this book is important.
We have a misconception about what strategy truly means. Some would think investment in machinery for automation or streamline operation are strategies but they are operational efficiency. A business has to do it regardless to survive. In contrast, strategy is a choice; a tradeoff between what to do and what not to do. Another reason is overconfidence. We tend to overestimate the success of a company when we fail to take into account what the competitors are doing.
You will learn about the 5 forces of competition, what create competitive advantage, how business create value, and how activities within a value chain form a company’s strategy. If you want to dig deeper into strategy, try Strategic Logic.
The Checklist Manifesto: How to Get Things Right by Atul Gawande
Most investors are concerned when the next crisis is going to hit. This is understandable given the magnitude of losses one can potentially suffer should such an event occur. But it’s not as important as you’d like to think. The main reason why most investors lose money isn’t that of some unpredictable global crisis. But rather silly, preventable mistakes that we make every day.
Atul Gawande looks into why simple mistakes can happen under different complex situations from surgical, construction to aviation and investing. And how having a checklist can reduce or prevent most of them. You won’t get an exact way on how to build a checklist in this book. But you’ll appreciate the importance of checklist, why it isn’t only for amateurs and how slowing down your decision making process can make a huge difference..
If you like this book, check out another book written by him – Being Mortal: What Matters in the End.
The Drunkard’s Walk: How Randomness Rules Our Lives by Leonard Mlodinow
My past 10 predictions are all correct with an average gain of 78%. What does that tell you? It is intuitive for us to think causally and find patterns in everyday lives. We do that all the time. We create stories from our memory to explain why a person is successful; what causes the market to drop yesterday; or why the train is delayed. The news is just as ready to fill us up with vivid details on how things happened. However, this cognitive advantage comes with a warning sign: the past always looks more predictable than it actually is.
Mlodinow walks us through the psychological aspect of thinking and why it is hard to think about randomness. He uses probability and statistics to explain the role of chance and how to use it as a thinking tool to make good decisions under uncertainty. You’ll understand the fallacy of small numbers and how hindsight bias creates an illusion of certainty. This is a sobering book, a reminder that many things can happen more often than we expected. A required reading to tame our overconfidence. Check out Gladwell’s Outlier: The Story of Success to find out how luck and circumstances shape our success.
While The Drunkard’s Walk approach randomness through maths and science (Leonard Mlodinow is a mathematical physicist), Nassim Taleb looks at it from the eyes of a trader and philosopher. You’ll learn how randomness can fool us; why we’re not wired to think probabilistically; and why the things that didn’t happen, alternate histories, are just as important as what happened. You’ll also understand how news is like french fries; it keeps us satiated while slowly killing us from the inside (but we don’t see it).
A required reading for those that say “If I had listened to you, I would have lost money”. This is the same group that believes everything you say when you tell them your past 10 predictions are correct. Fooled by Randomness is a hard book, but packed full of wisdom. Drawing examples from the stock market, medicine to philosophy and biology to explain what we think we know can be dangerous. It will change your perspective as an investor.
The Black Swan: the Impact of the Highly Improbable by Nassim Taleb
The Black Swan is the continuation of Taleb’s work on randomness. The book dives deep into the fat tails of randomness to understand why it is hard to predict rare events that carry extreme impacts.
While a black swan is normally associated with rare, global events such as 1997 Asian crisis or Black Monday of 1987, it is just as applicable to unseen risks that happen on a smaller scale. As an example, an overly concentrated portfolio or leveraged position can both result in large magnitude of losses. Narrative fallacy, confirmation bias, and silent evidence can all blind us to such risks. This book is more about ‘how not to’ than ‘how to’. While the book can be technical on a few chapters, it is nonetheless filled with interesting and widely applicable ideas that improve thinking.
The Demon-Haunted World: Science as a Candle in the Dark by Carl Sagan
What does a science book has to do with investing? Plenty. Carl Sagan puts it better than me.
“Science is more than a body of knowledge; it is a way of thinking. The scientific way of thinking is at once imaginative and disciplined. It invites us to let the facts in, even when they don’t conform to our preconceptions. It counsels us to carry alternative hypotheses in our heads and see which best fit the facts. It urges on us a delicate balance between no-holds-barred openness to new ideas, however heretical, and the most rigorous skeptical scrutiny of everything – new ideas and established wisdom.”
It is this kind of thinking, a balance between openness to new ideas and the most rigorous skeptical scrutiny of everything, that should be the spirit of investing. Investors often get caught up trying to validate their own hypotheses by finding supporting evidence, or worse, develop hypotheses that cannot be disproved. Having a healthy skepticism and self-criticism helps you avoid accepting things at face value, which I believe is the only solution to how investors can prevent themselves from making simple yet costly mistakes. You’ll see how Sagan uses his clear thinking to expose pseudoscience. And how that can equally apply to the stock market to detect nonsense and B.S.
More Than You Know: Finding Financial Wisdom in Unconventional Places by Michael Mauboussin
If you have read Mauboussin’s research papers, you’ll be familiar with this book. More Than You Know takes a multidisciplinary approach to understand how investing works and how you can become a better investor by incorporating fundamental knowledge from other disciplines. It covers a range of topics from investment philosophy, psychology, innovation and competitive strategy, and science and complexity theory.
Most of the ideas are counterintuitive. You will find some similarities here with other books such as focus on process over outcome; think probabilistically; psychological misjudgment; and inside versus outside view. Overall an easy book to read and should get you interested to start thinking in multi mental models.