When investing in a stock or any cash-generating asset, you are betting on the future. Buying a cash-generating asset means you are trading cash for future cash flows. Michael Mauboussin calls it a form of time travel where the buyer travels into the future to see what cash flow they can get from the asset and judge if the price quoted today makes sense.
The only problem with this approach is that we don’t have the time machine.
If you are patient and composed, you can already be ahead of the curve. If you don’t panic with the crowd and don’t get ecstatic when the market is bullish, you can differentiate yourself from the crowd. We know that only few people will be able to do that. Hence, it’s a minority sport and a source of alpha can come from our behaviour that separate us from the crowd.
So, most of us are guessing. And the downside with the guesswork is you will be wrong a lot of the time.
Even if your guess turns right, you shouldn’t credit yourself with the result. You may have factored some of the catalysts in your guesswork, and you may have missed a few. And those missed few would have altered the result that you expected had it gone the other way around.
There are too many unknowns, and we are working with probabilities of few knowable factors.
It is crucial to have the humility to recognise when you're at a disadvantage. Recognising this reality, you tread with caution. When you buy a stock, you don’t ask about the certainty of generating a return. You ask about the probability of getting a return. You understand that the probability of generating a return from a stock at $40 is higher than purchasing the same stock at $50. This sounds obvious but we don’t always think in this framework. It’s important to understand what you buy and it’s more important to emphasise what you pay.
While the future is filled with lots of unknowable factors, we work with the knowable few and make the best possible action by trying to reduce our cost of entry. We can do so when the market is less crowded and offers a lot of bargain.
Source of alpha doesn’t only come from the asset we buy, it also comes from our behaviour. The following quote of Nick Sleep that echoes Buffett and Munger’s philosophy sums it up.
“Good investing is a minority sport, which means that in order to earn returns better than everyone else we need to be doing things different to the crowd. And one of the things the crowd is not, is patient.” - Nick Sleep