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Posted on March 27, 2017

What’s in Your Wallet? A Powerful Portfolio Management Tool

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Published by Rob Furlong

When considering portfolio management tools many people think about complex spreadsheets or Bloomberg terminals flashing red and green stock quotes all day. While these are necessary, they are far from the most significant tool. I carry my most powerful portfolio management tool in my wallet: a library card.

When Warren Buffet is asked to describe his investment process he often replies, “I just sit in my office and read all day.” While this response is a bit tongue-in-cheek his point is well taken. Reading exponentially increases knowledge, and this is what greases the wheels of good decision making. Investing requires obvious reading like annual reports, earnings call transcripts and industry research. A giant pile of economic history books helps too (Against the Gods: The Remarkable Story of Risk by Peter Bernstein and Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed are two of my favorites). But, reaching for the biography and fiction shelves has several benefits as well. A broad reading list improves portfolio management in two ways: by developing second-level thinking and fostering an outside view to forecasting.

Second-level thinking is what separates great investors from the pack. This is the ability to look at the same information as everyone else and reach better conclusions (a chapter is devoted to this in one of my favorite books on investing, The Most Important Thing by Howard Marks). First level thinkers use “rules of thumb” to quickly find easy answers. An example of this is someone who proclaims, “XYZ Corp is a great company who pays a steady dividend, you should buy the stock.” Second-level thinkers know it’s not that simple. A medical diagnostic company may be great now, but the stock could be a disastrous investment because management failed to develop next-generation technologies. Having read about the history of genetics and emerging molecular methods could help identify this strategic flaw (I recommend The Gene by Siddartha Mukherjee and p53: The Gene that Cracked the Cancer Code by Sue Armstrong). Second-level thinking requires being one or two steps ahead or making connections others don’t yet see. This is far from easy, but knowledge accumulated by reading about diverse subjects makes it possible.

The second way reading improves portfolio management is by cultivating an “outside view” (this is talked about in Superforecasting: The Art and Science of Prediction by Philip Tetlock). Most people make decisions based on an “inside view.” We focus solely on the issue in front of us, gather evidence based on our recent experience, and extrapolate linearly. This usually leads to poor predictions. The “outside view” considers how likely an event is based on historical outcomes and uses these base cases to adjust a forecast accordingly. For example, a portfolio manager using the “inside view” could easily be persuaded to invest heavily into an emerging restaurant chain because management promises 20% revenue growth for the next decade and a quick visit confirms the food is delicious. An investor using the “outside view” wonders how difficult this task may be and discovers that going back to 1950 just 2% of all companies have achieved this level of growth over a 10-year period. This prompts deeper digging to understand if and why this restaurant is one of the rare exceptions. The best way to build a mental encyclopedia of these base cases is to read history books, and not just economic history. Having read about the struggles of the Impressionists to gain the respect of the 19th century Paris art scene provides valuable insight into how long it can take great new ideas, technologies or restaurants to break into the mainstream (What Are You Looking At?: The Surprising, Shocking, and Sometimes Strange Story of 150 Years of Modern Art by Will Gompertz is an entertaining survey course on modern art).

Long-term success as an investor comes from curiosity, focus, perseverance, self-criticism and open-mindedness. Reading, especially about unfamiliar topics or material you disagree with, fosters these qualities. This is increasingly important in today’s environment where uncovering true value requires more work than ever. This has pushed many investors to reach for advanced technology tools to manage portfolios. While these will help, I often argue the effective portfolio management tool might already be in their back pocket.