Keynes and the Market Part 6

Being Quiet

Homage to Catatonia Wisely and slow; they stumble that run fast.

-Shakespeare, ROMEO AND JULIET King ' s College, Keynes ' alma mater, is famed for its medieval chapel, considered one of the .nest examples of late - Gothic architecture any-where in the world. Declared the most beautiful church in England by Henry James, it was immortalized by William Wordsworth as a " glorious work of .ne intelligence . . . Where light and shade repose, where music dwells." It was into this place of otherworldly beauty, built by Henry VI to redound the glory of G.o.d, that Maynard Keynes strode one day in the mid - 1930s with a very speci.c task in hand. He surveyed the chap-el ' s lofty pillars and vaulted ceilings, but not, on this occasion at least, for their aesthetic charms. Rather, Keynes - mathematician that he originally was - proceeded with a rough reckoning of the cubic capac-ity of the building. His purpose was to determine whether the chapel could accommodate a large and imminent s.h.i.+pment of grain from South America.

Owing to one of his more .amboyant commodity plays, Keynes was about to be enc.u.mbered with the equivalent of a month ' s supply of wheat for the whole of the United Kingdom. Rather than pay the dif-ference between the spot price of wheat and the contract price - the conventional method for settling a futures contract - Keynes elected to back his judgment and take physical delivery of the grain, con. -dent that the market rate would eventually rise beyond his contracted price. In a rare victory for aesthetics over commerce, Keynes ' imperti-nent scheme to convert the King ' s College chapel into a granary was averted - apparently the building was simply not big enough to store the consignment. Instead, Keynes stalled by objecting to the quality of the cargo, complaining that the wheat contained more than the per-mitted number of weevils per cubic foot. By the time the grain was cleaned, the market price had risen such that the wily economist even-tually made money on the contract.

Keynes ' preposterous plan to turn the hallowed chapel into one of history ' s more elegant barns was emblematic not only of his transfor-mation from callow aesthete to hard headed money - man, but also the change in his investment philosophy from momentum investing to one of " faithfulness " in respect of a handful of " pets." As an early value investor, Keynes believed that " ' Be Quiet ' is our best motto " - short -term price .uctuations could be ignored as mere " noise " and the dis-ciplined investor should patiently wait for the market to rea.s.sert itself as a weighing machine rather than a voting machine.The only rational response to irrational mob behavior, he determined, was to let the game players have the short term to themselves, while Keynes instead prac-ticed a policy of " steadiness " in respect of his select portfolio of shares.

This buy - and - hold strategy was not only the natural complement to an investment philosophy that a.s.sessed stocks on the basis of future income streams, but it also offered long - term investors the not incon-siderable advantages of signi.cantly lower transaction costs, and allowed them to reap the enormous power of compound interest.

Whirlpools of Speculation Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.When the capital development of a country becomes a by - product of the activities of a casino, the job is likely to be ill - done.

-Keynes, THE GENERAL THEORY Teddy Roosevelt, the trust - busting American President of the early twentieth century, once averred that " there is no moral difference between gambling at cards or in lotteries or on the race track and gam-bling in the stock market." Keynes disagreed with this a.s.sessment - he thought that gambling on the stock market was far more deleterious to a nation ' s health than the innocent pleasures of the track or the gambling den. In an appearance before a Royal Commission in 1932, he argued that " it is much better that gambling should be a.s.sociated with frivolous matters of no great signi.cance rather than be bound up with the industry and trade of the country." Keynes believed that racecourses and the like were a relatively harmless safety valve for the speculative urge. " Industrial betting " on stock exchanges, on the other hand, could lead to " the whole of [a nation ' s] industry becoming a mere by - product of a casino."

Keynes contrasted the socially destructive effects of stock market game players with those of speculators in the commodity and currency markets.This latter cla.s.s of speculator, Keynes a.s.serted, provided " a use-ful, indeed almost an essential, service " by providing certainty in other-wise risky situations: Where risk is unavoidably present, it is much better that it should be carried by those who are quali.ed or are desirous to bear it, than by traders, who have neither the quali.cation nor the desire to do so, and whose minds it distracts from their own business.

In contrast, the " proper social purpose " of the stock market was, as Keynes explained, " to direct new investment into the most pro. table channels in terms of future yield." The price performance of a stock will in.uence not only the ability of the underlying company to raise capital on the equity market, but will also affect the company ' s borrow-ing capacity, its ability to make acquisitions, and the types of strategies it seeks to implement. A fundamental tenet of discriminating capital-ism is that the stock market should reward those businesses that are the most successful. Success in the capitalist system is de.ned in brutally reductionist terms - the ability to earn sustainable pro. ts over time.

Only " enterprise " investing, where the investment decision is informed by an estimate of the total prospective yield of a security, facilitates this social purpose. Stock market speculation - which, as Ben Graham remarked, " is largely a matter of A trying to decide what B, C, and D are likely to think - with B, C, and D trying to do the same " - merely serves to distort capital .ows, by potentially diverting capital and kudos away from performing businesses. As Keynes noted in The General Theory, " The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future." In Keynes ' perfect world, the stock market would be populated by individuals buying securities " for keeps ," based on " long - term fore-casts of the probable yield of an investment over its whole life " - not by trigger - .ngered game players attempting to antic.i.p.ate short - term swings in ma.s.s psychology.

Time on Your Side Foul - cankering rust the hidden treasure frets, But gold that ' s put to use more gold begets.

-Shakespeare, VENUS AND ADONIS Keynes had a happy ability to produce economic theories that con-formed to his own personal beliefs. One of the chief conclusions of The General Theory- that moribund economies could be kick - started by government spending - coincided perfectly with his view that money was meant to be spent, not h.o.a.rded. Keynes ' advocacy of " a somewhat comprehensive socialization of investment " re.ected his faith in state -appointed mandarins to, in certain circ.u.mstances, do a better job than the mobbish market.And his views on speculation in the stock market - as opposed to the currency and commodity markets - were in tune with his later incarnation as a value investor, while still allowing Keynes an occasional .irtation with the commodity and foreign exchange pits.

Both during his life and posthumously, Keynes weathered many attacks accusing him of a form of intellectual contortionism: essentially, molding his theories so that they satis.ed his personal predilections. In his defense, however, socially responsible stock market investing - a pol-icy of " steadfast holding " of stocks acquired on the basis of antic.i.p.ated yield - also happened to be most congenial to the creation of wealth in the long term. A long investment horizon not only allows investors to look beyond the distractions of constantly .uctuating prices, but also s.h.i.+elds them from the erosion of capital inevitably produced by trans-action costs inherent in trading.

Perhaps more importantly, a philosophy of " being quiet " - of limit-ing activity in the market only to those occasions when quoted prices appear to stray far from intrinsic value - allows the investor to reap the tremendous power of compound interest. Compound interest works like a kind of . nancial s...o...b..ll - if income from an a.s.set is reinvested, this income will in turn earn income, and the original capital contribution grows at a geometric rate.The " rule of 72 " neatly ill.u.s.trates the expo-nential increases available from compounding. Dividing the number 72 by the yield earned on an investment provides a close approximation of the amount of time required for a sum of income - earning capital to double in value - for example, a sum yielding 6 percent return per year, if re - invested, will double in twelve years, and an a.s.set with a 9 percent per annum yield will double in value in only eight years.

The intelligent investor, recruiting time as his ally in the value -creation process, relies on what Keynes called the " powerful . . . opera-tion of compound interest " rather than the vagaries of the market. For the buy - and - hold value investor, it is time in the market - rather than market timing - that is important.

Errors of Commission Stockjobber: a low wretch who gets money by buying and selling shares in the funds.

-Samuel Johnson, A DICTIONARY OF THE ENGLISH LANGUAGE Even from a relatively early age, Keynes viewed brokers and investment managers in an unfavorable light. In Indian Currency and Finance, his . rst book, Keynes asked rhetorically: . . . how long will it be found necessary to pay City men so entirely out of proportion to what other servants of society commonly receive for performing social services not less useful or dif. cult?

Later in life, he advised his nephew - just setting out in the world of investment - not to take any notice of brokers ' suggestions. Keynes hinted that a type of reverse Darwinism operated among the brok-ing fraternity, a survival of the dimmest. " After all," he reasoned with his young charge," one would expect brokers to be wrong. If, in addi-tion to their other inside advantages, they were capable of good advice, clearly they would have retired a long time ago with a large fortune."

The Berks.h.i.+re Hathaway duo share Keynes ' distaste for the . nan-cial advisory profession.Warren Buffett drolly notes that " Wall Street is the only place that people ride to work in a Rolls Royce to get advice from those who take the subway," and Charlie Munger has drafted in Keynes to support his argument: I join John Maynard Keynes in characterizing investment manage-ment as a low calling. Because most of it is just s.h.i.+fting around a perpetual universe of common stocks.The people doing it just cancel each other out.

As Gordon Gekko, that famous demysti.er of Wall Street, explained, stock market investing, in aggregate, is " a zero sum game - somebody wins, somebody loses." Interposing another level of intermediaries must, therefore, necessarily reduce the aggregate returns available to investors as a whole.

But brokers and investment managers exert a far more insidious effect on stock market game players. Like sharks, appropriately, brokers and other .nancial intermediaries require constant movement in order to survive. The interests of investors and brokers are poorly aligned - brokers are geared toward " churning " trades, thereby maximizing com-missions, at the expense of the investor. Not only do brokers encourage excessive trading - " Never ask a barber if you need a haircut," Warren Buffett quips - but commissions, bid - ask spreads, and other agency costs can seriously erode the capital base of an active investor.

Capital Punishment The avoidance of taxes is the only intellectual pursuit that still carries any reward.

-Keynes (attributed) Brokers ' charges and other transaction costs do, however, possess one positive attribute - they may act as something of a brake on excessive trading, encouraging stock market players to think twice before buying and selling, thereby sparing them from a potentially more punitive cost. The various forms of " capital gains taxes " - a levy imposed on prof-its realized on the sale of a.s.sets, including stocks - are not in fact taxes on capital gains; rather, they are a transaction tax. An investor holding a stock that has improved in price merely incurs a nominal tax liability in respect of his gains - only when the security is sold will the tax liability crystallize.

Buy - and - hold investors sometimes receive concessions on " long -term capital gains " - the tax rate may, for example, be lower for invest-ments held for more than a year. In addition to this explicit reduction in the tax rate, deferring a tax liability can - due to the power of com-pounding - have signi.cant positive effects on the after - tax value of an investor ' s portfolio. An active market player who turns his port folio over each year will incur an annual tax liability. The buy - and - hold investor, on the other hand, only incurs a theoretical tax liability for as long as he holds the stocks, and therefore still has his " before - tax " gains working for him - in effect, the investor receives an interest - free loan from the tax of.ce. Due to the exponential effects of compounding, the buy - and - hold investor will - all other things being equal - record a signi. cantly larger after - tax return.

Warren Buffett and Charlie Munger are particularly . erce critics of the " self - in. icted wounds " sustained from excessive market activ-ity. Buffett cautions that a " hyperactive stock market is the pickpocket of enterprise," and Charlie Munger commends a policy of minimizing " frictional costs " : There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You ' re paying less to brokers. You ' re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

As Buffett noted in a letter to Berks.h.i.+re stockholders," For investors as a whole, returns decrease as motion increases."

To Have and to Hold I believe now that successful investment depends on . . . [among other things] a steadfast holding of . . . fairly large units through thick and thin, perhaps for several years . . .

-Keynes to the King ' s College Estates Committee, May 8, 1938 Keynes, better than most, understood the .eeting but intense satis-factions of the successful speculator. Writing in The General Theory with the guilty knowledge of the poacher - turned - gamekeeper, he observed that " human nature desires quick results . . . and remoter gains are discounted by the average man at a very high rate." It was upon this psychological peculiarity - now pathologized as the condition of " hyperbolic discounting " by the behavioral . nance fraternity - that Keynes laid the foundation for his tremendous stock market success in the latter part of his investment career. Not only was a long - term hori-zon consistent with an investment policy based on realizing the latent potential of underpriced stocks, but this " steadiness " also protected the investor from transaction costs that can seriously erode the capital of the active investor.

In The General Theory Keynes suggested that compelling stock mar-ket partic.i.p.ants to adopt a long view would cure them of the malaise of short - termism and hyperactivity. " The introduction of a substantial government transfer tax on all transactions," he mused," might . . . [mit-igate] the predominance of speculation over enterprise." This idea was later taken up by Warren Buffett, who argued that a 100 percent tax should be applied to pro.ts made on stocks held for less than a year. Buffett ' s refusal to effect stock splits on Berks.h.i.+re paper - the company has the highest priced stock on the New York Stock Exchange, breach-ing the US$100,000 per share barrier in late 2006 - is his own way of attempting to curtail the liquidity of, and therefore the speculative pressure on, Berks.h.i.+re securities.

In considering the merits of a long - term approach to stock market investments, Keynes opined that: . . . to make the purchase of an investment permanent and indissolu-ble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long - term prospects and to those only.

For Keynes at least, the marriage metaphor was apt. He had evolved from a type of . nancial philanderer - engaging in the monetary equiv-alent of one - night stands on the foreign exchange and commodities markets - to a more steadfast individual, remaining loyal to his select group of stock market " pets."

Warren Buffett also adopts a matrimonial a.n.a.logy when discussing investment strategy, calling his stock market approach " our ' til - death -do - us - part policy " and remarking on Berks.h.i.+re ' s " determination to have and to hold." Jesse Livermore, a famous stock trader and market bear in the early part of the last century, once likened Wall Street to a " giant wh.o.r.ehouse " where brokers pimped their stocks to the aver-age Joe. Extending this admittedly crude metaphor, it might be said that Keynes - the reformed sinner, the speculator who eventually embraced the buy - and - hold approach - perhaps wanted to make hon-est women out of his stocks, seeking a faithful and fruitful relation-s.h.i.+p with his select handful of " stunners." As Buffett reminded his stock holder congregation in one of his missives, investors are not rewarded for activity - they are rewarded for being right.

Chapter 12

Eggs in One Basket

A Fugitive from the Law of Averages Too much of a good thing can be wonderful.

-Mae West, in MY LITTLE CHICKADEE Keynes ' paternal grandfather, like his ill.u.s.trious descendant, was adept at turning a pro. t. Exploiting England ' s enduring obsession with gardening, he accrued a small fortune from his . ower - growing business, making his . rst .nancial killing during the " dahlia craze " of the 1840s. Keynes senior was a shrewd businessman who resolutely focused on only the most lucrative . ower strains - .rst dahlias, later roses and carnations - rather than, in the words of one gardening magazine of the time," embark[ing] money and strength in dubious enterprises." Like his forebear, Maynard Keynes also believed that investing heavily in a few " pets " would typically deliver much better returns than an indiscriminate policy of diversi. cation.

Keynes was repeatedly reprimanded for making big plays on only a small number of stocks. In response to criticism from a colleague at

Provincial for purchasing " a large and exceptional unit " in a s.h.i.+pping company, Keynes bristled: Sorry to have gone too large in Elder Dempster . . . I was . . . suffering from my chronic delusion that one good share is safer than ten bad ones, and I am always forgetting that hardly anyone else shares this particular delusion.The price has, I think, now gone up by about 6 d, so you can get rid of any surplus without loss that you would like to.

In his indomitably contrarian way, Keynes rejected the orthodox view that an optimal stock portfolio is one that is widely diversi. ed. Conventional .nancial theory decrees that markets are ef. cient - that is, all stocks are correctly valued and one stock is just as likely as another to rise or fall in price in response to unknowable future events. Building on this a.s.sumption, accepted wisdom argues that it is better to hold a large number of stocks so as to minimize the impact of random under-performance by any particular share. Diversi.cation is the stock market application of the maxim " don ' t put all your eggs in one basket."

Keynes, like Warren Buffett after him, did not agree with this approach - he thought that a patient and informed investor could select a small group of " ultra favourites " having " prospects of rising enormously more than an index of market leaders." When these few " stunners " - or, as Buffett calls them, " superstars " and " grand - slam home runs " - are periodically thrown up by the market, intelligent investors should not be afraid to invest a relatively large proportion of their funds in these stocks.

Accordingly, in the latter half of his investment career Keynes maintained an extremely compact stock portfolio, with over half the value of his total stockholding represented by the shares of only a few . rms. For his faith in portfolio concentration, Keynes was rewarded with an investment performance far superior - albeit more volatile - than that of the broader market.

Basket Case I puts it all away, some here, some there, and none too much any-wheres, by reason of suspicion.

-Long John Silver, in Robert Louis Stevenson' s TREASURE ISLAND Portfolio diversi.cation is essentially a defensive strategy - by spreading funds between a large number of stocks, the extent to which poorly performing shares affect overall portfolio value is reduced. Further, the greater the diversi.cation within a stock portfolio - that is, the more representative it becomes of the market as a whole - the lesser the risk of underperforming relative to the market.This outcome is important to both orthodox theorists and the average investor. Conventional . nancial wisdom de. nes " risk " as the volatility of a portfolio relative to the broader market, and therefore a.s.serts that a diversi.ed portfolio must, by de. nition, be less " risky " than a more compact suite of stocks.The average investor, too, is generally risk averse and accepts that lower potential portfolio gains is the price to be paid for reducing the risk of potential losses.

Although Keynes himself was never satis.ed with a merely middling result, he did concede that a policy of " scattering one ' s investments over as many .elds as possible might be the wisest plan " for an individual with no special knowledge of the stock market.Warren Buffett repeated the point in a shareholder letter: Diversi.cation serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There ' s nothing wrong with that. It ' s a perfectly sound approach for somebody who doesn ' t know how to a.n.a.lyze businesses.

Keynes thought that, for an individual who cannot or will not rigorously apply the precepts of value investing, " it ought to be considered as imprudent for such a man to make his own investments as to be his own doctor or lawyer."

For these investors, index funds - investment vehicles that mimic broad market performance by building an appropriately weighted portfolio of stocks - offer low - cost exposure to the stock market.As Buffett explained to Berks.h.i.+re Hathaway shareholders, an unsophisticated investor seeking " to be a long - term owner of . . . industry " should: . . . both own a large number of equities and s.p.a.ce out his purchases. By periodically investing in an index fund, for example, the know - nothing investor can actually out - perform most investment professionals. Paradoxically, when " dumb " money acknowledges its limitations, it ceases to be dumb.

Moreover, an investor committing a .xed sum to an index fund at regular intervals - a practice known as " dollar cost averaging " - will automatically counteract the excesses of Mr. Market.When Mr. Market is in his manic phase - bidding up prices way above their fundamental value - the investor will buy fewer shares per investment contribution, due to the higher cost per share. Conversely, when Mr. Market is in a down period - with shares sinking far below fundamental value - the investor will purchase more shares for the same outlay. Dollar cost averaging is a simple, self - regulating contrarian strategy, absolving the unsophisticated investor from any misguided efforts to second - guess the market.

If You Can Beat Them, Don ' t Join Them A man must consider what a rich realm he abdicates when he becomes a conformist.

-Ralph Waldo Emerson, JOURNALS The price of joining the crowd, however, is that one will never stand out from it - diversi.cation limits volatility not only on the downside, but on the upside also. For an individual with a good understanding of the market, Keynes believed that a diversi.ed stock portfolio made no sense whatsoever. He thought that those investors who could properly a.n.a.lyze stocks should focus only on potential " stunners " and - when the market occasionally presents them to the investing public - buy them in meaningful quant.i.ties.

Toward the end of his investment career, Keynes concluded that: . . . it is out of these big units of the small number of securities about which one feels absolutely happy that all one ' s pro.ts are made . . . Out of the ordinary mixed bag of investments n.o.body ever makes anything.

Similarly, the Berks.h.i.+re Hathaway duo endorse the idea of " loading up " on " grand - slam home runs " - Charlie Munger commends an investment policy of " making a few great investments and sitting back," and Buffett advises that " the important thing is that when you do . nd [a ' superstar ' ] where you really do know what you are doing, you must buy in quant.i.ty." To borrow one of Buffett ' s aphorisms," If something is not worth doing at all, it ' s not worth doing well " : the impact of scoring a " home run " will be diluted if the stock const.i.tutes only a small portion of total portfolio value.

Portfolio concentration can produce better results than diversi. cation due to a number of factors, including lower transaction costs - broker commissions proportionately decrease as deal size increases - and potentially lower administration costs. But perhaps the most compelling argument for portfolio concentration by informed investors is the simple logic expressed in one of Warren Buffett ' s shareholder letters: I cannot understand why an [educated] investor . . . elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest pro. t potential.

The same impulse that propels stock market speculation also motivates the drive toward diversi. cation - the desire to be part of the crowd. As the .nancier Gerald Loeb recognized, a widely diversi. ed portfolio " is an admission of not knowing what to do and an effort to strike an average " - for those investors who believe that they can in fact rank stocks, a policy of portfolio concentration is preferable.

Keeping It Simple The art of being wise is the art of knowing what to overlook.

-William James, THE PRINCIPLES OF PSYCHOLOGY Diversi.cation is the tribute paid by investors to uncertainty. In what may well be the world ' s . rst pro - diversi.cation tract, the Book of Ecclesiastes counsels the reader to: Send your grain across the seas, and in time you will get a return.

Divide your merchandise among seven ventures, eight maybe, since you do not know what calamities may occur on earth.

This biblical injunction to go forth and diversify re.ects the conventional reaction to uncertainty - moderate risks by diluting them as much as practicable. Diversi.cation is, in reality, more a strategy of risk dispersion than risk reduction.

Keynes ' response to uncertainty and risk in the share market was radically different to the prevailing wisdom - as he explained in a letter to one of his business a.s.sociates: . . . my theory of risk is that it is better to take a substantial holding of what one believes shows evidence of not being risky rather than scatter holdings in . elds where one has not the same a.s.surance.

To ascertain which stocks " show evidence of not being risky," the value investor searches for those securities that exhibit a suf. ciently large margin of safety - that is, those stocks with a substantial gap between estimated intrinsic value and the quoted price.

In undertaking this a.n.a.lysis, the intelligent investor will necessarily focus only on those businesses he or she understands. Keynes noted that he would prefer " one investment about which I had suf. cient information to form a judgment to ten securities about which I know little or nothing." His contention was that intelligent, informed investors will reduce their downside risk by scrutinizing only those sectors within their " circle of competence " - to use Buffett ' s phrase - and then only investing in those stocks which exhibit a satisfactory margin of safety. Like Socrates, the intelligent investor is wise because he recognizes the bounds of his knowledge.

Searching for Holes in the Baskets Put all your eggs in the one basket and - WATCH THAT BASKET.

-Mark Twain, PUDD'NHEAD WILSON Paradoxically, diversi. cation - like all forms of insurance - can actually encourage riskier behavior. Just as those with .ood insurance may be tempted to build their houses closer to the water, or motorists wearing seatbelts may become more aggressive drivers, so, too, highly diversi. ed investors may similarly feel that they can afford to have a . utter on a speculative stock play if there is relatively little at stake - as the economist - stockbroker David Ricardo rationalized, " I play for small stakes, and therefore if I ' m a loser I have little to regret." Or, to quote Bob Dylan, a more modern authority on this phenomenon, " When you got nothing, you got nothing to lose."

In contrast to the diversi.ed stockholder, the focus investor will ordinarily demand a signi.cant margin of comfort prior to allocating substantial funds to a single stock. Fear of loss can concentrate the mind wonderfully, and the investor staking a large proportion of his or her total funds on only one security is more likely to rigorously scrutinize this potential investment. As Buffett summarizes, a policy of portfolio concentration should serve to increase " both the intensity with which an investor thinks about a business and the comfort - level he must feel with its economic characteristics before buying into it."

Focusing on only a handful of stocks should not, therefore, increase portfolio " risk," at least as it is de.ned by the layperson - that is, the possibility of incurring .nancial loss.The intelligent investor will only select those stocks that exhibit the largest shortfall between quoted price and perceived underlying value - that is, those securities that are likely to provide the greatest margin of safety against .nancial loss in the long term. Although a compact suite of stocks will be undeniably more volatile than a diversi.ed holding, short - term price . uctuations are of little concern to a long - term holder of stocks who focuses on income rather than capital appreciation. Indeed, value investors favor those stocks that display the potential for extreme volatility - the difference is that these investors expect predominantly upside volatility. Risk, for value investors, is not a four - letter word - it is embraced and addressed proactively, not defensively.

Waiting for a Fat Pitch I call investing the greatest business in the world because you never have to swing.You stand at the plate, the pitcher throws you Gen-eral Motors at 47! US Steel at 39! and n.o.body calls a strike on you. There ' s no penalty except opportunity lost.All day you wait for the pitch you like; then when the .elders are asleep, you step up and hit it.

-Warren Buffett, quoted in FORBES magazine A policy of portfolio diversi.cation is the logical outcome of a belief in ef.cient markets. As Keynes noted, it is " false to believe that one form of investment involves taking a view and that another does not. Every investment means committing oneself to one particular side of the market." A strategy of extreme diversi.cation is, at its core, a concession by the investor that stock - picking is futile for that particular individual - that, indeed, one stock is as good as another. It is a candid admission that the market knows more than that person.

Keynes rejected the notion that markets always priced securities correctly based on publicly available information and that, therefore, it was pointless to search for potential stunners. His view was much more pragmatic, and was grounded in his experience as an investor and .nancial theorist: Keynes believed that . nancial exchanges - although perhaps usually ef. cient - were not always ef. cient. On occasions, the stock market generates prices that veer radically from underlying value - Mr. Market is perhaps in the throes of a particularly acute bipolar episode - and it is at these times that the intelligent investor should buy in quant.i.ty.

The poet Paul Valery once asked Albert Einstein if he kept a notebook to record his ideas - Einstein is said to have replied, " Oh, that ' s not necessary - it ' s so seldom I have one." Similarly, opportunities to buy quality stocks at a material discount to fundamental value are infrequent.As stock investor and author Philip Fisher commented: . . . practical investors usually learn their problem is . nding enough outstanding investments, rather than choosing among too many . . . Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself.

Agreeing that " ultra - favorites " are usually thin on the ground, Keynes noted that " there are seldom more than two or three enterprises at any given time in which I personally feel myself ent.i.tled to put full con. dence."

When the market does offer a security at a substantial discount to its intrinsic worth the investor should, therefore, acquire meaningful amounts of that stock. Charlie Munger opts for a metaphor close to his heart when explaining Berks.h.i.+re Hathaway' s policy of " loading up " on mispriced bets: Playing poker in the Army and as a young lawyer honed my business skills.What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don ' t get a big edge often. Opportunity comes, but it doesn ' t come often, so seize it when it does come.

Good investment opportunities are too scarce to be parsimonious with, Buffett often reminds his acolytes - when a stunner presents itself, the value investor should not be afraid to back his or her judgment with relatively large capital outlays.

Crossing the Jordans You won ' t improve results by pulling out the .owers and watering the weeds.

-Peter Lynch, ONE UP ON WALL STREET For an investor who - like Keynes and Buffett - adopts a buy - and hold policy in respect of stocks, portfolio concentration is something that tends to happen naturally over time. Inevitably, some stocks within a portfolio will perform better than others and these " stunners " will come to const.i.tute a large proportion of total value. A policy of portfolio concentration cautions against an instinctive desire to " re- balance " holdings just because an investor ' s stock market investments are dominated by a few companies.

Buffett ill.u.s.trates this point with an a.n.a.logy. If an investor were to purchase a 20 percent interest in the future earnings of a number of promising basketball players, those who graduate to the NBA would eventually represent the bulk of the investor ' s royalty stream. Buffett says that: To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

Buffett cautions against selling off one ' s " superstars " for the rather perverse reason that they have become too successful.The decision to sell or hold a security should be based solely on an a.s.sessment of the stock ' s expected future yield relative to its current quoted price, rather than any measure of past performance.

Eggs in a Couple of Baskets . . . half of [my speculative positions] go up and half of them go down when the news is bad, and vice versa when the news is good; so I have what is called a " well - balanced position " . . .