How to Become a Great Investor – The First Six Tentacles of the Kraken

The Kraken’s power comes from its vast size and ability to wrap multiple tentacles around its prey.  At the height of its strength it can drag the biggest ships under the ocean and devour them.  As the Kraken grows, its reach expands into every corner of the ocean.  This is how I view my investing career.  I am continuing to expand my knowledge and experience.  Each subject of study is another tentacle which, as it expands, can help to wrap around any problems I wish to devour.

Most people in the investment world will recognize the inspiration from Charlie Munger’s “mental models”.  Whether it’s mental models, tools in the toolbox, or tentacles of the Kraken, there is a fairly wide consensus that being a good investor, and a good investment professional (slight difference), requires a multi-disciplinary approach.

The reason I like my Kraken philosophy so much is because the visual makes intuitive sense to me.  As you learn more and more in each area, that “tentacle” grows and expands and thus, you become more powerful.  Your reach expands.  The more tentacles you have with some real heft to them, the more damage you can do.

So here are the most important areas of study for anyone looking to be an investor or an investment professional.  These are the First Six Tentacles of the Kraken.

1)      Finance and Accounting –

Financial math and the ability to compound and discount cash-flows is essential to the investing process.  Accounting is the language of business.  You simply cannot function in a world of investing if you can’t speak the language of business or understand how value is derived from discounting cash-flows.

Most important concepts: Time Value of Money, calculating present and future, Dividend Discount Model (DDM), financial statement analysis

Additional Resources: The Economist Guide to Financial Management, Khan Academy, Investopedia

2)      Investment Fundamentals –

It is important that any investor know the very basics of investing – primarily the trade-off between return and risk, the structure of financial markets, and the benefits of diversification.  It’s not that you need to be beholden to the laws of Efficient Market Hypothesis (EMH) or Modern Portfolio Theory (MPT) but you better know what they are and why they are considered so important to the understanding of the practice.

Most Important Concepts: Capital Asset Pricing Model (CAPM) k = rf + β(rm -rf), Efficient Market Hypothesis (EMH)

Additional Resources: Check out the books in my post Investing 101 – The Five Best Books for Beginning Investors, Investopedia

3)      Economics –

Understanding the basics of supply and demand, trade, and taxation are essential to grasp how a company will operate within a market.  You don’t need to be a Keynes scholar (in fact, those from the Mises Institute will think of that as a handicap) but economic theory is all about learning how market systems work.  In a universe with a million inputs, which are the variables that pull the hardest in certain directions?  What effect will economic policy have on a given company’s end markets?  These are important questions in the investment process.

Most Important Concepts: Elasticity, interest rate parity, Competition

Additional Resources: Quora – working in a pizza parlor, Freakonomics, The Worldly Philosophers

 

4)      Psychology –

What makes a person prefer one brand over another?  What makes a person respond positively to one product and not another?  How does the psychology of an investor change during a year if the market goes up by 30%?  What if the market goes down by 30%?  Understanding the psyche of consumers and investors (and oneself!) is hugely important in a market that is often driven by what George Akerloff (Janet Yellen’s husband) calls Animal Spirits.

Most Important Concepts: How biases affect decision making, Prospect Theory, Emotional Intelligence

Additional Resources: The Psychology of Investing, Prospect Theory original study, Emotional Intelligence, Charlie Munger USC speech on Psychology of Human Misjudgement

 

5)      Statistics –

The art of risk management is really the ability to calculate odds, and knowing how much capital to put at risk dependent upon what those odds are.  Every investor should have a basic grasp of statistical analysis.  It’s not to say that distribution analysis is a perfect tool for determining risk – it’s not.  But it is essential to know the basic concepts of average, standard deviation, and correlation as a starting point.  What is your expected return on an investment and what is the likelihood that it will make money?  How will the odds change with the introduction of some new information?  These are all essential basic questions you need to be able to answer.

Most Important Concepts: Probability Theory, Bayes Theorem

Additional Resources: Khan Academy, The Black Swan, Against the Gods

 

6)      History –

Many investors love to throw out this quote attributed to Sir John Templeton “The most dangerous words in investing are: this time is different”.  It suggests that naïve investors get caught up in market bubbles and rationalize it with reasons why – this time – it is indeed different.  Inevitably, those bubbles pop and the naïve investors lose their shirts.  It is an important lesson to learn, but it’s an incomplete one.  The problem is that in reality, every time is different!  For instance, you could not have used a playbook from the tech bubble to navigate the recent financial crisis.  There were important differences in valuation at the peak, market structure, leverage, and reflation post-crisis, just to name a few.  But unless you truly read up on past events – study the players, the motivations, and the underlying causes – you will fall prey to the same errors of simply comparing past events to today.  Having a good grasp on where we have been will help you see clearer where we can go in the future.

Most Important Concepts: Economic cycles through history, investment manias and bubbles

Additional Resources: Empire of Wealth, Devil Take the Hindmost

 

These first six tentacles should get you 80% of the way there.  These topics are enough to draw some important connections in the world and lead you to some interesting investment opportunities.  Just remember that the first 80% takes only 20% of the effort.  The final 20% takes 80% of the effort!  It is fairly easy to be a decent, knowledgeable investor, but incredibly difficult to become great.

I would like to believe that I am in the that last 20% and expect to be there for the rest of my life. I am still developing all of my tentacles and constantly trying to establish new ones.  I may never become the largest, most feared monster in the ocean, but I am definitely looking to make some waves.

 

Until Next Time –

“You’ve got to have models in your head. And you’ve got to array your experience ‑ both vicarious and direct ‑ on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.”

Charlie Munger