I have just finished this book. I wrote about this book earlier here. I have also read N N Taleb’s earlier book – fooled by randomness and liked it a lot.

I will not be doing a detailed review of the book as that can be found on amazon and a lot of other website. I will however highlight some of the points, which struck me as important and how they impact me as an investor.

One of the key points, which the author makes, is about the complexity of the real world and lack of predictability. For ex: No one predicted the rise and the importance of the internet. The Internet has become one of the major forces shaping our world. It can be termed as a positive black swan. As a result all complex systems such as the economy, financial markets, which get impacted by such black swans, cannot be predicted. But that does not stop analysts and all the talking heads on TV from making predictions (predictions for 2008 etc etc)

Now one can argue that some prediction do come through. Well, you don’t have to be a guru for that. Just take some events, toss a coin and make a prediction based on the toss. You will be right 50% of the time. Analysts and TV gurus are worse than that in terms of their success rate. There are numerous studies supporting it, so you don’t have to take my word for it. Try this on your own – write down some predictions you hear this year and check back a year later.

Why are we suckers for this? because we want to resolve uncertainity and anyone who can or claims to provide visibility to the future is sought out (we do have astrologers !) . The author terms this as the narrative fallacy.

Personally, I stopped looking at predictions, analyst estimates, top picks/ hot picks etc etc long time back. If I want to be entertained I would rather watch a movie or a cricket match!

A logical question is how to invest if you do not predict. Does developing a DCF not amount to forecasting a company’s cash flow? Well it does. The difference is between a macro and a micro forecast. Forecasting a company’s cash flow is much easier than forecasting the direction of the stock market. If you know the company well, it is in your circle of competence, and you can figure out the few key variables driving the cash flow of the company then it is possible to arrive at a reasonable estimate. Will it be accurate? I don’t think so. However if you are conservative in your assumptions (don’t assume 50% growth rates) then the impact of the negative surprises would be minimal. I would not worry about positive errors (cash flow more than forecast) as I will gain from it. In addition, if you buy at a discount to the estimate of the intrinsic value (margin of safety concept), then you are protected further from errors in the forecast.

Compare this approach with macro, top down forecast. If some one says – infrastructure stocks will do well because infrastructure spending is to increase by 50%. In addition to all the stock specific factors, you thesis is also dependent on the increase in the spending which in turn depends on multiple factors. The more variables in the investment idea, the more there is a chance of something going wrong. In addition, you will also pay more for such an optimistic scenario. So if the macro forecast or something else with the company goes wrong, the losses can be severe.

I am currently reading the book – The Black swan by N N Taleb. This is a great book on low probability, high impact events which are termed as black swans.

I am still in the middle of this book. One key point which I came across is ‘confirmation bias’ on which the author has devoted a complete chapter.

The basic idea behind confirmation bias is that once we make a decision, we tend to look for evidence to confirm it. As a result we tend to ignore any negative information which could refute our decision. As a corollary to this concept, any additional information is of no use as it would only re-inforce the decision and not add any more value to the decision making process.

Like others, I am equally susceptible to this bias. My approach to reduce its impact is to write a single page thesis on an investment idea and sometimes post it on my blog. I try to gather negative information and also prefer to get negative feedback on my idea. That helps me in wieghing all negative information and arrive at a better decision (hopefully).

I am not sure if I have been entirely successfull in it, but I have rejected a few ideas after selecting them, once I was pointed out some key information (which I had missed out). In a few other cases, the negative information, which I had missed earlier resulted in reducing my estimate of intrinsic value for the stock – for ex: I missed the impact of liabilities in the case of VST. As a result I ended up taking a smaller position