Thinking like an investor Series: Part 2 – Core Fundamentals

March 2, 2019

Hope you enjoyed Part 1 of the Series.

In today’s article, I plan to share with you the three core fundamentals all investors need to familiarise themselves with. They are:

  • Rationality
  • Optimization
  • Marginal Analysis

The stock market and the investment landscape are a complex paradigm to navigate. You can simplify this task for yourself by understanding, humans are fundamentally rational in their behaviour. People will choose strategically in order to gain an advantage rather than act randomly, investors and traders in this regard act no differently.

To first fundamental is Rationality, which is to think rationally, for those who are new, let me share with you an easy to follow blue print.

Step 1 – Clarify and understand the objective

Step 2 – Consider alternative steps to achieve the objective

Step 3 – Analyse the pros and cons from each of the options

Step 4 – Select the best option and implement your decision

In today’s day and age where demand is outstretching supply and scarcity being a prevalent factor, identifying alternative is all about understanding and valuing the opportunity costs.

As an investor you should and will always choose the option with the highest net payoff; to do so otherwise would be irrational. This is what separates seasoned investors from emotional investors.

Regardless of whether the market goes up or down, investors understand that rationality works in two ways. Firstly, it helps us predict. Secondly, it gives us a way to evaluate and draw conclusions about values. The concept of strategic decision making and rationality as both an objective for and a description of human behaviour is fundamental to investors.

The second fundamental I want you to understand and familiarize your self with is Optimization in the equimarginal principle This is just another fancy way of saying “figuring out the best attainable allocation given a set of constraints”.

Let’s say you the reader and 10 other individuals were to participate in a survival contest in which I created. In the contest I drive you deep into the outback, with nothing but the clothes you have on your back. Upon reaching the destination, I hand you ten stamps that you get to exchange for either food or shelter for a period of 3 months.

If you think like an investor, you’re going to realize that survival is not about either food or shelter; it’s about the combination of the two. Not only that you’re going to understand the best combination to the conundrum your facing is the best balance between food and shelter that will make the marginal value of each of them equal; hence the name “equimarginal principle”. Hoarding food while freezing to death is not a good strategy, while having a safe shelter and starving to death is not a sensible either.

Now we are going to dwell into the third and final fundamental which I put a lot of emphasis on, marginal analysis. As an investor I always look carefully at sequences of small changes made on the margin. This is because most of the choices made in the financial landscape consists of different businesses fighting to achieve favourable trade-offs.

Let’s say we woke up tomorrow and found out that the prices of food have tripled, how would that affect our consumption? As the marginal value changes, more of something makes the marginal value fall; less of something makes the marginal value rise. With the cost of food being high, people will find that binge eating and going out to eat with friends often might not be worth it and eating in moderation and going out for only special occasions sounds sensible. Thinking like an investor we will reject claims that a change in price is going to make things stop altogether. We understand that people adjust on the margin until the value of their grocery and eating out reflects the new, higher costs of food.

When you start applying the three core fundamentals in tandem with the 5 principles checklist, you begin to realise that you are now starting to think like an investor. Some would even argue with you and say that your thinking like an economist instead.

What the core fundamentals and 5 principles checklist does is make you aware of the incentive’s businesses face and, perhaps more importantly, the incentives those around you face. It means anticipating what’s strategically rational for businesses, and how that will affect your everyday life. As an investor you start focusing on the margin, on trade-offs businesses make, and the consequent adjustments they make to find the optimal balance.

You will realise that the two questions any organisation always face is:

  • How much?
  • Of which?

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