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The not-so-basics of investing

It looks as if returns, liquidity and volatility are the basics of investing, but Warren Buffet says that there is something even more basic

The not-so-basics of investing

Returns, liquidity, volatility, and predictability. In our routine way of looking at investments, that is all that matters. There's nothing wrong with that approach and indeed, if those of us who get this much right are probably better than 99 percent of the investors out there. In our busy, result-oriented way of thinking, we look at only what investments are, and not for any deeper reasons of what they are.

However, a certain type of investor steps back and starts thinking a little more deeply. Here's something that Warren Buffett wrote in one of his famous letters to his shareholders. He tells the stories of two small (for him) investments he made, both of which were among the most unusual assets that he bought. One was a farm in rural Nebraska, the part of the USA where he lives, and the other was a retail property in downtown New York City, a sort of a mini-mall with a number of shops. Both were bought during distress sales by lenders who were failing and thus both were bought at times when the outlook for the businesses was not good.

Did Buffett try the 'returns, liquidity, volatility, predictability' formula. Not really. Here's how he says he evaluated the sales. For the farm, which he bought in 1986, he says: "I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm -- I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. He did something simple and similar for the New York retail property as well. Income from both the farm and the NYU real estate will probably increase in the decades to come. Though the gains won't be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and,subsequently, for my children and grandchildren."

The point he is making is very simple. You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations. Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on.

However, the key is NOT what other investors are paying for that asset, or what they were paying for it yesterday and what they will pay for it tomorrow. The logic of any investment is what it does, not what it costs or may cost. That's my view but surprisingly, Buffett is not that much of a fundmanetalist (at least in this letter) about what the logic of paying for an investment is. If you instead focus on the prospective price change of a contemplated purchase, you are speculating.There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss.

Buffett paid no attention to what these assets had cost in the past. He also paid no attention to what the macro outlook of experts on the economy was, or of any of the myriad factors that supposedly affect investments. Instead, the only point was that the two assets were productive, and would continue to be productive and that they were being purchased at a price which made this future productivity good value.

Now, a farm in the US farming heartland and a mini-mall in New York would, one the face of it, have little resemblance to equity investing in India, and that too in this uncertain pandemic situation. However, the principle holds even more strongly, both on the upside as well as the downside. Do you, yourself, see logic in the investments you are evaluating?

If the answer is yes, then this is an investment. Otherwise it's something else that you should avoid.