Investing and Life, Balance Sheets matter over Income Statements

How do you follow your investments? If you’re like a lot of people, you keenly await quarterly earnings announcements to track projected versus actual growth in Sales, EBITDA, Net Profit, EPS (Earnings per Share). Positive surprises mean high fives for the minor bump up in stock price. Negative surprises are explained with a range of reasons including “delayed project approval”, “rural distress”, “rising raw material prices” and so on. If the reason for the miss makes sense i.e. they seem significant enough that the company couldn’t have done much, you shrug and move on.

The problem with Salient-Recency

We use a similar construct in two key areas of our lives; health and wealth.

Step on the weighing scale, check number that appears. If lower than the previous reading or closer to a target weight, Great! If not, regret the extra helping of biryani the previous night, resolve to eat less / better and move on. Repeat the cycle next week.

“He makes XXL per month, lives in a penthouse apartment in <insert up-market neighbourhood in city> and drives a 2017 <insert German-made luxury car make-model>!” The awestruck comparison, in this case, is the average guy on those parameters. Translation, “He’s rich!”. Or when you feel the glow of being offered a salary hike that takes you past a milestone number “I now make XXL per year.”

Let’s call it Salient-Recency Bias (not really a named bias, just something I made up). Using distinctly visible results from the recent past to judge how well something is going.

Why do we need to watch out for salient-recency? The health of a human body is too multi-dimensional to be captured by a metric like weight. Weighing 2 kilograms less than you did last week could be loss of unhealthy fat (good), natural daily variance through the course of the day (neutral), or loss of muscle mass from lack of physical activity (bad). And yet, every morning, millions of people step on to a scale to determine whether to feel better or worse about themselves.

Similarly, current individual income is a poor proxy for wealth. Each hike in salary, higher paying job, generous year-end bonus tends to be channelled into taking on higher debt and expenses to service loans on larger homes, more expensive cars, iphones, and grander vacations. If this pattern seems recognisable, that’s because it’s so common, it has a name of it’s own, lifestyle creep. In fact, up to a certain level of income, lifestyle might even be a contra-indicator of wealth.

Since measuring something distinctly visible like weight and comparing against the recent past are indicators of salient-recency bias, the cure is simple, it’s just not easy.

Focus on Process over Outcomes

Ever seen an ad for one of those slimming belts on teleshopping networks? The claim: Wear a black neoprene belt that heats + vibrates, the combination literally melts fat off, so you lose inches around your waist. Most of us don’t need to be experts in human anatomy to scoff at such a product.

But if a “financial expert” on twitter quotes his own 6-month old tweet where he recommended a stock which is now up 350%, we experience intense dissatisfaction from the “missed opportunity” and wish we had sold everything and piled into that stock. We’re letting outcomes drive our thinking.

A lucky guess at the roulette table that wins you $1M is not a process, and therefore, not repeatable.  This is nothing but recognizing the impact of consistent repeatable actions, i.e. compounding.

Measure the right thing

Resting heart rate has been proven as a much better indicator of health than any other one metric. Understand why that is the case, track it over time to see whether you’re improving. But don’t just go by the reading, correlate to how you feel. Do you see other benefits as your resting heart rate goes from 62 bpm to 55 bpm?

Net Worth (Assets minus Liabilities) is a more robust measure of individual wealth than Income. But you can’t tell that for other people. That’s right, you don’t need to! You need to track your own net worth and whether it’s moving in the right direction year-on-year.

When evaluating investments, give more weight to the Balance Sheet (track record of everything the company has done up to that point especially the retained earnings it has accumulated over time) than just the Income Statement (snapshot of the last few months). Earnings per Share is a short-sighted easily manipulated metric, instead focus on cashflows and return on capital.

Focus on developing a process that incorporates a verifiable understanding of how something works, i.e. its first principles. Identify the metrics that are the truest measure of the outcome. Track whether you’re putting in the effort, observe the outcomes as feedback into the process. Improve consistently.

Further Reading:

The freakishly strong base – Morgan Housel

Outcome or Process – what investment focus succeeds over time – Barry Ritholtz

Successful investing needs a process focus – The Calm Investor

8 Simple tips to live longer and healthier – Outside Magazine

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