You Can Be a Stock Market Genius has handsomely exceeded my expectations, not because of how short the book is (yes, it is a quick read) but because of how good its messages are. Joel Greenblatt compounded his fund at 50% a year for about ten years before returning all external capital in 1995. Surely, there is something to be learned from Joel’s book. Here we go.

Understand people’s motives

The word “motive” / “motivation” appeared at least 10 times throughout the book, while accounting-oriented fundamental analysis did not make an appearance until the second last chapter. It is not that proper accounting computations are unimportant but that for successful investing, a human understanding of the other humans in the same market is terribly important as well. That, I think, was a key message that Joel was communicating. In analyzing spinoff situations, Joel wrote, “analyzing the actions and motives of insiders … is of particular benefit.”

Many times, asset owners decided to press the sell button for non-investment reasons. If asset owners are distributed securities of types that they are not allowed to invest in, they have no choice but to sell ASAP, thus creating an investment opportunity for others to buy. Joel wrote, “once the spinoff’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.” Yes, the price of a security should be determined by the security’s investment merits — we all learned that in school. Prices, however, are also determined by people’s motives — you learn that by being in the market and by paying attention. Pay attention to people’s motives.

“Risk/reward”: the most important investment concept

I increasingly believe that successful investing can be learned but cannot be taught. There is something soft and intangible in successful investing that simply cannot be taught or trained for (otherwise, all investors would be successful investors, which clearly is not the case). One of these is probably the idea of “risk/reward.”

The simple idea of “risk/reward” can be understood by most but executed by only a few. Warren Buffett said it well in The Superinvestors of Graham-and-Doddsville that “It’s instant recognition, or it is nothing.” Joel understood “risk/reward” extremely well and showed us numerous examples of how he successfully executed on it. Joel even called the concept of risk/reward “the most important investment concept of all.”

Throughout the book, I see at least four channels through which Joel expressed his mastery of the concept of “risk/reward.”

Avoid competition: The field of active investing is ultra-competitive, and it pays to be ultra-self-aware — i.e., avoid competition if you can. Once a particular corner of the investment industry becomes too competitive, its investment prospects dim. Why? Too many skillful investors compete too hard for an all too limited number of opportunities. Active investing may not be a zero-sum game, but active investing definitely is not a game where by adding more players, we get more winners. There is a “relative” perspective to investing and in that regard, investing is a crude game. Intense competition shrinks upsides, lowers IRR and destroys “risk/reward.” Seeing competition coming, investors who are self-aware should start to look elsewhere. That is why Joel advised investors to avoid risk arbitrage because of the “vastly increased competition.”

ROI of your time: Time is the input constraint for all investors. You can sleep-deprive yourself to squeeze out more time, you think, but in the end, you only get 24 hours a day, 7 days a week. Given the limited input, our goal should be to optimize the output. Therefore, there is a “risk/reward” perspective to how we spend our time. We simply cannot afford to research everything. We must prioritize. If you haven’t, you should read “the old story about the plumber” in the book’s 1st chapter. I quote that plumber in the story charging clients $100, “Banging on the pipes is only five dollars. Knowing where to bang — that’s ninety-five dollars.”

Some leverage, some concentration, but don’t do too much: Joel had a nuanced relationship with the idea of leverage. He disapproved of the idea of allocating 10% to 15% of a portfolio to LEAPS for the reason of options’ leveraged nature. Yet, Joel also embraced the idea of stub stocks, LEAPS and warrants, exactly because of their embedded leverages. Joel saw the benefits of diversification, yet he pointed out that after the first six to eight stocks, adding more stocks to a portfolio would add little extra diversification and only make the portfolio behave like market indices. He then suggested that investors should welcome some concentration and he wrote, “The penalty you pay for having a focused portfolio—a slight increase in potential annual volatility—should be far outweighed by your increased long-term returns.” In telling his “complex relationships” with leverage and concentration, I believe Joel was trying to achieve a balance between risk and reward.

“Trade the bad ones, invest in the good ones.” Joel was commenting on the quality of stocks. However, from Joel’s tip, I saw a time perspective. Even before reading this book, I have increasingly come to the belief of a “time dumbbell” — I should either hold an asset for very long, or trade in and out of it very quickly, and I should not attempt anything in the middle. What is in the middle? Casually investing into something, hoping it can produce some profits in a few weeks or months, that is the middle. As the capital markets become more and more efficient, profitable opportunities, those with better “risk/reward” profiles, I believe, will increasingly concentrate at the two ends of the “time dumbbell.” Fewer and fewer opportunities will lie in between. For investors, we have to be super patient (hold for longer than others) or be super quick (act much faster than others).

Make fewer bets: For most investors, they make some money here and lose some money there — in the end, they get nowhere. Joel understood this well and he argued that “If you don’t lose money, most of the remaining alternatives are good ones.” He went further and he put, “you only need one good idea every once in a while. It’s better to do a lot of work on one idea than to do some work on a lot of ideas.” Very true. By doing too much trading, investors run the risk of encountering large losses and bringing on permanent capital losses to their portfolios.

To wrap it up, let me quote Joel again:

“Remember, it’s the quality of your ideas, not the quantity, that will result in the big money.”

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