The Big Mistake: A Compelling Example

Take a look at this interesting example:

that you had encountered Warren Buffett at the end of 1975. Impressed
with his intellect and investment approach, you would have naturally
examined his track record — and almost certainly, to your everlasting
regret, not invested. Why? Because his results, as measured by the
stock price of Berkshire Hathaway, were truly dreadful over a four-year period. The stock not only declined and trailed the market during the 1973-74 downturn, but also in the 1975 rebound. Consider this data:

Yr    S&P 500  Berkshire
    18.9%      14.3%
1973   -14.8%     -11.3%
1974   -26.6%     -43.7%
1975    37.2%      -5.0%
TOTAL    2.0%     -45.8%


The rest is, of course, history. From $38/share at the end of 1975, Berkshire Hathaway has risen nearly 2,000 times to yesterday’s closing
price of $73,900. [For more information about the track records of
these investors (and many others), plus some of the wisest words ever
spoken about investing, see Buffett’s famous 1984 speech, The Superinvestors of Graham-and-Doddsville.]"

A complete account of this is available from Whitney Tilson on the Motley Fool Site.

The point is not that one should ignore performance.  That would be silly.  Performance is the ultimate test.  The problem is that the investor’s concept of the time frame necessary to gauge performance is far shorter than what occurs in reality.  I will elaborate on this in coming posts.  For now, it is important to understand that there can be muti-year eras of strange market behavior, like the Internet bubble.

Determining investment potential involves understanding the methods used, and whether these methods are sound on a long-term basis.  It takes both developing the method and the discipline to follow it even when there are painful setbacks.

Successful investing depends on profiting from the mistakes of other market participants.  It may not be possible to "time the market" by predicting when value will be recognized.

There will always be those that call a particular market turn, but the question is the method used.  Since many thousands of managers are always trying to do this, there will always be some who succeed.  How does one avoid being "Fooled by Randomness?"

This intriguing topic will be the subject of future posts.

The Biggest Investor Mistake

For most people, the information in today’s post is probably more important than any other single fact they can learn about investing.  Understanding and following this advice could make a million-dollar difference for a middle-class family thinking about college and retirement.

The problem is that the advice is extremely difficult to follow.  Since very few individuals will follow this advice, it is yet another source of market inefficiency.  It explains why Warren Buffett and other managers can maintain a positive expectancy in gains over the market.

Ready?  Here goes —

Don’t sell the bottom!

Don’t do it with stocks.  Don’t do it with mutual funds.

Let me explain the psychology first, and then show you some persuasive evidence of the effects.

They psychology comes from our desire to control, and the feeling that we can control our investments.  There is a strong marketing interest in persuading investors that they can and should make their own decisions.  It is profitable for brokerages, and they run many ads to that effect.

They show the "Power Guy" with his fancy trading tools telling a broker (as if he would really be talking to a broker in these days of online trading).  The Power Guy says "OK, I’ll buy a thousand shares, but if it goes down, I’m going to dump it!"  Firm, decisive, and wrong!  The market creates all sorts of movements in stocks.  If your fundamental reasons are intact, you should be prepared to buy more.  But it certainly sounds good.  The TV commercial plays upon our desire to show that we are in control, and that this sort of decisiveness makes sense.

Another commercial theme for Diamonds (the ETF that is a Dow 30 equivalent) highlighted a woman who did not have the time to study individual stocks, but who had a "feel for the market."  Just what people need — not!  Encouragement to try market timing based upon casual knowledge.  I wonder how much people have lost following that commercial.

And then there is the guy who spots a good investment because he is buying jeans for his daughter.  This is a perversion of some great advice from Peter Lynch.  It is fine to try to spot trends early. This provides a nice starting point, not the reason for an immediate investment.

The sad result is that individual investors make 1/3 to 1/2 of the market returns in every study I have seen on the subject.  Here is one such study, and there are many more.

Warren Buffett says the following:

"You can’t get rich with a weather vane."

"The market is there only as a reference point to see if anybody is offering to do anything foolish.  When we invest in stocks, we invest in businesses."

If you are not studying the individual companies, the financials, the trends, you are not analyzing the business.

In many stocks right now the market is offering an opportunity.  There is an extremely high level of concern, not about current conditions, but about an expectation that the Fed or oil prices or budget deficits, or something, will ruin the economy.  Before concluding that the market (which has predicted seven out of the last two recessions) has some great message, the investor should get some evidence.

The studies also show that the average investor applies the same criteria to investment managers, selling funds that did poorly recently to buy those that did well.  The investor is not making a careful decision because this strategy has been proven to work.  In fact, it has been proven to be a loser.  Investors behave this way because they want a simple rule, called a heuristic in behavioral finance, and this is the only information they have.  It gives the illusion of control, and costs them many thousands of dollars.

Warren Buffett on Market Efficiency

Warren Buffett is generally acknowledged as the world’s greatest investor.  He has gotten a lot of well-deserved publicity this week for his plan to give away most of his wealth.

Spending some time thinking about his success is a good exercise for anyone interested in markets or investing.  Janet Lowe’s book collecting useful wisdom is a good source.

Warren Buffett does not believe that markets are efficient.  If they were, he would have no advantage.  On the contrary, he feels that he gains an advantage from those who take the theory too seriously.

"I’d be a bum on the street with a tin cup if the markets were always efficient."

"Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards."

(Personally, I prefer to think of it as opponents who do not look at the cards!)

"It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn’t do any good to think."

Warren Buffett has spent a lifetime finding seriously mis-priced stocks to buy.  It is little wonder that he sees the market as inefficient.  Does that mean that Nobel prize-winning professor lose to the world’s greatest investor?