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Saturday, 23 October 2010

The Unintelligent Investor

Be Smart, Play Dumb

Most of the people who provide advice on stocks are either wrong or simply practising their sharpshooting, painting targets around their bullet holes. This means that the few people who actually know what they’re talking about and have proven track records form the small subset of humanity from which we might actually hope to learn a few lessons.

Unfortunately even the real gurus tend to have a less than one hundred percent record when it comes to not getting things catastrophically wrong. For all that they profess to follow the strictures of Ben Graham’s classical tome, The Intelligent Investor, all too often it seems that random happenstance of everyday life defeats the planned smartness of the human being. Operating as though we’re unintelligent is the best bet for most of us, because that’s exactly what we are.

Graham and the Wall Street Crash

The first example of this is none other than Ben Graham himself. Renowned in later life for being excessively cautious – a trait which frustrated his star pupil, Warren Buffett – he learned the need for this the hard way. Following the Wall Street Crash he geared up, borrowing money to invest in the huge range of cheap value stocks that were available in the market. Not being psychic he failed to divine that the recovery in ’30 was the prelude to the even greater drop in ’31.

Faced with ruination for himself and his clients he was lucky enough to be recapitalised by his partner's father-in-law and restored his and their wealth over the next few years, as the markets stabilised and some sort of normality took hold again. As Alice Schroeder recounts in The Snowball, by 1932:
"... his problem was capital. Through its stock-market losses the firm's account was down from $2.5 million to $375,000. Graham felt responsible for recouping his partners' losses, but that meant he would have to more than triple their money ... And, by Decemeber 1935, Graham did triple their money, and earned the losses back."
Greater Return Means Greater Risk

No one ever said he wasn't a good investor, just not a prescient one when faced with the worst crash ever. However, the point that value stocks – especially small capitalisation ones – yield excess returns because they expose the investor to excess risk, not because they're fundamentally cheap, is one he never forgot again. When markets go mad there’s no price worth paying for the weak and the crippled stocks that Graham habitually dealt in.

As we’ve seen before, however, a major abnormal event can end up being imprinted on our consciousnesses as a stereotype and this seems to have been what happened to Graham in 1931. He closed his investment partnership in the late 1950’s when he felt that the markets had got too high. Compared to his experience they had done, but they were to boom on for almost another decade before the post-war cult of equity ran aground. History offers lessons for the future, not a template.

Keynes on Currency Trading

On the other side of the investing coin was John Maynard Keynes. Not just the greatest macroeconomist of the first half of the last century – and the only one with a track record for getting predictions right – he was also an astute and energetic investor. Keynes, however, ran on the other side of the tracks from Graham. Rather than dealing in intrinsic valuation, an approach he felt would lead to the death of the markets if everyone followed it, he targeted instead the animal spirits of investors.

For Keynes investing was about figuring out what everyone else would want to buy and buying it ahead of them. Back in the Roaring Twenties he expressed this approach through currency speculation. Prior to the First World War this would have been an exercise in futility as major currencies were all pegged to the immovable Gold Standard: exchange rates didn’t move. However, the disruption to major economies caused by the conflict forced countries off gold and into a world of strangely shifting valuations.

Investing in Animal Spirits

In this new world Keynes saw the opportunity to apply his animal spirits philosophy and rapidly managed to generate a small fortune, by trading heavily on margin, as the German economy collapsed into hyperinflation, France struggled with an accelerating rate of change of governments and financial scandals, Britain failed to recognise its new place in the world order and the USA lapsed into protectionism. And then, as is the way of the investing world, there was a suddenly an inexplicable reversal in the trajectory of exchange rates and Keynes found himself and his fellow investors suddenly short of the cash needed to make good their positions.

As Ben Graham found, when you’re in dire need the best thing to have handy is a wealthy friend. In this case it was Keynes’ father who bailed him out. Over the coming years the investing approach he took mellowed somewhat – in fact it’d not be far from the truth to argue that he moved steadily in the direction of focussed value investing:
"As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes".
Which sounds more like Buffett and Munger than the father of glamour investing. Like Graham he learned the hard way that in the short-term markets can be more perverse than we can possibly imagine, and that trading using borrowed money is a dangerous game. And ironically, like Graham, he lost a fortune in the Wall Street Crash and made it back from '33 onwards.

(UPDATE: 6th April 2012 - see this new research on Keynes The Stockmarket Investor by David Chambers and Elroy Dimson).

Munger and the Oil Crisis

Even Charlie Munger found himself in trouble when the markets collapsed in 1973 and 1974. Shares in his partnership lost half their value, partially compounded by the use of borrowed money to buy stock. Between the beginning of 1973 and the beginning of 1975 investors lost over 53% of their money – worse than the general market declines, which were bad enough. Still, Munger knew that the intrinsic value of the fund’s investments were worth far more than the reported numbers: a 73% rebound in 1975 saw the truth of that.

As Janet Lowe puts it in Damn Right!:
"When dealing in only his own money, investment losses never bothered Munger much. To him it was like a losing night in a regular poker game where you knew you were one of the best players - you'd make up the difference later".
But reporting these losses to his investors was painful and Munger liquidated his partnership as soon as he reasonably could, having made sure that those investors who’d stayed the course – and most did, albeit with some persuasion – were well in profit. Out of the liquidation investors got shares in Blue Chip Stamps and Diversified Retailing, both of which were later transmuted into parts of Berkshire Hathaway. Anyone who held onto those has done very nicely, thank you very much.

Anecdotal Investment History

A couple of things are transparently clear from this anecdotal view of history. The first is that markets aren’t predictable, not even by the very best investors. The second is that taking on debt to buy stocks is a very risky business. Mostly, of course, if you have the liquidity to outwait the market then as long as the underlying investments have some genuine intrinsic value then the situation will right itself. Still, excessive gearing exposes investors to the tail end of the risk distribution, which bites when you least need it to.

It’s a sobering thought that some of the best investors of the last century have been so badly caught out by these relatively straightforward events, but the underlying psychology of the human means we’re peculiarly unable to recognise that chance plays a greater role in the unfolding of events than causality. In the middle of one of the longest periods of market underperformance in history, with uncertainty raging on all sides it’s hard to remain aloof from the underlying nervousness that’s spooking the crowds.

The Unintelligent Investor listens to these noises and believes they can predict the trajectory of the future from them. Truth is, the essential verities remain simple: invest in stuff with intrinsic quality and value, don’t rely on any predictions from anyone and make sure that you have enough liquidity to survive even the harshest downturn. Always assuming we don’t die first or that capitalism doesn’t completely implode, it’ll all turn out OK in the end. But, of course, it’s best to learn this lesson though the experience of others, rather than up-close and personal.

John Maynard KeynesThe Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger, Expanded Third Edition

Related articles: Why Markets Crash, Debt Matters, Is Intrinsic Value Real?

5 comments:

  1. In the middle of one of the longest periods of market underperformance in history

    Hmm, is that a prediction there, Timmar? ;)

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  2. My simple rules of investing:

    1) keep around half the portfolio in quality stocks;

    2) take a few punts here and there - it makes life more interesting and the experience is useful;

    3) don't become fixated on a system;

    4) accept your weaknesses and adapt your portfolio to them;

    5) always make sure you have plenty of cash.

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  3. The first is that markets aren’t predictable, not even by the very best investors.

    I don't think that's right.

    Graham was not factoring in the damage that the 1920s run-up in prices had done to the general economy. We know more about investing today than we knew then. Had he known then what we know now, he would have known to take a more moderate position.

    The true lesson of the Graham experience (in my view!) is -- Be Humble! We may not know it all today anymore than Graham knew it all in the early 1930s. We always THINK we know it all. We never do.

    Giving in to the temptation to just rule out making predictions is a trap. This is well-illustrated by Monevator's astute comment above. We ALL make predictions. If you didn't make some sort of prediction, you could never invest a dollar. If you are not willing to make any predictions whatsoever, you would not be able to get out of bed in the morning.

    The question is never "Is it a good idea to make predictions or not?" It is always "What are the best predictions available to an informed investor today?" The idea that predictions are not possible is just a rationalization for not making better informed predictions than the ones that one's emotions draws one to.

    Rob

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  4. In the middle of one of the longest periods of market underperformance in history

    Hmm, is that a prediction there, Timmar? ;)


    Define "middle" :)

    As for ...

    Graham was not factoring in the damage that the 1920s run-up in prices had done to the general economy. We know more about investing today than we knew then. Had he known then what we know now, he would have known to take a more moderate position.

    To be honest I didn't notice any improvement in investing gurus' predictive capabilities back in 2007 over 1928. As Damsio has shown, see Get An Emotional Margin of Safety, emotions and decision making are intricately tied together: without one the other's impossible. Which would suggest that until we can predict the ebb and flow of human emotion we won't be able to predict the future trajectory of markets. I, at least, hope it stays that way ...

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  5. emotions and decision making are intricately tied together: without one the other's impossible.

    Thanks for your response, Tim.

    We agree 100 percent re the words quoted above. I see this as a point of critical importance.

    Which would suggest that until we can predict the ebb and flow of human emotion we won't be able to predict the future trajectory of markets.

    Yes! Precisely so. This is why I am so hopeful re where we are headed in this field.

    Isn't that the purpose of Behavioral Finance? If we aren't predicting the ebb and flow of emotion, how do we add anything to the investing project?

    We cannot predict the ebb and flow of emotion perfectly even today (and this may well never become possible). But, yes, I would say that we have come a long, long ways from where we were in Graham's time. Didn't Shiller predict this economic crisis? Didn't Arnott? Didn't Smithers? Wasn't that a huge plus for those who listened to them? Wouldn't it be an even bigger plus if more listened? Weren't they predicting the ebb and flow of human emotion when they noted that permitting insane levels of overvaluation always leads to a crash and an economic crisis?

    My view is that we on the threshold of the biggest advance in knowledge of how investing works in history. If human emotion (evidenced through changes in valuation levels) is 50 percent of what you need to know to invest successfully, and if we have pretty much ignored this factor until now (most of today's investing analyses contain zero adjustment for valuation levels), then we could easily double our knowledge of how investing works overnight by taking the emotional/valuation aspects of the topic into consideration.

    The only thing that I see that is holding us back at this point is that this would be so big an advance that it would mean rewriting all the textbooks and redoing all the calculators and this sort of thing. But the losses suffered in the economic crisis are making people more open to advances all the time.

    Why shouldn't we advance in our understanding of investing just as we have in our understanding of many other life endeavors? Think where we would be if we took this "things can never improve even a little bit" attitude to our study of health issues or technology issues. Many of the most important advances of all time would have been lost to us.

    Rob

    ReplyDelete