Have you ever wondered what separates David Dreman, Warren Buffett, Charlie Munger, etc. from the rest of the world? The answer is simple, but the force behind it can make the difference between a great investor and an average investor. I am talking about investor psychology, also known as Behavior Finance.
One can learn value investing by picking up a couple of books, attending a couple of seminars, etc. but all that is useless if you let emotions interfere with your decision making process. In the preface to the 4th edition of Benjamin Graham’s The Intelligent Investor, Warren Buffett had this to say about successful investing:
To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.
The ability to do this is simple but not easy. Below is a list of investor mistakes Whitney Tilson listed in a 1999 Motley Fool column.
1) Herding behavior, driven by a desire to be part of the crowd or an assumption that the crowd is omniscient;
2) Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money;
3) Excessive aversion to loss;
4) Fear of change, resulting in an excessive bias for the status quo;
5) Fear of making an incorrect decision and feeling stupid;
6) Failing to act due to an abundance of attractive options;
7) Ignoring important data points and focusing excessively on less important ones;
8} “Anchoring” on irrelevant data;
9) Overestimating the likelihood of certain events based on very memorable data or experiences;
10) After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome;
11) Allowing an overabundance of short-term information to cloud long-term judgments;
12) Drawing conclusions from a limited sample size;
13) Reluctance to admit mistakes;
14) Believing that their investment success is due to their wisdom rather than a rising market;
15) Failing to accurately assess their investment time horizon;
16) A tendency to seek only information that confirms their opinions or decisions;
17) Failing to recognize the large cumulative impact of small amounts over time;
18) Forgetting the powerful tendency of regression to the mean;
19) Confusing familiarity with knowledge;
Investor Psychology is a huge subject and countless of books have been written on it so I will concentrate on market noise and how to avoid it.
What is market noise?
I consider market noise to be anything that is not associated with the underlying fundamentals of a business. Earnings estimates, interest rates, macroeconomic issues, are just a few on the list.
How to block market noise?
I am not going to sit here and act like I have not been a victim of one of Whitney Tilson’s investor mistakes. But lately I have developed a good modus operandi that has allowed me to avoid most if not all of the mistakes. I will start with avoiding the stock market while it is open. If you are on the West Coast like I am, this is an easy task to do as when the opening bell is rung you are either A) asleep or B) eating breakfast. When the market closes you are likely to be at work. This of course assumes you have a 9-5 job. This tip alone will block the majority of the market noise. When the new semester begins I take this a step further. I rely on the business section of my local newspaper. The business section is at best 4 pages long. One page is devoted to the top business headlines from the previous day. Page two is a continuation of those headlines. Page three provides a one paragraph summary of the markets. Page four usually features a local business and some classifieds. On times when I am real busy, I rely solely on Barrons. Barrons gives me the best of both worlds. First, it allows me to ignore the market during the week. Second, I still get in depth market analysis with insights on companies, industries, sectors, etc.
The ultimate example of avoiding market noise has to be Walter Schloss. Adam Smith wrote the following quote in Supermoney (1972) after Warren Buffett told him about Walter Schloss:
He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.
In The Superinvestors of Graham and Doddsville, Warren Buffett had the following to say about Walter Schloss:
I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.
Finally, I would like to direct you the reader to page 22 of the Berkshire Hathaway 2006 Annual Letter in which Warren Buffett devotes a section to Walter Schloss. The words speak for themselves.
Let me end this section by telling you about one of the good guys of Wall Street, my long-time
friend Walter Schloss, who last year turned 90. From 1956 to 2002, Walter managed a remarkably successful investment partnership, from which he took not a dime unless his investors made money. My admiration for Walter, it should be noted, is not based on hindsight. A full fifty years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.
Walter did not go to business school, or for that matter, college. His office contained one file
cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts.Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.
Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.
I first publicly discussed Walter’s remarkable record in 1984. At that time “efficient market theory” [EMT] was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.
And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory.
Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.
Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.
Maybe it was a good thing for his investors that Walter didn’t go to college.