In May of 1998, Adam Smith, author of the book “The Money Game,” interviewed Warren Buffett (link here). During that discussion, Mr. Smith asked Buffett one question that particularly caught my attention: Why do smart people do dumb things?
“That's the big question. Why do they do it in investing? Why do they do it in managing businesses? Because you have all these smart people out there. The money doesn't go to the people with the highest I.Q. There would be a very poor correlation between I.Q. and investing and results. And you say to yourself why does somebody with a 500-horsepower motor only get 100-horsepower out of it? And I would say that if you look at the intellect as being the horsepower that's available, but you look at the output as reflecting the efficiency of that motor, it is rationality that causes the capacity to be translated in output.
Now what interferes with rationality? It's ego. It's greed. It's envy. It's fear. It's mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it's not because we're so smart, it is because we're rational and we very seldom let extraneous factors interfere with our thoughts. We don't let other people's opinion interfere with it. We try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people's behavior. And those are the factors that cause smart people to get bad results.”
Upon reading this, individual investors should be able to note their single biggest advantage in investing over their competitors, who are largely institutional – that is the ability to wait, and the change to stand apart from the crowd without any consequences.
This ability to wait is where my name, “The Science of Hitting,” comes from; here’s Warren discussing it in that same interview:
“Ted Williams, in his book 'The Science of Hitting,' carved the strike zone up into 77 cells. In fact, he's got a diagram in the book. And he says if he swings only at balls in a certain cell, right in the middle of the plate more or less, he'd bat .400, but if he swings at balls in the worst cell, which is the lower outside corner, he'd bat .230. So he says the most important thing in terms of being a good batter is to swing at good balls. And in investing, it's the same principle.”
For the fund manager, this is easier said than done. A great example would be Apple (AAPL), which has likely crept into funds far and wide for the simple satisfaction of saying “we own it,” even if the manager doesn’t believe the stock is particularly attractive; with clients hungry for market-beating returns and the company accounting for nearly 5% of the index, there’s a good chance that many have bought the stock due to the angst of being left behind by the herd.
The most recent quarterly letter from GMO co-founder Jeremy Grantham sums up why in the first sentence: “The central truth of the investment business is that investment behavior is driven by career risk.” He continues on this topic, saying the following:
“Missing a big move, however unjustified it may be by fundamentals, is to take a very high risk of being fired. Career risk and the resulting herding it creates are likely to always dominate investing. The short term will always be exaggerated, and the fact that a corporation’s future value stretches far into the future will be ignored. As GMO’s Ben Inker has written, two-thirds of all corporate value lies out beyond 20 years. Yet the market often trades as if all value lies within the next five years, and sometimes five months.”
All you need to do is take a look at the Fairholme Fund's assets under management (AUM) to see this occurring in real time; a decade of superior results was evaporated in 12 short months, despite multiples conferences with shareholders to explain the rationale for the company's portfolio. Even with the fund in the top 1% of its peer group to date this year, AUM still stands at more than 50% below where it was 18 months ago (it was down 70% in 2011).
This same idea is found outside of the investment community as well; Warren talked about this phenomenon when explaining his purchase of IBM for Berkshire Hathaway (BRK.B) on CNBC in November:
“I was chairman of the board, believe it or not, of a tech company one time, and computers used to use zillions of tab cards and IBM in 1956 or 1957 signed a consent decree and they had to get rid of half the capacity. So two friends of mine, one was a lawyer and one was an insurance agent, read the newspaper and they went into the tab card business and I went in with them. And we did a terrific job and built a nice little company. But every time we went into a place to sell them our tab cards at a lower price and with better delivery than IBM, the purchasing agent would say, nobody's ever gotten fired [for] buying from IBM.
This phenomenon plays itself out in professional investing time and time again. Managers window dress the portfolio at the end of the quarter to avoid standing apart from the crowd (particularly if those securities that are apart from the crowd have been big losers), and many simply closet index in order to assure that their returns don’t deviate too far from the S&P or the Dow Jones Industrial Average.
The guy sitting at home managing his $100,000 IRA should be ecstatic. Without any clients to report to, you can sit back and laugh off the volatility, and continue loading up on beaten-down and unloved names without having to explain your rationale to unhappy clients. If you don’t capitalize upon this opportunity, or even worse, turn it into a headwind, you are passing up on one of the single largest advantages that you have as an individual investor.
I’ll end it by repeating the key quote from above: “If Charlie and I have any advantage it's not because we're so smart, it is because we're rational and we very seldom let extraneous factors interfere with our thoughts.”
An IQ of 160 is not a prerequisite for being a successful investor; an understanding of economics, business moats, and basic valuation tools (math skills), all of which can be learned via rigorous study, are all that’s required from an intellectual perspective.
Rationality and patience are the differentiators, and are often stripped (to some extent) from the investment manager due to career risk and an obsession with short term results; for the individual investor, these are the key traits that can lead you to “big leagues” returns, rather than a spot on the bench in the minor leagues.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.