While Sir Isaac may not have been thinking about criminals, economists at the University of Sussex should have been listening – as highlighted in a recent publication of the Economist, they have calculated the average loot and success rate of bank robberies in order to determine the economics of taking down the local branch; they have concluded that the average bank robber in Britain should be fined £34,000 (roughly equal to the income opportunity of a minimum age worker over the term of an average jail sentence for bank robbery) in order to deter potential miscreants – in essence, they expect criminals to perform cost-benefit analysis calculations.
From the economists, we move to the practitioners - William "Willie" Sutton was among the best at what he did; in a forty-year career as a bank robber, he stole an estimated $2 million (his prime would have been in 1935 dollars; that is equal to roughly $34 million today). In Mr. Sutton’s autobiography (Where the Money Was: The Memoirs of a Bank Robber), Willie answered the $64,000 question: why do you rob banks? His response was instructive – “Because I enjoyed it.”
The economists at Sussex have made the same miscalculation as the academics in finance have for the last fifty years; in addition, they’ve clung to their outlandish assumptions at all costs – to this day, you cannot complete an undergraduate degree in Finance or pass the industry’s highest certifications without spending countless hours studying the efficient market hypothesis (EMH). In a nutshell, this teaching is based upon the idea that all investors are rational – and forms the basis of finance (in determining risk, equity valuations, etc) as taught by academics.
Yogi Berra said it best: “In theory there is no difference between theory and practice. In practice there is.” Just like the bank robber doesn’t scratch out cost-benefit analysis calculations, the average retail investor doesn’t sit at home running through mean-variance optimizations. Harry Markowitz, who won a Noble Prize for his work on Portfolio Theory, had this to say when asked about the construction of his own portfolio: “I should have computed the historical covariances of the asset classes and drawn an efficient frontier, but I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”
The point isn’t to bash the academics; while they continue to defend/teach EMH and CAPM, it is clear that behavioral finance and value investing (which requires irrationality in the markets) have taken long strides over the past three decades to jump to the forefront of practical (rather than theoretical) financial studies.
The real point is that investors should be cognizant of the fact that other market participants are much like Mr. Sutton – they might simply enjoy the game, no more, no less. The media loves to use the stock price as an explanation, when in reality intrinsic value is the measure that matters; and while that’s easy to say when the waters are calm, the noise can overwhelm the best among us when things get choppy.
For value investors, who are often swimming among the unloved and unappreciated, it is critical to recognize that stock prices and volatility aren’t the corollary of value and risk; while the first two are ticking across the computer screen five days a week, the other two are less apparent - yet critically important. The intelligent investor who recognizes this must focus on two things: developing a toolbox that leads you to conservatively estimating the intrinsic value of a company, and the patience to sit on the sidelines when the price/value differential is not attractive enough to merit a commitment of capital.
While these tools are not easy to acquire, I personally believe that they can be attained; however, this is a secondary concern. The first step is simply being cognizant of the fact that any exercise that does not involve an estimation of intrinsic value is speculation – and then being willing to avoid any and all investments that result in speculation (much easier said than done).
This article isn’t about how to value a business – it’s about the differentiation between investment and speculation; everyone wants above average returns, but then acts like herd – they speculate based upon what they perceive to be true (as told by CNBC or the stock price) rather than focusing on the truth as spelled out in years of financial statements.
The point is to be true to yourself – when you’re buying a company, honestly determine whether or not it is speculation or an investment. Have you analyzed years of financial data, looked at competitors, outlined the potential risks, and calculated a conservative range of intrinsic value? If the answer to these questions is no, then you are speculating to some extent – and I believe that many people would find they are checking this box more often than they would like.
Run through your holdings and see where you currently stand; if you take an honest look and find out that the amount of guessing is higher than you thought, it might just be that you’re not so different from the herd after all – but you’ve taken the first step to move away from the crowd.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.