While reading Margin of Safety, I ran into one of Klarman’s statements that turns out to be very real and defines the implicit difficulty of being an investor:
“Many investors greedily persist in the investment world’s version of a search for the Holy Grail: the attempt to find a successful investment formula. It is human nature to seek simple solutions to problems, however complex. Given the complexities of the investment process, it is perhaps natural for people to feel that only a formula could lead to investment success.
"One simplistic, backward-looking formula employed by some investors is to buy stocks with low P/E ratios. The idea is that by paying a low multiple of earnings, an investor is buying an out-of-favor bargain. In reality, investors who follow such a formula are essentially driving by looking only at the rear-view mirror. Stocks with a low P/E ratio are often depressed because the market price has already discounted the prospect of a sharp fall in earnings. Investors who buy such stocks may soon find tha the P/E ratio has risen because earnings have declined.
"The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew. Investors would be better off to redirect the time and effort commited to devising formulas into fundamental analysis of specific investment opportunities.”
As we already know, to be successful in the market one requires more than an ability to process numbers, incorporate projections and perceptions into quantitative outputs, but also the emotional intelligence to recognize one’s limits and opportunity areas. As Klarman mentions, one of the most common mistakes that we make is to follow formulas blindly, without stopping to think about the many (and moving) parts that are playing a role for a company, which could never be considered a precise science.
I think that Klarman’s statements recognize the flaws we might incur in when thinking, specially since we tend to add intuition into our thinking process, more of a System 1 and 1 mixture, as Daniel Kahneman would say in Thinking, Fast and Slow. To avoid this, it is important to run a checklist, as Pabrai, Munger, Buffett and many other successful investors do.
Based on your experiences, what are your recommendations to avoid investment mistakes?
