What is the difference between good and bad investors? A simple answer to this question might be that a successful investor makes money, and an unsuccessful investor loses money. However, this is a little reductive: we know that, in the short term, an unlucky person with a good process can lose money, whereas someone with a poor process and a lot of luck can make money. Therefore, to ascertain whether an investor is likely to be successful, we must look at the reasons for their decisions, rather than just the outcomes of those decisions.
As a grizzled value investor and founder of the Baupost Group, Seth Klarman (Trades, Portfolio) knows a thing or two about successful investing. I find his answer to the above question to be particularly interesting and somewhat different to other common responses.
Is the wisdom of the crowd real when it comes to markets?
Before we address the difference between good and bad investors, I want to first talk about the concept of "the wisdom of the crowd," an old idea that has gained renewed interest in the last decade that states - broadly speaking - that the decision-making of a group will be, on average, better than the decision-making of the individuals within it. This phenomenon is certainly real in some instances - the classic example is that of a crowd at a county fair guessing the weight of an animal, where the median guess is almost exactly the correct one. The wisdom of the crowd works because it cancels out the random errors that all individuals suffer from.
When all individuals suffer from the same systematic error, however, all the crowd does is compound it. For instance, falling prices tend to beget further price decreases. This is why, for Klarman, the differentiator between good and bad investors is their attitude toward the wisdom of the crowd. Unsuccessful investors look to the market for guidance. Successful ones understand that the enlightened market is a chimera - it does not exist.
The market does not "know" anything - the prices that you see quoted on your screen are just the product of the decision-making of thousands of human beings. When all of these human beings are looking to each other for guidance, rather than thinking about the problem of price for themselves, prices can quickly get out of line from reality. The empirical record of good investors suggests that only those who think for themselves tend to do well over long periods of time.
Klarman is fond of saying that value investing is an inherently arrogant act. It takes a certain amount of self-confidence to look at the product of thousands of choices and to say, “You know what, I think all of these people are wrong.” At the same time, a good value investor must also have enough humility to recognize that, most of the time, markets are actually pretty efficient and that any available edge is unlikely to be lying on the surface. If something seems too good to be true, it probably is.
Read more here:
- Joel Greenblatt: How to Handle the Emotional Aspects of Investing
- What's Up With the New Trade Deal?
- A Conversation With Benjamin Graham
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