I recently came across an interview with investor Joel Greenblatt (Trades, Portfolio) while reading Jack Schwager’s book "Hedge Fund Wizards." The book is a compilation of interviews between the author and many high-performing hedge fund managers, and contains many excellent pieces of advice collated from some of the best minds in the industry. Greenblatt was asked about the three biggest mistakes that investors tend to make - this is what he said.
Mistake number one: Succumbing to emotion
This one is straightforward. Humans are by nature emotional animals, and life would certainly not be worth living without emotion. As investors, however, we need to learn to discipline and compartmentalize our emotions. Greenblatt says those who make emotional investment decisions based on what they read in the paper or see on the television are making a mistake - such knee-jerk decisions are exactly what lead people to buy based on greed and sell based on fear (when they should be doing the opposite).
Mistake number two: Investing without knowledge
Greenblatt puts it this way:
“If you can’t value a company, you have no basis on which to invest. Valuing a company is pretty hard, and probably no more than 1 percent or 2 percent of investors have the ability to properly value companies. You can’t buy companies for a lot less than they are worth unless you can figure out what they are worth in the first place.”
Not having a framework for valuation is like sailing without any navigational tools. You can’t "buy low" if you don’t know what "low" is. Nonetheless, Greenblatt said the vast majority of investors choose to go to sea without a compass. This makes them particularly susceptible to "stories" - if you don’t have a robust quantitative mechanism for valuing stocks, the only thing you have to go off of is the narrative that has been built up around them. In fact, this is arguably the number one reason why so many retail investors end up holding the bag in market manias like the dotcom bubble.
Mistake number three: Placing too much weight on past performance
This applies most to mutual funds. Like most things in the world, the performance of mutual fund managers tends to revert to its historical average. Outperformance tends to lead to underperformance, and vice versa. This fact is lost on many mutual fund investors, who sell when their fund does poorly and buy into highly-priced competitors who have recently done well.
In short, Greenblatt’s advice revolves around one main theme: don’t overreact when you run into underperformance in the short term. If you are confident and have done your research, then you have no reason to make emotional, knee-jerk decisions.
Read more here:
- Do Successful Investors Need to Be Great Forecasters?
- Charlie Munger: How to Be a Rational Investor
- How to Invest in Real Estate Using the Stock Market
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