What happens when a professor of business strategy turns his mind to investing?
For Anurag Sharma of the Isenberg School of Management at the University of Massachusetts, it was to discover a great divide between academic finance and the most illustrious practitioners of investing. Put another way, it was a core difference between the schools of Harry Markowitz and Benjamin Graham.
In his 2016 book, “Book of Value: The Fine Art of Investing Wisely,” Sharma plunged into that divide, figuring out these two schools of investing thought and where they diverged. At the heart of the divergence, he found two different perspectives on investors as people.
On the practitioner’s side, he found Graham and David Dodd’s “Security Analysis” (1934) and John Burr William’s “The Theory of Investment Value” (1938) as the seminal texts. They emphasized investments as commitments to real businesses, which could be analyzed, and the importance of psychology. Warren Buffett (Trades, Portfolio), one of the greatest investors of all time, came out of that school.
The other school grew out of the work of Markowitz, who as a graduate student in the 1950s was trying to quantify portfolio risks. Using statistics and probabilities, he built a mathematical approach to investing; he described it in a 1955 article titled “Portfolio Selection.” Sharma reported that variance and the standard deviation of past returns became the basis of mathematical finance.
Markowitz’s ideas were to become known as modern portfolio theory, which became popular among both academics and some practitioners. This school also produced the efficient market hypothesis, which argued that all available information about stocks would be known by all investors and, thus, more risk was required to pursue higher returns.
He argued that academic finance had “virtually no penetrating insights into the inner lives of investors as real people”. On the other hand, Graham and Dodd had “intuited” the essentials of behavioral finance in “Security Analysis,” having watched the madness of investors in the late 1920s.
As an educator, Sharma saw that while academic finance had brought some value to investment education, mathematical modeling and the study of prices, investors needed a better approach. Therefore, he proposed that investing should not be addressed as “a mathematical problem of gamble,” but as “a very human problem of choice.”
The author deals with these issues in more detail and more nuance in the preface and prologue of “The Book of Value,” but I’d like to explore these issues from another perspective before we move on to the main body of the book.
When most of us were new to investing, we saw the investing landscape in much the way we see the menus of previously unvisited ethnic restaurants. A wide mosaic about earnings per share and momentum and indicators and squiggly lines on gridded backgrounds and 93% success rates if you just subscribe to the right newsletter.
Later we arrived at some practical place, where we found a strategy that generally worked for us even though we might not know why. Of course, we didn’t know if our successes and failures emerged from our thoughts and actions, or from the strategy.
Now Sharma has shown us the view from above, in which we can see the two main schools of investment thought from 10,000 feet. We see there is an academic finance school that emphasizes data and its manipulation. We also see there is the Graham and Buffett school, with its emphasis on the realities of business and human behavior.
Those of us who chose to follow the value investing path are part of the Graham and Buffett school. We study businesses as well as how our reactions to these businesses are shaped by natural human biases. Often those biases work against us, and we make bad decisions simply because we do not know what unconscious emotions and thoughts are tugging us in one direction or another.
On the business side, we have two broad goals. First, to find the earnings potential of these businesses, since earnings are the main driver of dividends and capital gains. Second, we look for a margin of safety; it’s all very well to own a great company, but if we pay too much for it, our future profits will be stunted. As Buffett wrote, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
On the behavioral side, Graham and Dodd were aware of investor psychology nearly a century ago and, in recent years, the impact of emotions has been studied more deeply as well as more widely, developing into a field known as behavioral finance. The study of businesses is never fully rational; it always contains at least some conscious or unconscious judgments or preferences. By becoming aware of mental elements that may be sabotaging our own analyses and interests, we can become better investors.
If you check the list of GuruFocus gurus, you’ll find scores of money managers who have at one time or another—and in a few cases, always—earned outstanding returns for their investors. They have been able to master not only the art and science of analyzing companies, but also mastered their own minds to some extent.
With this context, I hope that newcomers to investing will more fully appreciate the examination of investment behavior in Sharma’s following chapters.
Conclusion
In the preface and prologue of “Book of Value: The Fine Art of Investing Wisely,” Sharma explained that the world of investing has developed into two broad schools of thought. There is the school of academic finance, which focuses on data and its manipulation, and there is the Graham-Buffett school that emphasizes business analysis and awareness of emotions in investment decisions.
I added a section that built on Sharma’s work, hoping to provide context for newer investors who may be trying to figure out this often-puzzling landscape.
Finally, we should acknowledge again the dividing issue between the schools, which is the treatment of investors as people. Sharma has made the important point that investment without consideration of human elements is far from optimal, and thus he chose to follow Graham rather than Markowitz.
Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Are There Any Markets That Are Not Overvalued?
- Are US Markets Still Overvalued?
- Global Value: Allocating Your Assets With a Value Mindset
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