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The Science of Hitting
The Science of Hitting
Articles (690) 

What the Future Holds

Thoughtful advice from the late Peter L. Bernstein

In 2004, Wall Street Journal reporter Jason Zweig interviewed the late Peter L. Bernstein, the esteemed author of investment classics like "Against the Gods: The Remarkable Story of Risk" and "Capital Ideas: The Improbable Origins of Modern Wall Street." Zweig described Bernstein as an "economist, historian, investment thinker and one of the wisest and most philosophical people on Wall Street." During the interview, Zweig asked Bernstein about the most important things that he had to unlearn over the course of his career. This was Bernstein's answer:

"That I knew what the future held, I guess. That you can figure this thing out. I've become increasingly humble about it over time - and comfortable with that, I might add. You have to understand that being wrong is part of the process… You have to keep learning that you don't know, because you find models that work, ways to make money, and then they blow sky-high. There's always somebody around who looks very smart. I've learned that the people who are the smartest aren't going to make it. What's great about this business is that you keep learning. In fact, I don't know anybody who left investing to become an engineer, but I know a lot of engineers who left engineering to become investors. It's just so infinitely challenging. You just have to be prepared to be wrong and to understand that your ego had better not depend on being proven right. Being wrong is part of the process. It's really why the market fluctuates."

There are a few nuggets in that answer that jump out at me.

The first is the importance of humility. Investing is a competitive endeavor. If there was a way to quickly and easily generate attractive returns, there would be a long line of people signing up for the chance to do so. The end result of this competition is markets that are generally efficient. As an individual investor, that means consistently outperforming the markets is unlikely - and as a corollary, that periods of underperformance are a near certainty. You must be humble enough to recognize that you will not avoid this iron clad rule of being an active investor.

Humility is also an important part of how you internalize your financial situation and your investment results relative to your peers. People will always find ways to make money – and potentially a lot more than you'll make. In many cases, they'll do so by utilizing their unique set of skills, which may not align with what you bring to the party. They may do so in ways that you recognize as smart or innovative (well earned), or they may do so in ways that you view as foolish or lucky.

Either way, your reaction should be the same: That's life. Accept it. You think Tesla (TSLA) never deserved to be a $30 billion company, and now people have made 10x their money? Who cares. Focus your time on finding an approach that works for you In addition, accept that others will find their own way through life, and may recevied outsized financial rewards along the way. As is often the case, Charlie Munger (Trades, Portfolio) has the right approach for dealing with this problem:

"Generally, I would say that if you have a lot of lovely wealth in a form that makes you comfortable, and somebody down the street has found a way to make money a lot faster, in a way you don't understand, you should not be made miserable by that process. There are worse things in life than being left behind in possession of a lot of lovely money."

Second, I'm drawn to Bernstein's idea of finding models that work, while simulteanously thinking about the idea that every approach has a shelf life (or at least a time and a place). It makes me think about the limitations that some investors put on themselves that reduce their flexibility (as an example, I'm thinking of fund managers who market themselves as a certain style of investor). For example, let's say you view yourself as a growth investor. If a company isn't expected to deliver double digit revenue and EPS growth over the next few years, you want nothing to do with it.

This is the problem I have with that approach: it assumes markets will always present opportunities that play to your style. But what if that stops being accurate? What if you find yourself in a period where these type of businesses are highly sought after, with prices that reflect that reality (for example, like the late 1990's, or possibly today)? Instead, I think you should try to retain as much flexibility as possible, with one condition: companies under consideration must be within your circle of competence. Beyond that, I think you should always be looking for new ways of thinking or operating that may widen and diversify the opportunity set in front of you at any given time.

Finally, I think Bernstein makes an astute point about smart people and the importance of avoiding overconfidence bias. This is something I can speak to from experience: operating under the belief that you're always right, and that other market participants are the ones making an error, is a path to ruin. John Hempton of Bronte Capital spoke about this in 2017 ("When do you average down?"):

"Warren Buffett (Trades, Portfolio) is famously fond of "averaging down". If you liked it at $10 you should love it at $6. If it goes down "just buy more". And in the value investing canon you will not find that much objection to that view. But averaging down has been the destroyer of many a value investor. Indeed, averaging down is the iconic way in which value investors destroy themselves (and their clients). After all, if you loved something at $40 and you were wrong, you might love it more at $25 and you almost as likely to be wrong, and like it more still at $12 and could equally be wrong."

Bernstein offers some useful advice for minimizing the cost of overconfidence: "You just have to be prepared to be wrong and to understand that your ego had better not depend on being proven right."

I've been in this position multiple times, and often on names that I've publicly tied my reputation to through my articles on Gurufocus. The list includes IBM (NYSE:IBM), J.C. Penney, Kraft Heinz (NASDAQ:KHC), and Wells Fargo (NYSE:WFC), among others (I think the jury is still out on the last two, but clearly those investments have clearly not gone as planned). What I learned in these difficult situations is that being wrong on an investment is usually a manageable problem to have (if you've sized the position appropriately). But where you can really run into trouble is when you refuse to acknowledge the error and stubbornly continue to add to the position every time the stock price declines. That's a quick way to turn a manageable loss of 3%, 4%, or 5% of your portfolio into a much larger issue. It's a mistake I've made in the past, and one I've worked hard to avoid lately.

Conclusion

Bernstein offers a concise summary of how to be a better investor. Be humble, keep getting better, be open-minded to new ways of playing the game, and never conflate the validity or confidence of your ideas with how aggressively you're willing to size the position. And finally, accept uncertainty as a part of investing and life. If you take Bernstein's advice, I think you'll become a better investor.

Disclosure: Long Kraft Heinz and Wells Fargo

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

Praveen Chawla
Praveen Chawla premium member - 3 weeks ago

Some great quotes here. I agree with risk of doubling down on a losing investment is quite likely there is something in your blind spot to which you are oblivious. The wisdom of the crowd is not always wrong.

We have seen very smart people like Bill Miller (with banks & insurance companies) and Berkowitz (with Sears) nearly destroy themselves.

On the other hand we have also seen companies like Apple, Merck, Starbucks, Kroger, Walmart, Bestbuy and now Tesla come back from deep holes when investors had left them for dead.

The Science of Hitting
The Science of Hitting - 3 weeks ago    Report SPAM

Praveen - Agreed. Doubling down on a losing investment can be very profitable if the sell-off proves unfounded. The question, of course, is how do you decide if it was justified? I think Hempton offers some useful ideas for trying to do this in practice. Thanks for the comment!

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