Widely regarded as one of the greatest investors of all time, Warren Buffett (Trades, Portfolio) has been a defining figure in the investing world for decades. Like all investors, he also makes mistakes sometimes, but he has always been very forthcoming with his errors, candidly discussing where he went wrong in interviews as well as his annual letters to shareholders and Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) annual shareholder meetings.
For investors, Buffett’s mistakes are just as valuable as his successes, as the advice he has provided in his storied investing career after learning from such mistakes is incredibly insightful. Thus, in this discussion, we will go over three common investor pitfalls that Buffett has covered extensively in the past.
Confirmation bias
People have a tendency to more readily accept as fact information that fits in with what they already believe, all while discounting information that does not fit in with what they already believe. This is what psychologists refer to as “confirmation bias.”
Buffett combats confirmation bias first by admitting that he can indeed fall victim to it, and then by listening to opinions that contradict his own.
In fact, at the 2013 Berkshire annual meeting, he even invited Doug Kass, an open critic of Buffett and his investing style who was known to be shorting Berkshire stock at the time, to speak with him. These kinds of events are usually scripted, but Buffet said he invited Kass because he wanted to “spice things up.”
Kass’ criticisms of Berkshire include his expectation that the larger Berkshire gets, the more difficult it becomes to outperform. He also pointed out once that the value of insurance float diminishes when interest rates are near zero, and that the value of “very old economy” stocks like Coca-Cola (KO, Financial) no longer hold up like they used to because of their “breached moats.”
Going even further back, in a Forbes article in 2001, Buffett wrote the following:
“Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man's natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience - a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.”
Loss aversion
An investing mistake that happens all too often is when an investor clings to a loss-making position simply because they do not want to sell the stock and turn the paper loss into a real loss. This is called “loss aversion,” and it happens because humans have an asymmetric experience of loss versus gains, typically seeing a loss as much more painful than a gain of equivalent value. This can result in making up justifications for why the stock will go up in the future that are not necessarily based on reason.
Another form of loss aversion is when investors give up on a stock too quickly just because it goes down in the near term. Following in the footsteps of his teacher Benjamin Graham, Buffett does not pay too much attention to the day-to-day fluctuations of the stock market.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine,” Buffett wrote in a 1987 letter to Berkshire Hathaway shareholders, referring to how the daily stock market fluctuations are driven by sentiment while the long-term changes are more influenced by the reality of each business.
As long as your analysis of the business holds up and nothing fundamental has changed to make you alter your long-term outlook, there should theoretically be no reason to sell a stock just because of the day-to-day mood swings of Mr. Market.
At the 2002 Berkshire shareholder meeting, when asked about why he sold certain stocks, Buffett responded that there are two main reasons why he would sell a stock: one is if a better opportunity comes along and the second, more common reason is if a business’ fundamentals or its competitive landscape have changed.
This brings us to the main method of avoiding making mistakes due to loss aversion: doing your research on a stock so that you have a better idea of when to have faith in your analysis and when to take the loss before it gets worse.
Following the herd
It is natural for people to want to do what their friends and peers are doing. That spills over to investing as well, with people often allowing rational investing principles to take a backseat to the stocks they see everyone else investing in.
If other people are hoping to make a lot of money on a stock, it is not a good feeling to be the one left behind. This is especially true if a stock that your friends bought has gone up recently. Not wanting to be the only one not making money, you might even buy at a much higher price than your friends due to the fear of missing out on further gains.
Yet, following the herd is a practice that all too often leads to an unwanted conclusion. The most prolific examples of herd investing are when investors pile into speculative stocks during bull markets, hoping to make a killing once their favorite bets turn profitable.
In reality, the speculative stocks that do not end up failing due to fundamental issues or the emergence of a bear market often lose a good chunk of their value once they become profitable, as businesses cannot grow their top lines as quickly once the business actually becomes big enough to sustain itself, resulting in future cash flow models being revised downwards.
That is why it is important to avoid investing in a stock just because it is popular or because the stock price is increasing.
Following the herd is a dangerous practice not only because it causes people to ignore rational analysis of stocks, but also because it can result in buying high and selling low.
One of Buffett’s most frequently quoted tips is to “be greedy when others are fearful and fearful when others are greedy.” Long-term investors make most of their money in a bear market because that is when stocks are more likely to be trading at a discount. In comparison, if you buy high and sell low, the odds are heavily stacked against you.
