Every investor faces temptations -- mostly recently, for example, it was bitcoin and cryptocurrencies. But, as long as there have been investors, there have always been greener fields, just over the hill. Michael Steinhardt, a hedge fund pioneer and one of the most successful investment managers of the second half of the 20th century, headed for those greener fields.
His story is chronicled in “Big Mistakes: The Best Investors and Their Worst Investments,” a 2018 book in which Michael Batnick looked into errors committed by the best minds in the investment business. His goal was to help individual investors avoid similar mistakes, and to encourage those of us who have made our own big mistakes to carry on.
Early in chapter six, the author provides the example of Warren Buffett (Trades, Portfolio), who avoided the excesses of the tech bubble in the 1990s. At that time, Buffett only bought or bought into companies that had businesses he understood. As a result, he and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) looked like they had passed their best-before dates as the prices of tech stocks roared.
All around them, even amateur investors were getting rich with hot new tech stocks. In July 1999, Berkshire was down 12% from the previous year while the tech-rich NASDAQ 100 was up 74%. As we now know, many of those tech companies were very, very overvalued and collapsed, often into bankruptcy, when the tech bubble burst. Buffett had the last laugh.
Steinhardt ended his investing career in 1995, just before that bubble began developing. Some 40 years earlier he had begun investing — with his bar mitzvah money, at age 13, as he recalled in his autobiography, “No Bull.” He was a boy wonder and then an adult wonder, as he obsessively pored over data about domestic stocks.
Batnick reported that Steinhardt, along with George Soros (Trades, Portfolio) and Julian Robertson (Trades, Portfolio), was one of the big three hedge fund pioneers. His company, Steinhardt, Fine, Berkowitz & Company, averaged 24.5% annually — and that’s after deducting its 20% commission. An investor who invested $10,000 in 1967 would have a fortune worth $4.8 million by the time the fund closed in 1995; someone who invested $10,000 in the S&P 500 index would have just $190,000.
The man behind that record is politely described by Batnick as “an aggressive trader with unbridled emotions.” Steinhardt admitted that he once experienced uncontrollable rage because a portfolio manager had “mismarked” some bonds. Batnick went on to report, “Steinhardt was aware of his tyrannical behavior, but he didn't do much to change it. On top of his temper, he could also be incredibly arrogant, especially when things were going well.”
But, because of his exceptional performance, everyone wanted to invest in his funds, even after he got caught in the crash of 1987. In the 1990s, his reputation and an explosion of interest in hedge funds meant investors were practically begging him to take their money.
Thanks to an avalanche of money available, Steinhardt created a fourth fund in 1993, the Steinhardt Overseas Fund. And, it was big, almost $5 billion. That meant trading very large blocks of stocks, which was slow stuff, and a hazard to performance.
So, what was a stock picker who specialized in domestic small and midcap stocks to do? Plunge right into global investing. Batnick wrote, “Much of Steinhardt's success had come from his deep understanding of the markets he was trading. Now, he was tempted by potential up”and”comers in emerging markets where he knew little about the business environment and political system. In his memoir he recalled, “Unfortunately, we walked forward unafraid.”
Not only was he moving into foreign stocks, which were outside his circle of confidence, but he and the fund were trading swaps and making directional wagers on national debts and currencies. In America, he was well connected with everyone he wanted to know in the investment industry, but in Europe he had no such network.
Besides being outside his circle of competence, Steinhardt was also far too confident about his abilities, believing that he could leverage his in-depth knowledge of the American market elsewhere in the world. That presumption was soon put to the test.
The Federal Reserve raised interest rates a quarter point on Feb. 4, 1994. That led to a dampening of American bonds, but European bonds were dramatically affected. Steinhardt lost $800 million in just four days after the rate hike. For the year, he was down 29%. More importantly, it shook the guru’s confidence:
“Putting too much money into something you don't fully understand is a good way to lose a lot of money. But what's more damaging than losing money is the psychological scar tissue that remains after the money vanishes. His decision to exit his circle of competence sealed his fate. The episode from 1994 left Steinhardt mentally drained.”
Steinhardt himself had written, “1987 had shaken me; 1994 had been devastating. It had taken a part of me that could not be retrieved.” The clients who stayed with him recouped at least some of their loss as the fund returned 26% in 1995.
But, for the great hedge fund manager, that was enough. He retired at the end of 1995, at the age of 54.
With that, Batnick wrote briefly about the phenomenon known as the behavior gap, the idea that investors sabotage their own returns through their emotional actions and reactions. For example, “Since March 2009 to August 2016, investors in the largest S&P 500 ETF, SPY, have underperformed the fund by 115%!” In other words, by jumping in and out of the fund, trying to time its ups and downs, investors did far worse than if they had simply bought and held.
Batnick concluded:
“Bad behavior is one of the greatest dangers investors face, and traveling outside your circle of competence is one of the most common ways that investors misbehave. It's not important how wide your circle of competence is, but what is critically important is that you stay inside it. Knowing what you don't know and having a little discipline can make all the difference in the world.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.Â
Read more here:Â
Big Mistakes: John Meriwether and Long-Term Capital ManagementÂ
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