Making The Same Mistakes

We’ve talked about this before, but it’s still a question in my mind: why do people make the same old mistakes over and over again? We know what they do; the data you present shows that. But why do they do it?

There are all kinds of issues that come to mind in answering your question – groupthink, greed, perverse financial incentives for professionals, the urge to gamble, and much more. But the number one issue is a failure by most investors to appreciate – or even think about – the quality and value of what they own. For example, ETFs (exchange-traded funds) are one of the most popular investment products today, and like any “packaged” security product, they mask the underlying holdings.

On the institutional level, many colleges, universities, and pension funds have virtually their whole portfolios today in hedge funds, often with little or no understanding of what those funds actually own. For example, when colleges in Vermont were recently confronted by students demanding that they divest big oil companies, local news reported that the University of Vermont said it was “impossible for the school to break out exactly how much of the [$346 million] endowment is invested in fossil fuels, because a large chunk of the endowment is tied up in hedge funds rather than individual stocks.”

According to Robert Prechter and Wayne Parker in an article in The Journal of Behavioral Finance, this lack of certainty regarding valuation explains why investors – both individuals and professionals – make the wrong decisions at the worst times. When the prices of clothes or groceries go down, demand for those items goes up, since consumers have an idea of what they are worth. But when financial assets like stocks decline in price, demand goes down, since most investors – including investment professionals – lack certainty about their value. Instead, they figure the sellers must know something they don’t, so they decide to sell too. As Prechter and Parker explain:

When certainty about personal valuation applies, people maximize utility and markets seek equilibrium. When uncertainty about others’ valuations applies, people herd and markets are dynamic. The first state is common in markets for utilitarian goods and services; the second is common in markets for financial assets.

Their argument is that consumers are what economists call “rational actors,” while investors are driven by irrationality and emotion. In particular, investors are very susceptible to “herding,” since the human brain is unconsciously wired to rely on the actions of others in a group in the presence of uncertainty. Moreover, since the brain is aware it should have a reason for its actions, investors come up with various rationalizations for their herding behavior. Prechter puts it this way:

People unaware of the power of these forces simply employ their reason to excuse the actions that their unconscious impulses impel them to take. This is what most investors, money managers, economists and media commentators do. If a statement about market causality appears to make sense, they use it as a ‘reason’ for their views and actions.

The result is mass delusions that suck in not only individuals, but even investment professionals, like the New Economy during the Internet Bubble, or the idea that real estate never goes down in price before real estate tanked in 2007, or Peak Oil before oil collapsed nearly 80% in 2008.

Buffett explains that the key to avoid being caught up in this mass psychology is to focus instead on the quality and value of the business behind the stock:

The very liquidity of stock markets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a McDonald’s franchise you don’t think about what it’s going sell for tomorrow or next week, or next month, you think about how is this business going to do. But stocks with this huge liquidity suck people in and they turn what should be an advantage into a disadvantage.

Without this understanding of business value, it is very hard for most people to tolerate market price declines in securities. It doesn’t bother me at all, probably because I grew up in the business and got used to holding great companies through painful bear markets and seeing how much money you could make. Also, I know how to evaluate the underlying business, so I know what it’s really worth. That makes all the difference. I can buy something great when it’s cheap while most investors don’t even know what's in their ETF.

Charlie Munger had an interesting response when asked how much he worried when Berkshire Hathaway went down in price:

Zero. This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%... In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament.

So a key to success as an investor is to focus only on the highest quality businesses. I went to business school and studied businesses, and I really like and appreciate good companies. If you look around the room you’re in, everything there came from a business. Some company built the table and chair, made the paint on the walls, delivered the furniture to a store, etc., etc. Our whole standard of living depends on the quality of our businesses, their strategies, how well they’re run, how they treat their employees and shareholders, their innovation. And the very best businesses often have a business genius running them like Buffett, obviously, or Pete Rose at Expeditors International, or years ago Tom Murphy at Capital Cities and Walt Disney at Disney, or many, many others.

We’ve been in a period where businesses are less appreciated than usual, which has just made investors’ normal tendency to not consider the underlying business even worse. That has actually worked to our advantage, since we’ve been able to buy great businesses at some amazing prices. But it definitely is not good for most investors.