Wednesday, November 08, 2006
Business and investing quote of wisdom of the week
"The most important quality for an investor is temperament, not intellect."
Warren Buffett once mentioned "any IQ above a reasonable level of intellect is wasted." To start, a conclusion can also be drawn that temperament is necessarily some function of intellect, though not in the conventional way. A person ability to evaluate his individual competence is strongly related to capability. This may not be in the exact same form of the conventional for intellectual capability. But it is an important capability that measures a person ability to react to different emotional situation.
By consciously making an effort to continuously harness temperament, it will lead to fewer investment errors. After all, simple math demonstrates that it takes 100% gain to offset a 50% loss, and the former are lamentably scarcer than the latter. Randomly, three manifestations of temperament are suggested towards reducing erroneous ideas. No doubt there are hundreds more.
TEMPTATION is a pervasive and often hard to rid of human trait. This trait is often the major factor for causing EXCESSIVE TRADING. Many of us just simply cannot resist the temptation to constantly buy and sell due to a lack of patience. The more you trade, the more likely you are pursuing a low return strategy. By trying to sell a stock in the hope of buying it back cheaper, or trying to outwit the impossibly resourceful Wall Street, or hoping to precisely time short term price jumps, there is no one who is known to have done it successfully. It is a struggle to list investors who have accumulated serious wealth through furious trading. But it is easy to come out with a list showcasing wealthy investors who owe their success to holding shares of great businesses for a long time. The most legendary is Warren Buffett. A few of his investments include, Coca Cola, American Express, Gillette (now merged with P&G), Washington Post, See's Candies, Netjets, and so on. Moreover furious trading means high turnover of your holdings, naturally, it incurs a cost - frictional cost like commissions - so why volunteer for more? The next time you find your finger on the trading trigger, stop and ask whether you can prove your action will be more profitable than inaction.
INDEPENDENT CONVICTION was originated popularized by Benjamin Graham, the father of value investing. To paraphrase one of his quotes: "You are neither right nor wrong because others agree with you. You will be right if your facts and reasoning are correct." The challenge in investing is that decisions bear an important financial consequence, and are often made alone. Many famous value investors - especially those who were Graham students like Buffett, Browne, Schloss and many others - they make investment decisions independent from each other, their portfolios are totally different from one and other. But what is similar is they have the same principle in making an investment decision. It can be so easy to submit to a need for emotional reassurance by following the herd with other investors - especially for those who need to justify decisions to clients. Why do investors like to follow most others are doing? Because by being in the herd, it provides a sense of belonging and warmth which you cannot get if you are to stand alone. So when they made a wrong decision, they would not appear as embarrassing. And the best thing is nobody will fault them because the majority is making the same mistake. But if any one of them decide to stand on himself, he stands the chance of being ridiculed if his performance does not appears to be as good as how the other side is doing. But if you decide that by following the herd is a better method, then it is important for you to figure out where among the herd you should stand in relation to the others that will make the difference. The grass is always greener and much more if you are at the edge of the herd. Then by following the herd, it can be frightfully expensive because investors who bought Cisco in Jan 2000, Enron before it went bust, or Xerox in Dec 1972 will be able to illustrate to you.
As with any temperament-honing strategies, basic awareness is a critical step. Here, it is important to subscribe to the mindset of "fact finding." Personally I think if investors are to substitute a reference to "the crowd or herd" with a reliance on verifiable stock-specific facts will definitely inoculate themselves from the market's emotional swings. By developing a fact base for your investments will also help you to avoid getting surprised or spooked by any temporary price declines. It is meaningless to buy stocks with a large margin of safety if a transitory 10% price decrease makes you sell. In fact, with your fact base, and if you refer back to it, it provides a better window of opportunity to accumulate shares of a great business at a better price. In any case, this is much easier said than done, but if it isn’t, then how on earth could moats be worth much more if everyone could have one?
ENVY is uglier than greed though both are the downfall to sustainable success. Charlie Munger lists envy as the worst of all sins because this is the only sin which does not provide any positive outcome. Any other sins like lust, gluttony provides you temporary joy or satisfaction but envy produces absolutely zero satisfaction. In fact, it causes resentment even more and distort any logical ideas that you originally may have thought of. When you weigh its financial ill effects, envy may actually be one of the major factors in causing wrong and emotional decision. It is amazing how many investors furiously scramble into the market's hottest sector or stock, seemingly not wanting to miss out on the "easy" profits others are making. But personally I find this behavior as odd. Why buy when prices are highest and margins of safety and return are lowest? I can never answer the question logically if these people are using facts to make a decision. They rely on emotions and where the arrow is pointing at. Yet the lure of the 1990s dot-com bubble, today's real estate appeal, or any historical famous bubbles amply demonstrate envy's powerful siren sound. Some people they just simply cannot stand anyone beating them at any point in time. They must always be at the head of the line. But some investors, at somewhere, will bound to always have earned a higher return over any recent period or at any time. Even if some investors get richer a little faster than you, so what? I think the demons of envy can be thwarted with a combination of awareness and a disciplined strategy of limiting investments to those that can be purchased with a margin of safety. Sure, there'll always be a "hot" sector, if there isn’t any stories, Wall Street will draw blanks.
Frankly, this can get endless. Temperament is merely just a subset of the broader academic research into behavior finance, and what have been mentioned here, we barely scratched the surface. Serious investors should explore this field in much more depth than my space constraints and limited knowledge would permit. I'd recommend "Poor Charlie's Almanac" for those seeking an experienced practitioner's overview, and John Bogle "Common Sense."