CHAPTER 12

Of Sound Mind

Value investors have been eager students of—and active contributors to—the increasingly popular field of behavioral finance, which draws from both psychology and economics in an effort to understand the economic decisions human beings make. These are not the fully rational decisions that efficient-markets enthusiasts assume, but the messier actual decisions people make that impact market prices and are driven by a variety of social, cognitive, and emotional factors. Behavioral finance looks to understand and explain investors' natural and evolutionarily supported tendencies toward—to name a few—overconfidence, sticking with the herd, panicking in the face of trouble, disliking losses more than they like gains, falling in love with what they own, overweighting more recent information, and craving the big score.

Of course it's one thing to understand how human nature can conspire against rational investment decision-making, and quite another to keep it from happening to you. As Warren Buffett puts it: “Investing is not a game where the 160-IQ guy beats the guy with the 130 IQ. Rationality is essential when others are making decisions based on short-term greed or fear. That is when the money is made.” In fact, many of the strategies, processes, and disciplines articulated throughout this book are meant to help eradicate those irrational and painful “What was I thinking?” types of mistakes.

Beyond more concrete elements of strategy and tactics, the best investors often also emphasize the importance of mindset to their ultimate success. What are common elements of their mindset? They're competitive. They're contrarian. They balance self-confidence with humility. They're inherently curious. They're constantly learning. While such traits may be more innate than learned and more difficult for the outside observer to assess, they're extremely important in distinguishing the investors who have what it takes from those who don't.

COMPETITIVE SPIRIT

Over a total of 38 years as a Division I college basketball coach, the late Norm Stewart amassed 728 wins, most of those at his alma mater, the University of Missouri. Known as a tireless recruiter, the first question he would often pose to aspiring high school players was a simple one, “Do you love to play?” All of course said yes, but how they answered was often telling.

Stewart explained that he asked out of a conviction that those who didn't truly love to play would never have the dedication and drive necessary to compete at the highest levels, regardless of how talented they were. This universal insight certainly holds true for investors. If their love of the game isn't evident, it calls into question their ability to play it well.

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What other business is as intellectually stimulating as this? Other than maybe intelligence gathering for national security, I don't know of one. If you like winning, there's a scorecard. If you like game theory and trying to logically deduce what's likely to happen, this is a great application for that and it's very gratifying to be proven correct.

—Kyle Bass, Hayman Advisors

I'd use the analogy of a professional baseball player. If you think about what would motivate someone to put so much time and energy into doing something as repetitive as playing baseball, you could probably boil it down to three things. It could be they just like the process of playing the game, because they're good at it and get a lot of personal validation out of it. It could be because they're very competitive and want to be on the winning team and want to succeed in an objectively measured way. Or it could be they're just in it for the money, to become accomplished in the field, and be well compensated for their talent.

For me, I enjoy the process of trying to figure out what's going on in the world and think investing is about as good as it gets in business in terms of intellectual stimulation. Second, I'm very competitive, but in the positive sense of trying to improve and always measuring how well I'm doing that. The third part—making money—is not required, but conveniently and pleasantly is a result of being good at the first two.

John Burbank, Passport Capital

I love the challenge of investing—for a competitive person there's nothing better than when you absolutely nail something that no one else was getting. It's also a great business for people who are intellectually curious. I've followed the battery industry for 20 years, but I learned several new things from my conversation earlier today with the president of Exide. It's a new game every day—why would I do anything else?

—Candace Weir, Paradigm Capital

When I started the business I was motivated by being a real competitor. I love to win, and the idea of being in an industry where you keep score and know where you stand every day was highly appealing to me—and, in the end, seemed inherently fair.

—John Rogers, Ariel Investments

So many things impact the markets, from history, to politics, to popular culture, and those elements change day-to-day. The challenge of working through all that is consistently exciting–and you can see your results on a real-time basis.

—Tom Perkins, Perkins Investment Management

I love learning about businesses and the intellectual challenge of investing. I'm also intensely competitive about generating great returns. I love that you get a scorecard at the end of the day and I love to win. Winning to me is looking back after 30 years and saying, “Wow, look at that track record—these guys did it well and they did it right.”

That's not to say I'm particularly fond of those days when you feel like an idiot and your numbers make you look like an idiot. But as a competitive person, I wouldn't have it any other way.

—Ricky Sandler, Eminence Capital

Figuring things out and solving the puzzles is still the most exciting part. It's very fun to think we understand something that it appears most people view differently. Then you get to find out who's right.

—David Einhorn, Greenlight Capital

There's a big difference between loving to win and hating to lose, which has a lot to do with one's approach to risk. Someone who loves to win is willing to take a lot of risks because the euphoria of winning outweighs the bad outcomes. If you hate to lose, though, any bad outcome is not acceptable. To be a great investor, I think you really have to hate to lose.

—Jon Jacobson, Highfields Capital

Investing is a fun game and you want to find the people who are just smitten with it. I wouldn't say for the best ones that it's about the money—it may fall off the back of the truck, but it's not at all why they play the game.

—Joel Greenblatt, Gotham Capital

People who are in a good mood are more inclined to try learning new skills, to see things in a broader context, to think of creative solutions to problems, to work well with other people, and to persist instead of giving up. If you were writing a recipe for how to make more money, those are among the first ingredients you would include.

Jason Zweig, Author, Your Money and Your Brain

I've always considered myself privileged to live the life I do, making a living doing something I enjoy very much.

—Francisco Garcia Parames, Bestinver Asset Management

[My level of competitiveness] was important, yes. I always said that when Tiger Management was going, that our employees would have taken a 15 to 20 percent pay cut if that would have somehow guaranteed us to be number one. That definitely mellows out over time, but I still like winning, which is one reason I've done this same thing for a long time. You can get too much competitiveness, though, and then you're competitive with your subordinates and your superiors and you're kind of a horse's ass.

—Julian Robertson, Tiger Management

I did worry when I shut down my main hedge fund in 2000 that I didn't want my tombstone to say, “He died getting a quote on the yen”—as if I had nothing better to do in the middle of the night than that.

—Julian Robertson, Tiger Management

INDEPENDENT THOUGHT

One of our favorite quotes with clear application to investing is from Spanish/American philosopher George Santayana, who wrote, “Skepticism is the chastity of the intellect, and it is shameful to surrender it too soon or to the first comer.” The best investors are without question a skeptical lot, quick to question the status quo or conventional wisdom, and slow to build the conviction necessary to go against either.

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If you subscribe to the thesis—as I do—that the greatest amount of money is made from having great confidence in contrarian positions, I think you'd find the people who are comfortable taking these positions don't tend to fit in with the mainstream.

Going against the grain is clearly not for everyone—and it doesn't tend to help your social life—but to make the really large money in investing, you have to have the guts to make the bets that everyone else is afraid to make.

—Carlo Cannell, Cannell Capital

Figuring out what you should do as an investor isn't that difficult. You can read all Warren Buffett has written or said over the years, for example, and basically emulate that. The hard part is to have the discipline and the patience to execute.

The bottom line is that to be a good investor you need to only buy when it's emotionally the hardest, only sell when it's emotionally the hardest, and do pretty much nothing while waiting for market extremes to offer opportunities to do either. That's all incredibly hard. You often don't know you've been right until months or even years later. Most people need more immediate gratification than value investing typically offers up.

—Steve Leonard, Pacifica Capital

One of the keys to this business is having conviction based on your work that you're right and the rest of the world is wrong. If you don't have that confidence, you'll never buy anything because there's always something that can go wrong. Everyone thought the idea of buying stock in General Growth Properties right before it went bankrupt in the middle of the financial crisis was the stupidest idea they've ever heard of, and plenty of people said so. The stock was at 35 cents a share, down from $63, and we bought 25% of the company. You can't get much more contrarian than that.

—William Ackman, Pershing Square Capital Management

Acknowledge the complexity of the world and resist the impression that you easily understand it. People are too quick to accept conventional wisdom, because it sounds basically true and it tends to be reinforced by both their peers and opinion leaders, many of whom have never looked at whether the facts support the received wisdom. It's a basic fact of life that many things “everybody knows” turn out to be wrong.

How can an investor use that? The uncertainty involved in predicting complex events would argue for some level of diversification and a greater focus on hedging. At the same time, the fact that people tend toward overconfidence and follow conventional wisdom should provide opportunity for those taking contrarian positions against that. The trick, of course, is to have concrete justification for why the crowd is wrong.

—Robert Shiller, Yale University

As value investors, we're quite used to being short on social acceptance at different periods of time. It's always important to keep in mind that our own balance and equanimity should not be based on external perceptions.

—Matthew McLennan, First Eagle Funds

You learn quickly in this business that you're not going to look smart all the time, which inevitably brings criticism. We always remind ourselves of that great Jean-Marie Eveillard quote, “I'd rather lose clients than lose clients' money.”

—David Samra, Artisan Partners

As it turns out, one of the key lessons of investing is that the best successes are born during times when you're not a winner. I was down 2 percent in 1999 [a year the S&P 500 rose 21 percent] and it was probably my best year. Nothing worked that year, but resisting the temptation to chase ideas I didn't believe in left me positioned for some of my best years thereafter.

It's a long race, not a sprint—if you rely on the market's validation all the time, not only are you going to be very disappointed, you're also going to make a lot of mistakes.

—Thomas Russo, Gardner Russo & Gardner

I think our being based in Columbus, Ohio makes it easier for us to be independent thinkers, which is so important to successful investing. When we leave the office, we're not very likely to be influenced by what other investors are talking about because there aren't many out there. I honestly believe that's an advantage—there's no herd mentality because there's no herd.

—Ric Dillon, Diamond Hill Investments

One reason our results have been relatively strong is because our mistakes have been in smaller positions and our successes in larger ones. I attribute a lot of that to our partnership: I tend to be a glass-half-full person, while Ed [co-manager Edward Studzinski] behaves more as if the glass is broken and empty. He helps restrain my more aggressive instincts and his natural skepticism has been incredibly valuable.

—Clyde McGregor, Harris Associates

We tend to be conservative and deliberate, which often keeps us from buying as much as we should as quickly as we should. Having said that, I think being skeptical and wary about all the things that can go wrong is a good way to avoid making a lot of mistakes. Anyway, it's my nature to be that way and even if I could change it, I wouldn't really want to.

—Wayne Cooperman, Cobalt Capital

An early mentor of mine, T. Edmund Beck, started out during the Depression and used to always say we were in the rejection business—that we're paid to be cynical and that a big part of success in investing is knowing how to say no. He never dwelled on missed opportunities because something else—even the same thing later on—would always come along. I'm a big believer in that approach.

—Spencer Davidson, General American Investors

PERPETUAL STUDENT

Unlike basketball, investing is a game at which you should become more proficient with the long passage of time. This can only happen, however, with the mindset of a perpetual student, as conversant in historical precedent as you are in future possibility.

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The nice thing about investing is that if you can protect your physical and mental health you should only get better at it over time. Experience improves your ability to recognize patterns and to exercise judgment in difficult situations, of which there have certainly been no shortage in recent years.

—David Nierenberg, D3 Family Funds

I enjoy being a perpetual student, and working with good people. I'll probably be here until I go non compos mentis. I'll lose my marbles, then they have a right to get rid of me.

—Martin Whitman, Third Avenue Management

I generally find the best investors are very open and have almost a child-like curiosity about how everything works. They don't come to the table with preconceived notions. Americans, in fact, are more likely to have this kind of attitude than Europeans or Asians. It's much harder to learn new things when you think you already know everything.

—Oliver Kratz, Deutsche Asset Management

Soon after graduating from college I went through some testing at the Johnson O'Conner Institute and found I have two prominent aptitudes, inductive reasoning and what they call ideaphoria. These don't often go together—one involves a logical progression from specific observations to arriving at broader generalizations, while the other is an unusually high-frequency flow of ideas, many of which are unfocused and non-linear. You don't want much ideaphoria if you're an accountant, but those two aptitudes combined seem to be conducive to investing.

—Carlo Cannell, Cannell Capital

Fortune magazine recently had an interesting article about how successful people work and one of the people they spoke with was Wynton Marsalis, the great jazz trumpeter. He said that if you want to be able to find a groove, you have to practice, practice, practice. You've got to know the scales and you've got to know the basics if you want to improvise.

—Mitchell Julis, Canyon Capital

Things trade at different values from their true worth because human beings look at them in certain ways in certain circumstances. Those ways and circumstances can change, so the tools you use and your thought processes have to evolve. The exact same thing doesn't always work over and over again—the market's too smart for that.

—Lisa Rapuano, Matador Capital Management

One of the things about which we're institutionally most proud is having outperformed the S&P 500 in every rolling 10-year period since 1969. That means we've had to be open to change and not just do exactly what had worked for the previous 10 years, because the best funds in any 10-year period are always the funds optimized to that period—in healthcare, say, or commodities or technology. The biggest risk we worry about is not adapting to the times and participating in change. That's what keeps us on our toes.

—Christopher Davis, Davis Advisors

I'm a golfer, and one of the things I love about it is that you can play the same course 20 days in a row and every day will be different. It just rained, or it's hot, or the wind is blowing from a different direction. You have to adjust all the time for a lot of changing factors, which is also true of investing. People who really love to invest wouldn't have it any other way.

—Robert Leitzow, Lakeway Capital

I've had the good fortune of being around smart investors my whole life, including my father. Because of that, I'm sure things maybe clicked a bit more quickly when I started getting interested in investing. But I'd have to say learning from what works and what doesn't is how you really become a better investor. In the end, the market is the best teacher.

—Wayne Cooperman, Cobalt Capital

You have to have your eyes open all the time and devote yourself, as Charlie Munger says, to lifetime learning. As I like to say, in life as well as in business I'm lucky if I have learned something new every day—and I'm doubly lucky if it didn't cost too much to do so.

—Chuck Akre, Akre Capital Management

Will Rogers once said, “Good judgment comes from experience, and a lot of that comes from bad judgment.” I add to my base of experience every day.

—Donald Yacktman, Yacktman Asset Management

One great thing about investing is that, unlike the pitcher who starts to lose his fastball in his mid-30s, my fastball as an investor should keep getting better. I'm one of those guys who says “Thank God it's Monday,” because this is as much my hobby as it is how I make a living. If you don't feel that way, you should probably be doing something else.

—Andrew Pilara, RS Investments

TO ERR IS HUMAN

Critical to the learning process is a rigorous assessment of how and why past mistakes were made. No portfolio manager would admit that he or she makes little effort to learn from mistakes, but we have often found in this regard that words often don't match deeds. Money managers expect executives of the companies whose stocks they own to be open and honest about mistakes, to be quick to correct them, and to be diligent in trying to make sure they don't happen again. Investors should expect nothing less from those to whom they have entrusted their money.

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We have a deliberate process to at least once a year sit down and look at the mistakes we've made. If you do it too often you probably don't achieve much at all because you're constantly looking over things before the mistake is actually clear.

We try to focus more on process errors we can control than just on what went wrong in terms of outcomes. It's also important to make sure you learn the right lessons—it's very easy to learn a specific lesson that isn't very helpful because you won't find yourself in exactly that specific situation again. You want to learn the most general lesson you can from the mistakes you make.

—James Montier, GMO

I'm playing golf in a foursome that includes someone who's a terrible golfer. He's teeing off and takes a big swing and misses, digging up a divot off to the side of the ball and tee. He regroups, takes a deep breath and then does the exact same thing again, digging an even bigger divot in the same place. He looks at his caddy, who walks over and takes the ball and tee and puts it into the divot hole and says, “Try this.”

I thought that was hilarious, but it gets to the importance of working hard not to repeat mistakes. We set up our process so that we're formally addressing as many of the answers as possible to the question, “If it turns out two years from now we've made a mistake, why would that be?” It obviously doesn't eliminate all mistakes, but for a concentrated manager, if as a result you make only two material mistakes per year rather than four, that can make a huge difference in your performance.

—Jeffrey Bronchick, Cove Street Capital

We do post-mortems on all of our positions—as well as regular position reviews of what we own—to constantly assess what we got right and what we didn't. That matters because we want to learn from mistakes even if the investment outcome turned out fine because we were lucky. Luck is not a sustainable way to make money as an investor. Avoiding mistakes that you've made before is.

One primary virtue of experience is that you're constantly learning the ways in which things can go wrong. If you internalize that into your process, you're identifying more of what can go wrong and assessing how that changes your investment case. Minimizing the number of times you get blindsided is a very worthy goal.

—Shawn Kravetz, Esplanade Capital

Some investors don't want to dwell on their mistakes, but we closely track over rolling five-year periods how all of our buy/sell decisions are working out. In the same way we don't beat ourselves up for missing something that truly couldn't have been seen in advance, we don't want to take comfort when an investment works out but our analysis was wrong.

—Ric Dillon, Diamond Hill Investments

Mistakes of judgment are the toughest to learn from, because each one is different. They tend to be in companies in which there has been gradual degradation—hard to pick up from the outside—either in the competitive landscape or the culture of the company. Because each case is different, it's hard to draw general lessons and you don't want to learn the wrong one. There were a lot of ways to look at the mistake of buying AT&T when Michael Armstrong took over—successful executive from outside the industry—that would have prevented you from buying IBM when Lou Gerstner came in.

—Christopher Davis, Davis Advisors

I did a simulation of how often a top money manager earning 20 percent per year with a 15 percent standard deviation would lose money over short time periods. A 20 percent return would be about double the market's long-term average return and a 15 percent standard deviation would be lower than historic market volatility. So this is someone who's doing very well.

But on any given day, this hypothetical manager would lose money almost half the time. He'd lose money in 35 percent of the months and in an average of one quarter per year. Once every 10 years he'd have a losing year.

I think it's healthy for investors to remember that even great long-term records are full of plenty of down months and quarters. Remembering that is hard to do sometimes as time horizons in the industry have gotten so short.

—Bryan Jacoboski, Abingdon Capital

My time playing golf taught me some useful lessons as an investor. For one, you make mistakes all the time and you try to learn from them, but it's always about the next shot. It's about properly preparing and then executing to the best of your ability. That's an excellent mindset for an investor to have.

—Pat English, Fiduciary Management, Inc.

I've been doing this for more than 25 years and have learned never to take mistakes lightly. What's most important for us, though, is to stay focused on the discipline of only investing in companies with the characteristics of leaders, laggards, and innovators that we've seen work as investments over a long period of time. That discipline keeps us grounded, and helps us keep mistakes in perspective. Otherwise, you can drive yourself crazy.

—Philip Tasho, TAMRO Capital

Don't be paralyzed by the fear of making a mistake. Understand that the best opportunities usually carry more perceived risks, and distinguish carefully between the risks that matter most and those you can live with. As long as I know the risks I'm taking and the stock prices are compensating me to take those risks, I can live with that.

—Brian Gaines, Springhouse Capital

You want to make mistakes once in a while. If you never make a mistake, you're being too conservative and missing profit opportunities you shouldn't.

—Ed Wachenheim, Greenhaven Associates

BE EVER SO HUMBLE

There's no question confidence in one's abilities is critical to successful investing. To commit one's own and others' hard-earned capital requires conviction, and conviction requires confidence. But as with fine scotch or pepperoni pizza, too much of a good thing can cause problems. It can at times be difficult to see, but quite often even the most accomplished money managers exhibit a level of humility about their craft that, far from a sign of weakness, is often a prerequisite to long-term success.

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One can see the investment universe as full of certainties, or one can see it as replete with probabilities. Those who reflect and hesitate make far less in a bull market, but those who never question themselves get obliterated when the bear market comes. In investing, certainty can be a serious problem, because it causes one not to reassess flawed conclusions. Nobody can know all the facts. Instead, one must rely on shreds of evidence, kernels of truth, and what one suspects to be true but cannot prove.

—Seth Klarman, The Baupost Group

You obviously need to develop strong opinions and to have the conviction to stick with them when you believe you're right, even when everybody else may think you're an idiot. But where I've seen ego get in the way is by not always being open to question and to input that could change your mind. If you can't ever admit you're wrong, you're more likely to hang on to your losers and sell your winners, which is not a recipe for success.

—Kyle Bass, Hayman Advisors

It is much harder psychologically to be unsure than to be sure; certainty builds confidence, and confidence reinforces certainty. Yet being overly certain in an uncertain, protean, and ultimately unknowable world is hazardous for investors. To be sure, uncertainty breeds doubt, which can be paralyzing. But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt. Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for justifiable conviction.

—Seth Klarman, The Baupost Group

When I worked for New York City, I met an old-time surveyor in my department who had gone broke betting on horses. The first time he had gone to the racetrack he decided to bet on a horse named Surveyor, and the worst possible thing happened—the horse won. This guy figured it was easy money and over the next 20 years he proceeded to lose just about everything he had.

People forget it all the time, but it's important as investors to differentiate between luck and skill. Over short periods of time, you can do the wrong thing and make a lot of money and do the right thing and look like an idiot. We try to stick to what we do well and not get too caught up in what's working at any given moment. In the long run, that sort of discipline will keep you from blowing up. It's a lesson a lot of smarter guys than us have obviously forgotten.

—Phil Goldstein, Bulldog Investors

Whatever the environment we try to remain humble, which means maintaining our discipline of buying only great companies with strong balance sheets when they're priced with a wide margin of safety. It's when you're not humble that you end up doing things that will make you humble.

—François Rochon, Giverny Capital

Over a long career you learn a certain humility and are quicker to attribute success to luck rather than your own brilliance. I think that makes you a better investor, because you're less apt to make the big mistake and you're probably quicker to capitalize on good fortune when it shines upon you.

—Spencer Davidson, General American Investors

We know our investors are going to worry about their portfolios over short time periods, but we explain to them that we won't. We try to look at short-term market gyrations as nothing more than opportunities to smartly enter or exit a position, subject to valuation and fundamentals. While I hope that keeps us rational, I wouldn't say I'm always calm. My style at heart is out of the pages of Andy Grove's book, Only the Paranoid Survive. When our stocks are going down I'm driving everyone nuts to see what we might be missing. When our stocks are going up I'm not any more comfortable. I'm worried whether they're going up for the right reasons and how it might all come crashing down. I say we invest paranoid somewhat tongue-in-cheek, because we couldn't take the sizable positions we do if we were truly paranoid. I just worry about it every step of the way.

—Steven Romick, First Pacific Advisors

I've seen too many businesses—investment firms and others—run into the ground by impressive people who start to think they're smarter than everyone else. That's when big mistakes get made. There are enough ways to screw up in this business without bringing it on yourself because of ego.

—Barry Rosenstein, JANA Partners

Attempting to achieve a superior long-term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year, and through discipline to have highly superior relative results in bad times, is: (1) less likely to produce extreme volatility; (2) less likely to produce huge losses which can't be recouped, and (3) most importantly, more likely to work.

—Howard Marks, Oaktree Capital

This is the world's best business when you're doing well and somewhat less so when everybody's yelling at you because you're trailing the market. It's important not to get carried away with yourself when times are good, and to be able to admit your mistakes and move on when they're not so good. If you are intellectually honest—and not afraid to be visibly and sometimes painfully judged by your peers—investing is not work, it's fun.

—Jeffrey Bronchick, Reed, Conner & Birdwell