Warren Buffett’s first common stock investment was a disappointment, both financially and emotionally. I think we can excuse him, though; he was only 11 years old. You might remember from Chapter 1 that Buffett and his sister Doris pooled their savings and bought a total of six shares of Cities Service Preferred stock at $38.25 per share. A few months later, it was trading at $26.95, down 30 percent.
Even at that young age, Buffett had done his homework, which at the time included analyzing the price charts and piggybacking on one of his dad’s favorite stocks. Still, Doris was beside herself at the thought of losing money. Not a day went by that she didn’t pester her younger brother about their investment. As soon as Cities Service Preferred recovered and their investment was safely in the black, Buffett sold the stock, then watched in disbelief as it later soared to more than $200 per share.
Despite this painful experience, Buffett’s first at-bat in the stock market was not a total waste of time. He did learn two very important lessons. First was the value of patience; second, although short-term changes in stock prices may have little to do with value, they can have a lot do with emotional discomfort. In the next chapter, we will examine the role of patience in long-term investing. For now, we will study the debilitating effect that short-term changes in stock prices often have on investor behavior. This takes us into the fascinating realm of psychology.
Few aspects of human existence are more emotion-laden than our relationship to money, and this is particularly important when we are talking about the stock market. Much of what drives the decisions that people make about stock purchases can be explained only by principles of human behavior. And since the market is, by definition, the collective decisions made by all stock purchasers, it is not an exaggeration to say that the entire market is pushed and pulled by psychological forces.
The study of what makes us all tick is endlessly fascinating. It is particularly intriguing to me that it plays such a strong role in investing, a world that is generally presumed to be dominated by cold numbers and soulless data. When it comes to investment decisions, our behavior is sometimes erratic, often contradictory, and occasionally goofy.
What is particularly alarming, and what all investors need to grasp, is that they are often unaware of their bad decisions. To fully understand the markets and investing, we now know we have to understand our own irrationalities. The study of the psychology of misjudgment is every bit as valuable to an investor as the analysis of a balance sheet and an income statement.
In recent years we have seen what amounts to a revolution, a new way of looking at issues of finance through the framework of human behavior. This blending of economics and psychology is known as behavioral finance, and it has slowly moved down from the universities’ ivory towers to become part of the informed conversation among investment professionals . . . who, if they look over their shoulders, will find the shadow of a smiling Ben Graham.
Ben Graham, widely known as the father of financial analysis, has taught three generations how to navigate the stock market with a mathematical road map. But what is often overlooked is Graham’s teachings on psychology and investing. In both Security Analysis and The Intelligent Investor, Graham devoted considerable space to explaining how investor emotions trigger stock market fluctuations.
Graham figured that an investor’s worst enemy was not the stock market but oneself. They might have superior abilities in mathematics, finance, and accounting, but people who could not master their emotions were ill suited to profit from the investment process.
As Warren Buffett, his most famous student, explains, “There are three important principles to Graham’s approach.” The first is simply looking at stocks as businesses, which “gives you an entirely different view than most people who are in the market.” The second is the margin-of-safety concept, which “gives you the competitive edge.” And the third is having a true investor’s attitude toward the stock market. “If you have that attitude,” says Buffett, “you start out ahead of 99 percent of all the people who are operating in the stock market—it is an enormous advantage.”1
Developing an investor’s attitude, Graham said, is a matter of being prepared, both financially and psychologically, for the market’s inevitable ups and downs—not merely knowing intellectually that a downturn will happen, but having the emotional ballast needed to react appropriately when it does. In Graham’s view, an investor’s appropriate reaction to a downturn is the same as a business owner’s response when offered an unattractive price: ignore it. “The true investor,” says Graham, “scarcely ever is forced to sell his shares and at all other times is free to disregard the current price quotation.”2
To drive home his point, Graham created an allegorical character he named “Mr. Market.” The well-known story of Mr. Market is a brilliant lesson on how and why stock prices periodically depart from rationality.
Imagine that you and Mr. Market are partners in a private business. Each day, without fail, Mr. Market quotes a price at which he is willing to either buy your interest or sell you his.
The business you both own is fortunate to have stable economic characteristics, but Mr. Market’s quotes are anything but. You see, Mr. Market is emotionally unstable. Some days he is cheerful and can only see brighter days ahead. On these days, he quotes a very high price for shares in your business. At other times, Mr. Market is discouraged and, seeing nothing but trouble ahead, quotes a very low price.
Mr. Market has another endearing characteristic, said Graham. He does not mind being snubbed. If Mr. Market’s quotes are ignored, he will be back again tomorrow with a new quote. Graham warned that it is Mr. Market’s pocketbook, not his wisdom, that is useful. If Mr. Market shows up in a foolish mood, you are free to ignore him or take advantage of him, but it will be disastrous if you fall under his influence.
More than 60 years have passed since Ben Graham created Mr. Market. Yet the mistakes of judgment that Graham warned against are very much with us. Investors still act irrationally. Fear and greed still permeate the marketplace. Foolish mistakes are still the order of the day. Along with good business judgment, then, investors need to understand how to protect themselves from the emotional whirlwind that Mr. Market unleashes. To do that, we must become familiar with behavioral finance, that place where finance intersects with psychology.
Behavioral finance is an investigative study that seeks to explain market inefficiencies by using psychological theories. Observing that people often make foolish mistakes and illogical assumptions when dealing with their own financial affairs, academics began to dig deeper into psychological concepts to explain the irrationalities in people’s thinking. It is a relatively new field of study, but what we are learning is fascinating, as well as eminently useful to smart investors.
Several psychological studies have pointed out that errors in judgment occur because people in general are overconfident. Ask a large sample of people to describe their skills at driving a car, and an overwhelming majority will say they are above average. Another example: Doctors believe they can diagnose pneumonia with 90 percent confidence when in fact they are right only 50 percent of the time. “One of the hardest things to imagine is that you are not smarter than average,” said Daniel Kahneman, professor of psychology and public affairs at Princeton University’s Woodrow Wilson School of Public and International Affairs and winner of the Nobel Prize in economics.3 But the sobering reality is that not everyone can be better than average.
Confidence per se is not a bad thing. But overconfidence is another matter, and it can be particularly damaging when we are dealing with our financial affairs. Overconfident investors not only make silly decisions for themselves but also have a powerful effect on the market as a whole.
Investors, as a rule, are highly confident they are smarter than everyone else. They have a tendency to overestimate their skills and their knowledge. They typically rely on information that confirms what they believe, and disregard contrary information. In addition, the mind works to assess whatever information is readily available rather than to seek out information that is little known. Too often, investors and money managers are endowed with a belief that they have better information and therefore can profit by outsmarting other investors.
Overconfidence explains why so many money managers make wrong calls. They take too much confidence from the information they gather, and think they are more right than they actually are. If all the players think their information is correct and they know something that others do not, the result is a great deal of trading.
One of the most important names in the field of behavioral finance is Richard Thaler, professor of behavioral science and economics, who moved from Cornell to the University of Chicago with the sole purpose of questioning the rational behavior of investors. He points to several recent studies that demonstrate that people put too much emphasis on a few chance events, thinking that they spot a trend. In particular, investors tend to fix on the most recent information they received and extrapolate from it; the last earnings report thus becomes in their mind a signal of future earnings. Then, believing that they see what others do not, they make quick decisions based on superficial reasoning.
Overconfidence is at work here, of course; people believe they understand the data more clearly than others and interpret it better. But there is more to it. Overconfidence is exacerbated by overreaction. The behaviorists have learned that people tend to overreact to bad news and react slowly to good news. Psychologists call this overreaction bias. Thus, if the short-term earnings report is not good, the typical investor response is an abrupt, ill-considered overreaction, with its inevitable effect on stock prices. Thaler describes this overemphasis on the short term as investor “myopia” (the medical term for nearsightedness), and believes most investors would be better off if they didn’t receive monthly statements.
To illustrate his ideas about overreaction, Thaler developed a simple analysis. He took all the stocks on the New York Stock Exchange and ranked them by performance over the preceding five years. He isolated the 35 best performers (those that went up in price the most) and the 35 worst performers (those that went down the most) and created hypothetical portfolios of those 70 stocks. Then he held those portfolios for a subsequent five years, and watched as “losers” outperformed “winners” 40 percent of the time. In the real world, Thaler believes, few investors would have had the fortitude to resist overreacting at the first sign of a price downturn, and would have missed the benefits when the losers began to move in the other direction.4
Overreaction bias, as a concept, has been understood for some time now. But in the past few years it has been profoundly exacerbated by modern technology. Before the advent of the Internet and cable financial news programs, most investors looked at stock prices infrequently. They might check their brokerage statement at the end of each month, check their quarterly results after three months, and then tabulate their annual performance at year-end.
Today, with the advancements in communication technology, investors are able to stay connected, continuously, to the stock market. Mobile devices allow people to check their portfolios while riding in a car or train. They can check their performance walking to and from meetings or standing in a checkout line. Online brokerage accounts can tell you how well your portfolio has been performing since the opening bell. These accounts can calculate your relative performance for trailing one-day, five-day, 10-day, monthly, quarterly, and yearly returns. In short, investors can check the prices of their stocks every second of every 24-hour day.
Is this constant fixation on stock prices healthy for investors? Richard Thaler has a crisp answer. He lectures frequently at the Behavioral Conference sponsored by the National Bureau of Economic Research and the John F. Kennedy School of Government at Harvard University, and he always includes this advice: “Invest in equities and then don’t open the mail.”5 To which we might add, “And don’t check your computer or your phone or any other device every minute.”
When Doris Buffett badgered her younger brother about their investment in Cities Service Preferred, it was a clear demonstration that it was difficult for her to endure the discomfort associated with declining stock prices. But let’s not be too harsh on Doris. She was suffering from an emotional condition that affects millions of investors each and every day. It is called loss aversion, and it is, in my opinion, the single most difficult hurdle that prevents most investors from successfully applying the Warren Buffett approach to investing.
This psychological condition was discovered 35 years ago by two giants in the field, Nobel laureate Daniel Kahneman, whom we met earlier in the chapter, and Amos Tversky, professor of psychology at Stanford University. The two men, longtime collaborators, were interested in the theory of decision making.
In 1979, Kahneman and Tversky wrote a paper titled “Prospect Theory: An Analysis of Decision under Risk.” It would later become the most cited paper ever to appear in Econometrica, the prestigious academic journal of economics. Up until that point, the utility theory of decision making, popularized by John von Neumann and Oskar Morgenstern in their book Theory of Games and Economic Behavior (Princeton University Press, 1944), was the accepted dogma in economics. Utility theory states that it should not matter how the alternatives are presented to someone making a decision. What matters most is for that person to do what is best for himself or herself. For example, if presented with a game that gives a 65 percent chance of winning and a 35 percent chance of losing, a person following utility theory should play, because the game has a positive sum outcome.
The utility theory is mathematically pristine. In an ideal world it’s the perfect approach to decision making. However, Kahneman and Tversky were trained as psychologists, not economists, and they weren’t so sure. They had spent their careers studying specific errors in human judgment, and they had learned that individuals weight gains and losses differently. Under utility theory, value is assigned to the final asset. Under Kahneman and Tversky’s prospect theory, value is assigned individually to gains and losses. Kahneman and Tversky were able to prove that people do not look at final wealth, as dictated by utility theory, but rather they focus on the incremental gains and losses that contribute to their final wealth. The most important discovery in prospect theory was the realization that people are loss averse. In fact, Kahneman and Tversky were able to prove mathematically that people regret losses more than they welcome gains of the same size—two to two and one-half times more.
In other words, the pain of a loss is far greater than the enjoyment of a gain. Many experiments have demonstrated that people need twice as much positive to overcome a negative. On a 50/50 bet, with precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss.
This is known as asymmetric loss aversion: The downside has a greater impact than the upside, and it is a fundamental bit of human psychology. Applied to the stock market, it means that investors feel twice as bad about losing money as they feel good about picking a winner. The impact of loss aversion on investment decisions is obvious, and it is profound. We all want to believe we made good decisions. To preserve our good opinion of ourselves, we hold on to bad choices far too long, in the vague hope that things will turn around. By not selling our losers, we never have to confront our failures.
This aversion to loss makes investors unduly conservative. Participants in 401(k) plans whose time horizons are decades still keep large amounts of their money invested in the bond market. Why? Only a deeply felt aversion to loss would make anyone allocate so conservatively. But loss aversion can affect you in a more immediate way, by making you irrationally hold on to losing stocks. No one wants to admit making a mistake. But if you don’t sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.
Over the years, Richard Thaler had the good fortune to study and collaborate with Kahneman and Tversky as well as several other academics in the field of behavioral finance. He has written several articles on decision making, many of which can be found in his popular book, The Winner’s Curse: Paradoxes and Anomalies of Economic Life (Free Press, 1992). However, Thaler is best known for his 1995 article titled “Myopic Loss Aversion and the Equity Risk Premium,” cowritten with Shlomo Benartzi, professor and cochair of the behavioral decision-making group at the University of California at Los Angeles Anderson School of Management. In their article, Thaler and Benartzi took loss aversion described in Kahneman and Tversky’s prospect theory and connected it directly to the stock market.
Thaler and Benartzi were puzzled by one central question: Why would anyone with a long-term horizon want to own bonds over stocks when they know that stocks have consistently outperformed? The answer, they believed, rested on two central concepts from Kahneman and Tversky. The first was loss aversion, which we have already explored. The second was a behavioral concept called mental accounting, which describes the methods people use to code financial outcomes. It refers to our habit of shifting our perspective on money as surrounding circumstances change. We tend to mentally put money into different “accounts,” and that determines how we think about using it.
A simple situation will illustrate. Let us imagine that you have just returned home from an evening out with your spouse. You reach for your wallet to pay the babysitter, but discover that the $20 bill you thought was there is not. So, when you drive the sitter home you stop by an ATM machine and get another $20. Then the next day you discover the original $20 bill in your jacket pocket.
If you’re like most people, you react with something like glee. The $20 in the jacket is found money. Even though the first $20 and the second $20 both came from your checking account, and both represent money you worked hard for, the $20 bill you hold in your hand is money you didn’t expect to have, and you feel free to spend it frivolously.
Once again, Richard Thaler provides an interesting academic experiment to demonstrate this concept. In his study he started with two groups of people. People in the first group were given $30 in cash and told they had two choices: (1) pocket the money and walk away, or (2) gamble on a coin flip in which if they won they would get $9 extra and if they lost they would have $9 deducted. Most (70 percent) took the gamble because they figured they would at the very least end up with $21 of found money. Those in the second group were offered a different choice: (1) try a gamble on a coin toss: if they win they’d get $39 and if they lost they’d get $21, or (2) get an even $30 with no coin toss. More than half (57 percent) decided to take the sure money. Both groups of people stood to win the exact same amount of money with the exact same odds, but the situation was perceived differently.6
The implications are clear: how we decide to invest, and how we choose to manage those investments, has a great deal to do with how we think about money. For instance, mental accounting has been suggested as one further reason why people don’t sell stocks that are doing badly: In their minds the loss doesn’t become real until it is acted on. It also helps us understand our risk tolerance: We are far more likely to take risks with found money.
Thaler and Benartzi weren’t through. Thaler remembered a financial riddle first proposed by the Nobel laureate Paul Samuelson. In 1963, Samuelson asked a colleague if he would be willing to accept the following bet: a 50 percent chance of winning $200 or a 50 percent chance of losing $100. According to Samuelson, the colleague turned down the initial offer but then reconsidered. He would happily play the game, he said, if he could play 100 times and did not have to watch each individual outcome. The willingness to play the game under a new set of rules sparked an idea for Thaler and Benartzi.
Samuelson’s colleague was willing to accept the wager with two qualifiers: lengthen the time horizon for the game and reduce the frequency in which he was forced to watch the outcomes. Moving that observation into investing, Thaler and Benartzi reasoned that the longer the investor holds an asset, the more attractive the asset becomes but only if the investment is not evaluated frequently.
When analyzing historical investment returns, we find that the vast majority of long-term returns are a result of just 7 percent of all trading months. The return of the remaining 93 percent averages out to approximately zero.7 What is clear, then, is that evaluating performance over shorter periods of time increases the chances that you will see a loss in your portfolio. If you check your portfolio daily, there is a 50/50 chance you will experience a loss. The odds don’t improve much if you extend the evaluation period to a month.
But if you don’t check your portfolio every day, you will be spared the angst of watching daily price gyrations; the longer you hold off, the less likely you will be confronted with volatility and therefore the more attractive your choices seem. Put differently, the two factors that contribute to an investor’s emotional turmoil are loss aversion and a frequent evaluation period. Using the medical word for shortsightedness, Thaler and Bernatzi coined the term myopic loss aversion to reflect a combination of loss aversion and frequency.
Next, Thaler and Bernatzi sought to determine the ideal time frame. We know that over short periods, stock prices are much more volatile than bond prices. We also know that if we’re willing to extend the period in which we measure changes in stock prices, the standard deviation of stock returns will diminish. What Thaler and Bernatzi wanted to know was this: How long would investors need to hold stocks without checking their performance to reach the point of being indifferent to the myopic loss aversions of stocks versus bonds? The answer: one year.
Thaler and Bernatzi examined the return, standard deviation, and positive return probability for stocks with time horizons of one hour, one day, one week, one month, one year, 10 years, and 100 years. Next they employed a simple utility function based on Kahneman and Tversky’s loss-aversion factor of 2 (utility = probability of price increase − probability of decline × 2). Based on the math, an investor’s emotional utility factor did not cross over to a positive number until it reached a one-year observable time period. I have often wondered whether Warren Buffett’s preference that the stock market be opened only once a year for trading dovetailed with the psychological findings of myopic loss aversion.
Thaler and Bernatzi argue that any time we talk about loss aversion we must also consider the frequency with which returns are calculated. If investors evaluate their portfolios over shorter and shorter time periods, then it is clear that they will be less attracted to volatile stocks. “Loss aversion is a fact of life,” explain Thaler and Benartzi. “In contrast, the frequency of evaluations is a policy choice that presumably could be altered, at least in principle.”8
One other psychological trap that beckons investors is the temptation to follow what everyone else is doing, whether or not it makes sense. We might call it the lemming fallacy.
Lemmings are small rodents indigenous to the tundra region and are noted for their mass exodus to the sea. In normal periods, lemmings move about during the spring migration in search of food and new shelter. Every three to four years, however, something odd happens. Because of high breeding and low mortality, the population of lemmings begins to rise. Once their ranks have swollen, lemmings begin an erratic movement under darkness. Soon, this bold group begins to move in daylight. When confronted by barriers, the number of lemmings in the pack increases until a panic-like reaction drives them through or over the obstacle. As this behavior intensifies, lemmings begin to challenge other animals they normally would avoid. Although many lemmings die from starvation, predators, and accidents, most reach the sea. There they plunge in and swim until they die from exhaustion.
The behavior of lemmings is not fully understood. Zoologists theorize that the mass migration occurs because of changes in their food supply and/or stressful conditions. The crowding and competition among lemmings possibly evoke a hormonal change that induces an alteration in behavior.
Why do so many investors behave like lemmings? To help us understand, Buffett shared one of Ben Graham’s favorite stories in Berkshire Hathaway’s 1985 annual report.
An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence,” said St. Peter, “but as you can see, the compound for oilmen is packed. There’s no way to squeeze you in.” After thinking for a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so he gave his okay. The prospector cupped his hand and yelled, “Oil discovered in hell.” Immediately the gates to the compound opened and all the oilmen rushed out. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”
To help investors avoid this trap, Buffett asks us to think about professional money managers, who are too often compensated by a system that equates safe with average and rewards adherence to standard practices over independent thinking. “Most managers,” Buffett has said, “have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious; if an unconventional decision works out well, they get a pat on the back, and if it works out poorly, they get a pink slip. Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.”9
Each of these common ways of thinking about money creates problems for investors unable to escape their harmful repercussions, but in my opinion the most serious one is myopic loss aversion. I believe it is the single greatest psychological obstacle that prevents investors from successfully applying the Warren Buffett Way. In my almost three decades of professional experience, I have observed firsthand the difficulty investors, portfolio managers, consultants, and committee members of large institutional funds have with internalizing losses made all the more painful by tabulating those losses on a frequent basis. Overcoming this psychological burden penalizes all but a very few select individuals.
Perhaps it is not surprising that one person who has mastered myopic loss aversion is also the world’s greatest investor—Warren Buffett. I have always believed that Buffett’s long-term success has had much to do with the unique structure of his company. Berkshire Hathaway owns both common stocks and wholly owned businesses, so Buffett has observed firsthand how inextricably linked are the growth in value of these businesses and the prices of their common stocks. He does not need to look at stock prices every day, because he does not need the market’s affirmation to convince him he has made the right investment. As he often states, “I don’t need a stock price to tell me what I already know about value.”
A side observation as to how this works for Buffett can be found in Berkshire’s $1 billion investment in the Coca-Cola Company in 1988. At the time it was the single-largest investment Berkshire had ever made in a stock. Over the next 10 years, the stock price of Coca-Cola went up tenfold while the S&P 500 index went up threefold. Looking back, we might think Coca-Cola was one of the easiest investments an investor could have made. In the late 1990s, I participated in numerous investment seminars and I always asked the audience, “How many of you owned Coca-Cola over the past 10 years?” Practically all the hands would immediately go up. I then asked, “How many of you got the same rate of return on your Coca-Cola investment as Buffett did?” Sheepishly, people in the audience slowly dropped their hands.
Then I would ask the real question: “Why?” If so many in the audience owned shares of Coca-Cola (they actually made the same investment as Buffett), why did none of them get the same return? I think the answer comes back to myopic loss aversion. During the 10-year period (1989–1998) Coca-Cola did outperform the market, but on an annual basis it outperformed the stock market only six years. By the mathematics of loss aversion, investing in Coca-Cola had a negative emotional utility (six positive emotional units − four negative emotional units × 2). I can only imagine that those individuals who owned Coca-Cola came into a year when the stock was underperforming the market and they decided to sell. What did Buffett do? He first checked the economic progress of Coca-Cola—still excellent—and continued to own the business.
Ben Graham reminded us that “most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble—i.e., to give way to hope, fear, and greed.”10 Investors must be prepared, he cautioned, for ups and downs in the market. And he meant prepared psychologically as well as financially—not merely knowing intellectually that a downturn will happen, but having the emotional wherewithal to act appropriately when it does.
“The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage,” said Graham. “That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by another person’s mistakes of judgment.”11
Warren Buffett’s approach to investing, thinking of stocks as businesses and managing a focus portfolio, is directly at odds with the financial theories taught to thousands of business students each and every year. Collectively, this financial framework is known as modern portfolio theory. As we will discover, this theory of investing was built not by business owners but by ivory tower academicians. And it is an intellectual house that Buffett refuses to reside in. Those who follow Buffett’s principles will quickly find themselves emotionally and psychologically disconnected from how a majority of investors behave.
In March 1952, Harry Markowitz, a University of Chicago graduate student, published a 14-page article in the Journal of Finance entitled “Portfolio Selection.”12 In it, Markowitz explained what he believed was a rather simple notion, that return and risk are inextricably linked, and presented the calculations that supported his conclusion that no investor can achieve above-average gains without assuming above-average risk. It seems almost ridiculously obvious today, but it was a revolutionary concept in the 1950s, a time when portfolios were constructed haphazardly. Today that brief article is credited with launching modern finance.
Seven years later, Markowitz published his first book, Portfolio Selection: Efficient Diversification of Investments (John Wiley & Sons, 1959). In what many believe was his greatest contribution, he now turned his attention to measuring the riskiness of an entire portfolio. He called it covariance, a method for measuring the direction of a group of stocks. The more they move in the same direction, the greater is the chance that economic shifts will drive them down at the same time. By the same token, a portfolio composed of risky stocks might actually be a conservative selection if the individual stock prices move differently. Either way, Markowitz said, diversification is the key. The smart course for investors, he concluded, is first to identify the level of risk they are comfortable handling, and then to construct an efficient diversified portfolio of low-covariance stocks.
In 1965, Eugene Fama of the University of Chicago published his PhD dissertation, “The Behavior of Stock Market Prices,” in the Journal of Business, proposing a comprehensive theory of the behavior of the stock market. His message was very clear: Predictions about future stock prices are pointless because the market is too efficient. In an efficient market, as information becomes available, a great many smart people aggressively apply that information in a way that causes prices to adjust instantaneously, before anyone can profit. At any given point, prices reflect all available information and hence we say the market is efficient.
About 10 years after Markowitz’s paper first appeared, a young PhD student named Bill Sharpe talked with him at length about his work in portfolio theory and the need for countless covariances. The next year, in 1963, Sharpe’s dissertation was published: “A Simplified Model of Portfolio Analysis.” While fully acknowledging his reliance on Markowitz’s ideas, Sharpe suggested a simpler method. Sharpe believed that all securities bore a common relationship with some underlying base factor, and therefore analysis was simply a matter of measuring the volatility of an individual security to its base factor. He gave his volatility measure a name: beta factor.
A year later, Sharpe introduced a far-reaching concept called the capital asset pricing model (CAPM), a direct extension of his single-factor model for composing efficient portfolios. CAPM says that stocks carry two distinct risks. One risk is simply the risk of being in the market, which Sharpe called systemic risk. Systemic risk is “beta” and it cannot be diversified away. The second type, called unsystemic risk, is the risk specific to a company’s economic position. Unlike systemic risk, unsystemic risk can be diversified away by simply adding different stocks to the portfolio.
• • •
In the space of one decade, three academicians had defined important elements of what would later be called modern portfolio theory: Markowitz with his idea that the proper reward-risk balance depends on diversification, Fama with his theory of the efficient market, and Sharpe with his definition of risk. Thus for the first time in history, our financial destiny rested not with Wall Street or Washington, D.C., and not even in the hands of business owners. As we moved forward, the financial landscape would be defined by a group of university professors on whose doors the finance professionals had finally come knocking. From their ivory towers, they now became the new high priests of modern finance.
Now let’s return to Warren Buffett. He had started an investment partnership with a few thousand dollars and turned that into $25 million. With the profits from his investment partnership, he had taken control of Berkshire Hathaway and was quickly heading toward a net worth that would soon exceed $1 billion. In all those 25 years, he had given little or no thought to the covariance of stocks, strategies to reduce the variability of a portfolio return, or—heaven forbid—the idea that the stock market was efficiently priced. Buffett did think deeply about the concept of risk, but his interpretation was far removed from what academicians were now saying about risk.
Recall that in modern portfolio theory, risk is defined by the volatility of the share price. But Buffett had always perceived a drop in share prices as an opportunity. If anything, a dip in price actually reduces risk. He points out, “For owners of a business—and that’s the way we think of shareholders—the academic’s definition of risk is far off the market, so much so that it produces absurdities.”13
Buffett has a different definition of risk: the possibility of harm or injury. And that is a factor of the “intrinsic value risk” of a business, not the price behavior of the stock. The real risk, Buffett says, is whether after-tax returns from an investment “will give him [an investor] at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.”14
Risk, for Buffett, is inextricably linked to an investor’s time horizon. This alone is the single greatest difference between how Warren Buffett thinks about risk and how modern portfolio theory frames risk. If you buy a stock today with the intention of selling it tomorrow, Buffett explains, then you have entered into a risky transaction. The odds are no better than the toss of a coin—you will lose about half the time. However, says Buffett, if you extend your time horizon out to several years, the probability of its being a risky transaction declines meaningfully, assuming of course that you have made a sensible purchase. “If you ask me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning,” Buffett says, “I’d say that that’s a very risky transaction.”15 But in Buffett’s way of thinking, buying Coca-Cola this morning and holding it for 10 years, that’s zero risk.
Buffett’s unique view on risk also drives his portfolio diversification strategy; here, too, his thinking is the polar opposite of modern portfolio theory. According to the theory, remember, the primary benefit of a broadly diversified portfolio is to mitigate the price volatility of the individual stocks. But if you are unconcerned with short-term price volatility, as Buffett is, then you will also see portfolio diversification in a different light.
“Diversification serves as a protection against ignorance,” explains Buffett. “If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody that doesn’t know how to analyze businesses.” In many ways, modern portfolio theory protects investors who have limited knowledge and understanding of how to value a business. But the protection comes with a price. According to Buffett, modern portfolio theory “will tell you how to do average. But I think almost anybody can figure out how to do average by fifth grade.”16
Last, if the efficient market theory (EMT) is correct, there is no possibility, except a random chance, that any person or group could outperform the market, and certainly no chance that the same person or group could consistently do so. Yet Buffett’s performance record for the past 48 years is prima facie evidence that it is possible, especially when combined with the experience of other bright individuals who also have beaten the market following Buffett’s lead. What does this say about the efficient market theory?
Buffett’s problem with the efficient market theory rests on one central point: It makes no provision for investors who analyze all the available information and gain a competitive advantage by doing so. “Observing correctly that the market is frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”17
Nonetheless, the efficient market theory is still religiously taught in business schools, a fact that gives Warren Buffett no end of satisfaction. “Naturally, the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham,” he wryly observed. “In any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught it’s useless to even try. From a selfish standpoint, we should probably endow chairs to ensure the perpetual teaching of EMT.”18
Today, investors are caught at an intellectual and deeply emotional crossroads. To the left lies the pathway of modern portfolio theory. The theory has a 50-year history full of academic papers, neat formulas, and Nobel Prize winners. It seeks to get investors from point A to point B with as little price volatility as possible, thereby minimizing the emotional pain of a bumpy ride. Believing the market is efficient, hence price and intrinsic value are one and the same, adherents to modern portfolio theory focus on price first and asset value later—or sometimes not at all.
To the right lies the pathway that Warren Buffett and other successful investors have taken. It is a 50-year history that is full of life experiences, simple arithmetic, and long-term business owners. It seeks to get investors from point A to point B not by providing a smooth short-term price ride but by orchestrating an investment approach that seeks to maximize, on an economic risk-adjusted basis, the intrinsic-value rate of growth. Proponents of the Buffett approach do not believe the market is always efficient. Instead, they focus on asset values first and prices later—or sometimes not at all.
• • •
Now that you have an outline, albeit brief, of the concepts of modern portfolio theory, you can easily see how applying the Buffett approach will put you in conflict with its proponents. Not only are you intellectually at odds with modern portfolio theorists, but you are also vastly outnumbered, both in the classroom and the workspace. Embracing the Warren Buffett Way makes you a rebel looking out across the field at a much larger army of individuals who invest totally differently. As you will learn, being an outcast has its own emotional challenges.
I have written about Warren Buffett for over 20 years. Over that time period, I have not met anyone who has vehemently disagreed with the methodology outlined in The Warren Buffett Way. I have, however, met countless individuals who, although they wholeheartedly agree with Buffett’s writings, were never emotionally able to apply his lessons. This, I have come to believe, is the single most important key to understanding his success, and it is one part of the puzzle that has not been fully explored. In a word, Warren Buffett is rational, not emotional.
In 2002 Daniel Kahneman—a psychologist—was awarded the Nobel Prize in economics “for having integrated insights from the psychological research into economic science, especially concerning human judgment and decision-making under certainty.” That signaled the formal arrival of behavioral finance as a legitimate force in how to think about capital markets. Despite computer programs and black boxes, it is still people who make markets.
Because emotions are stronger than reason, fear and greed move stock prices above and below a company’s intrinsic value. When people are greedy or scared, Buffett says, they often will sell stocks at foolish prices. In the short run, investor sentiment—human emotion—has a more pronounced impact on stock prices than a company’s fundamentals.
Long before behavioral finance had a name, it was understood and accepted by a few renegades like Warren Buffett and Charlie Munger. Charlie points out that when he and Buffett left graduate school, they “entered the business world to find huge, predictable patterns of extreme irrationality.”19 He is not talking about predicting the timing, but rather the idea that when irrationality does occur it leads to predictable patterns of subsequent behavior.
Buffett and Munger aside, it is only quite recently that the majority of investment professionals have paid serious attention to the intersection of finance and psychology. When it comes to investing, emotions are very real, in the sense that they affect people’s behavior and thus ultimately affect market prices. You have already sensed, I am sure, two reasons why understanding the human dynamic is so valuable in your own investing: (1) You will have guidelines to help you avoid the most common mistakes. (2) You will be able to recognize other people’s mistakes in time to profit from them.
All of us are vulnerable to individual errors of judgment, which can affect our personal success. When a thousand or a million people make errors of judgment, the collective impact is to push the market in a destructive direction. Then, so strong is the temptation to follow the crowd, accumulated bad judgment only compounds itself. In a turbulent sea of irrational behavior, the few who act rationally may well be the only survivors.
In fact, the only antidote to emotion-driven misjudgment is rationality, especially when applied over the long haul with patient perseverance. And that is the subject of our next chapter.
Notes
1. Outstanding Investor Digest, August 10, 1995, 11.
2. Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1973), 106.
3. Jonathan Fuerbringer, “Why Both Bulls and Bears Can Act So Bird-Brained,” New York Times, March 30, 1997, section 3, p. 6.
4. Jonathan Burton, “It Just Ain’t Rational,” Fee Advisor, September/October 1996, 26.
5. Brian O’Reilly, “Why Can’t Johnny Invest?,” Fortune, November 9, 1998, 73.
6. Fuerbringer, “Why Both Bulls and Bears Can Act So Bird-Brained.”
7. Larry Swedore, “Frequent Monitoring of Your Portfolio Can Be Injurious to Your Health,” www.indexfunds.com/articles/20021015_myopic_com_gen_LS.htm.
8. Shlomo Benartzi and Richard Thaler, “Myopic Loss Aversion and the Equity Risk Premium,” Quarterly Journal of Economics 110, no. 1 (February 1995): 73–92.
9. Berkshire Hathaway Annual Report, 1984, 14.
10. Graham, Intelligent Investor.
11. Ibid.
12. For a comprehensive and well-written historical summary of the development of modern finance, see Peter Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street (New York: Free Press, 1992).
13. Berkshire Hathaway Annual Report, 1993, 13.
14. Ibid.
15. Outstanding Investor Digest, June 23, 1994, 19.
16. Outstanding Investor Digest, August 8, 1996, 29.
17. Berkshire Hathaway Annual Report, 1988, 18.
18. Ibid.
19. Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett (Birmingham, AL: AKPE, 1988), 683.