In his epic masterpiece War and Peace, Leo Tolstoy made this profound observation: “The strongest of all warriors are these two—time and patience.” He of course was speaking from a military perspective, but the idea also brilliantly applies to economics, and it has great value to those who would deepen their understanding of capital markets.
All market activity lies on a time continuum. Moving from left to right, we observe buy-sell decisions that occur in microseconds, minutes, hours, days, weeks, months, years, and decades. Although it is unclear exactly where the demarcation line is located, it is generally agreed that activity on the left side (shorter time frame) is more likely to be speculation and activity on the right side (longer times) is considered investing. Warren Buffett, it probably goes without saying, sits comfortably on the right—quietly patient over the long term.
This prompts the question: Why are so many people frantically scrabbling on the far left, trying to make as much money as fast as possible? Is it greed? Is it a mistaken belief that they can predict changes in market psychology? Or could it be that they have lost faith in the possibility of achieving positive long-term investment returns after experiencing two bear markets and a financial crisis over the past decade? Truth be known, the answer to all three questions is yes. Although each is problematic, it is the last observation, a lack of confidence in long-term investing, that troubles me the most—because long-term investing lies at the heart of the Warren Buffett Way.
The seminal work comparing short-term and long-term strategies was written over 20 years ago by Andrei Shleifer, a Harvard professor and winner of the John Bates Clark Medal, and Robert Vishny, professor of finance at the University of Chicago’s Booth School of Business. In 1990, Shleifer and Vishny wrote a research paper for the American Economic Review titled “The New Theory of the Firm: Equilibrium Short Horizons of Investors and Firms.”1 In it, they compared the cost, risk, and return of short-horizon and long-horizon arbitrage.
The cost of arbitrage is the amount of time your capital is invested; risk is the amount of uncertainty over the outcome; and return is the amount of money made on the investment. In short-horizon arbitrage, all three elements are less. With long-horizon arbitrage, your capital is invested longer, the knowledge about when the payoff occurs is more uncertain, but the returns should be higher.
According to Shleifer and Vishny, “In equilibrium, the net expected return from arbitrage in each asset must be the same. Since arbitrage in long-term assets is more expensive than it is for short-term assets, the former must be more mispriced in equilibrium for net returns to be equal.”2 Put differently, because long-horizon arbitrage is more expensive than short-horizon arbitrage, the investment return must be greater.
Shleifer and Vishny point out that common stocks can be used for short-horizon arbitrage. For example, short-term speculators, acting as information arbitragers, may bet on the outcome of a takeover possibility, or an earnings release, or any other public announcement that would make the mispricing disappear quickly. Even if the stock price does not react as expected, the trader is able to exit the position rapidly with little financial repercussion. Following Shleifer and Vishny’s train of thought, the speculator’s cost is minimal (capital is invested for a short period of time) and the risk is small (the uncertainty over the outcome is settled quickly). However, the return is also small.
It should be noted that in order to generate substantial returns from short-term arbitrage, the strategy must be employed frequently, over and over again. Shleifer and Vishny also explain that, to increase your investment return beyond what a speculator would likely receive, you must be willing to increase the cost of the investment (the amount of time your money is invested) as well as take on more risk (uncertainty as to when the outcome will be resolved). The controlling variable for both speculators and investors is the time horizon. Speculators work in short-horizon periods and accept smaller returns. Investors operate over long-horizon periods and expect larger returns.
This leads us to the next question: In long-horizon arbitrage, do large returns from buying and holding common stocks actually exist? I decided to look closely at the evidence.
We calculated the one-year return, trailing three-year return, and trailing five-year return (price only) between 1970 and 2012. During this 43-year period, the average number of stocks in the S&P 500 index that doubled in any one year averaged 1.8 percent, or about nine stocks out of 500. Over three-year rolling periods, 15.3 percent of stocks doubled, about 77 stocks out of 500. In rolling five-year blocks, 29.9 percent doubled, about 150 out of 500.
So, back to the original question: Over the long term, do large returns from buying and holding stocks actually exist? The answer is indisputably yes. And unless you think a double over five years is trivial, this equates to a 14.9 percent average annual compounded return.
Of course, the value of that research is relevant only to the degree investors have the ability to select, beforehand, which stocks have the potential to double in five years. The answer obviously lies in the robustness of their stock selection process and portfolio management strategy. I am confident those investors who apply the investment tenets outlined in The Warren Buffett Way and stick to a low-turnover portfolio strategy stand a good chance of isolating a fair number of five-year doubles.
Finance theory tells us investors are rewarded for identifying mispricings. We can assume if the excess returns from any one stock are large enough, it should attract a larger number of investors who seek to close the gap between price and value. When the number of arbitrageurs increases, we also know the returns from arbitrage should decrease. However, examining the average percentage return from our basket of rolling five-year doubles between 1970 and 2012, we cannot point to any significant diminution in the excess returns. Yes, the absolute number of investment doubles does correlate to the performance of the overall market. Stronger markets beget a higher number of doubles, while weaker markets produce fewer. But the percentage outperformance of the doubles relative to the market, whatever the environment, remains impressive. In short, the army of long-horizon arbitrageurs one would expect to attack this mispricing pool remained largely absent.
Who is best positioned to close the price-value gap over rolling five-year periods? Answer: long-term investors. However, because that gap has remained wide for the past 43 years, perhaps the market’s constituency has become dominated by short-term traders.
Between 1950 and 1970, the average holding period for stocks was between four and eight years. However, beginning in the 1970s, the holding period has persistently declined, to the point that today the average holding period for mutual funds is measured in months. Our research indicates that the greatest number of opportunities to bag high excess returns occurs after three years. No doubt, with portfolio turnover ratios in excess of 100 percent, this all but guarantees that most investors are excluded.
One can make a strong argument that the market is best served by having a balance between short-term traders and long-term investors. If the market comprised an equal force of arbitrageurs, half who attack short-term mispricing and half who seek to close the long-term price-value gap, then, so the argument goes, the market’s short-term and long-term inefficiencies would largely be erased. But what happens to the market when this balance is disrupted? A market dominated by long-term investors would leave unattended the mispricing that occurs over short periods of time, and a market dominated by short-term traders is largely uninterested in long-term mispricing.
Why has the market lost so much of the diversity that once characterized it? Because of the slow migration of people who converted from long-term investing to short-term speculation. The results from this evolutionary shift are somewhat predictable. It’s a question of simple arithmetic. With so many people now speculating, the difficulty of winning short-term bets has gone up while the returns have gone down. The powerful magnet that has pulled so many people into becoming short-term speculators has left but a rarefied few to close the inefficiencies, the excess returns, of long-term investing.
Rationalism, according to the Oxford American Dictionary, is a belief that one’s opinions or actions should be based on reason and knowledge rather than emotional responses. A rational person thinks clearly, sensibly, and logically.
The first thing to understand is that rationality is not the same as intelligence. Smart people can do dumb things. Keith Stanovich, a professor of human development and applied psychology at the University of Toronto, believes that intelligence tests like IQ tests or SAT/ACT exams do a very poor job of measuring rational thought. “It is a mild predictor at best,” he says, “and some rational thinking skills are totally dissociated from intelligence.”3
In his book, What Intelligence Tests Miss: The Psychology of Rational Thought, he coined the term dysrationalia—the inability to think and behave rationally despite high intelligence. Research in cognitive psychology suggests there are two principal causes of dysrationalia. The first is a processing problem. The second is a content problem. Let’s look at them closely, one at a time.
Stanovich believes we humans process poorly. When solving a problem, he says, people have different cognitive mechanisms to choose from. At one end of the thinking spectrum are mechanisms that have great computational power. But this great computational power comes with a cost. It is a slower process of thinking and requires a great deal of concentration. At the opposite end of the thinking spectrum are mechanisms with very little computational power; they require very little concentration and permit quick decisions. “Humans are cognitive misers,” writes Stanovich, “because our basic tendency is to default to the processing mechanisms that require less computational effort, even if they are less accurate.”4 In a word, humans are lazy thinkers. They take the easy way out when solving problems; as a result, their solutions are often illogical.
Let us now turn our attention to the role of information. The information we require speaks to the subject of this chapter—patience—and the value of a “slow-traveling idea.”
Many readers may not know Jack Treynor. But he is an intellectual giant in the field of financial management. First trained as a mathematician at Haverford College, he graduated with distinction from Harvard Business School in 1955 and began his career in the research department at Arthur D. Little, a consulting firm. As a young analyst, Treynor generated 44 pages of mathematical notes on the issue of risk while on a three-week vacation in Colorado. A prolific writer, he eventually became editor of CFA Institute’s Financial Analysts Journal.
Over the years, Treynor swapped papers with many of the leading finance academicians, including Nobel laureates Franco Modigliani, Merton Miller, and William Sharpe. A number of Treynor’s articles won prestigious awards, including the Financial Analysts Journal’s Graham and Dodd Award and the Roger F. Murray Prize. In 2007, he won the prestigious CFA Institute Award for Professional Excellence. Fortunately, Treynor’s writings, which were once loosely noted, are now available in a 574-page volume titled Treynor on Institutional Investing. It deserves a place on every serious investor’s bookshelf.
My copy is a bit dog-eared and tired looking, because several times a year I reread my favorite parts. Tucked near the back, on page 424, is my favorite article—“Long-Term Investing.” It first appeared in the May–June 1976 issue of the Financial Analysts Journal. Treynor begins by talking about the ever-present puzzle of market efficiency. Is it true, he wondered, that no matter how hard we try we’ll never be able to find an idea that the market hasn’t already discounted? To address the question, Treynor asks us to distinguish between “two kinds of investment ideas: (a) those whose implications are straightforward and obvious, take relatively little special expertise to evaluate, and consequently travel quickly and (b) those that require reflection, judgment, and special expertise for their evaluation, and consequently travel slowly.”5
“If the market is inefficient,” he concludes, “it will not be inefficient with respect to the first kind of idea, since by definition the first kind is unlikely to be misevaluated by the great mass of investors.”6 To say this another way, the simple ideas—price-to-earnings ratios, dividend yields, price-to-book ratios, P/E-to-growth ratios, 52-week-low lists, technical charts, and any other elementary ways we can think about a stock—are unlikely to provide easy profits. “If there is any market inefficiency, hence any investment opportunity,” says Treynor, “it will arise with the second kind of investment idea—the kind that travels slowly. The second kind of idea—rather than the obvious, hence quickly discounted insight relating to ‘long-term’ business developments—is the only meaningful basis for long-term investing.”7
You have, I’m sure, already realized that the investment tenets outlined in The Warren Buffett Way are the ideas that “travel slowly” and that relate to “‘long-term’ business developments,” and thus are the basis for “long-term investing.” Let’s be clear: The slow-moving idea is not intellectually difficult to grasp, but it is more laborious than relying on the “straightforward and obvious.”
For years, psychologists have been interested in the idea that our cognition processes are divided into two modes of thinking, traditionally referred to as intuition, which produces “quick and associative” cognition, and reason, described as “slow and rule-governed.” Today, psychologists routinely refer to these cognitive systems as System 1 and System 2 thinking. System 1 thinking is where simple and straightforward ideas travel quickly. It takes little time and not much intellectual work to calculate a price-earnings ratio or a dividend yield.
System 2 thinking is the reflective part of our cognition process. It operates in a controlled manner, slowly and with effort. Our “slow-moving ideas” that require “reflection, judgment, and special expertise” are housed in System 2 thinking.
In 2011, the Nobel laureate Daniel Kahneman wrote an important book titled Thinking Fast and Slow. It was a New York Times best seller and one of the top five nonfiction books that year—quite an accomplishment for a 500-page book on decision making. My favorite part of the book is Chapter 3, “The Lazy Controller.” Kahneman reminds us that cognitive effort is mental work, and, as with all work, many of us have the tendency to get lazy when the task gets harder. He is surprised by the ease with which intelligent people appear satisfied enough with their initial answer that they stop thinking.
Kahneman tells us activities that put demands on System 2 thinking require self-control, and continuous exertion of self-control can be unpleasant. If we are continually forced to do something over and over that is challenging, there is a tendency to exert less self-control when the next challenge arrives. Eventually we simply run out of gas. In contrast, “those who avoid the sin of intellectual sloth could be called ‘engaged.’ They are more alert, more intelligently active, less willing to be satisfied with superficially attractive answers, more skeptical about their intuitions.”8
Shane Frederick, associate professor of marketing at Yale University, has given us a fascinating look at how people with fairly high IQs navigate between System 1 and System 2 thinking. He gathered a group of Ivy League students from Harvard, Princeton, and MIT (presumably all highly intelligent) and asked them the following three questions:
To Frederick’s surprise, over half of the students got the answers wrong, leading him to delineate two significant problems. First, people are not accustomed to thinking hard about problems and often rush to the first plausible answer that comes to mind so they don’t have to engage the heavy burden of System 2 thinking. The second problem, which is disturbing in itself, was the realization that the System 2 process does a very poor job of monitoring System 1 thinking for errors. It seemed clear to Frederick that the students were stuck in System 1 thinking and could not, or would not, convert to System 2.
How do System 1 and System 2 thinking work in investing? Say an investor is considering making a common stock purchase. Using System 1 thinking, the investor would tabulate a company’s price-to-earnings ratio, book value, and dividend yield. Seeing that the two ratios are trading near historical lows and the company has raised the dividend each year for the past 10 years, the investor might quickly conclude that the stock is a good value. Sadly, too many investors rely almost exclusively on System 1 thinking to make a decision, never stopping to engage System 2 thinking.
What does it mean to be engaged? Quite simply, it means your System 2 thinking is strong, vibrant, and less prone to fatigue. So distinct is System 2 thinking from System 1 thinking that the psychologist Keith Stanovich has termed the two as having “separate minds.”
But a “separate mind” is separate only if it is distinguishable. Put in the context of investing, the “separate mind” that inhabits System 2 thinking is distinguishable from the “separate mind” in System 1 thinking only if it is adequately armed with the required understanding of a company’s competitive advantages, the strength of a company’s management team to rationally allocate the capital of the company, the important economic drivers that determine a company’s value, and the psychological lessons that prevent the investor from making foolish decisions.
It appears to me that much of the decision making that goes on in Wall Street is System 1 thinking. It operates mainly by intuition. Decisions are made automatically and quickly with little or no time for thoughtful reflection. System 2 thinking is serious thought. It is deliberate and requires concentration. System 2 thinkers are naturally patient. For System 2 thinking to work effectively, you must allocate time for deliberation and, yes, even meditation. You will not be surprised when I point out that the tenets outlined in The Warren Buffett Way are best suited for slow thinking, not the rapid-fire decisions common to System 1.
The second cause of dysrationalia, according to Stanovich, is lack of adequate content for System 2 thinking. Psychologists who study decision making refer to content deficiency as a mindware gap. First articulated by David Perkins, a Harvard cognitive scientist, mindware is all the rules, strategies, procedures, and knowledge people have at their mental disposal to help solve a problem. “Just as kitchenware consists of tools for working in the kitchen, and software consists in tools with your computer, mindware consists in the tools for the mind,” explains Perkins. “A piece of mindware is anything a person can learn that extends the person’s general powers to think critically and creatively.”10
What mindware would you need to activate System 2 thinking? At a minimum, you would read a company’s annual report and the annual reports of competitors. If it appears the company has a strong competitive position with a favorable long-term outlook, you would next run several dividend discount models that include different growth rates of the company’s owner earnings over different time periods to get a sense of approximate valuation. Then you would study and understand management’s long-term capital allocation strategy. Last, you might call a few friends, colleagues, or financial advisers to see if they have an opinion about your company or, better yet, your company’s competitors. Take note: None of this requires a high IQ, but it is more laborious and requires more mental effort and concentration than simply figuring out the company’s current price-to-earnings ratio.
Even though there is ample evidence that long-term thinking, patiently applied, is the best course for investing success, it appears that nothing much has changed. Even the 2008–2009 financial crisis and bear market haven’t changed our behavior. These days virtually all market activity is short-term. In 1960, the annualized value-weighted NYSE/AMEX turnover was less than 10 percent. Today, that ratio is greater than 300 percent—a 30-fold increase over the past 50 years.11 It is hard to believe that this dramatic increase in activity has not had a transformative effect on both the market and its participants.
Theoretically, an increase in market participation coupled with higher trading volumes is thought to lead to better price discovery, which in turn leads to a narrowing of the price-value gap with a corresponding reduction in market noise and volatility. But in reality, we have learned that if the majority of the market participants are speculators, not investors, then we are likely to see the exact opposite: The increase in trading activity will work to widen the price-value gap, increase the noise in the system, and lead to spikes in volatility. In this world, an investor who is hostage to short-term performance pressures will feel nothing but discontent.
It doesn’t have to be that way. The success of Warren Buffett is very much about his desire to play the game differently. And we are all invited to join him in that game. The only requirement for successful play is the willingness to adopt a different set of rules. Of these, none is more important than the value of patience.
Time and patience, two sides of the same coin—that is the essence of Buffett. His success lies in the patient attitude he quietly maintains toward both Berkshire’s wholly owned businesses and the common stocks held in the portfolio. In this high-paced world of constant activity, Buffett purposefully operates at a slower speed. A detached observer might think this slothlike attitude means forgoing easy profits, but those who have come to appreciate the process realize that Buffett and Berkshire are accumulating mountains of wealth. The speculator has no patience. Buffett, the investor, lives for it. As he reminds us, “The best thing about time is its length.”
And so we come back full circle, to the critical issue of emotion and its counterpoint, rationality. Intelligence alone is not enough to ensure investment success. The size of the investor’s brain is less important than the ability to detach the brain from the emotions. “Rationality is essential when others are making decisions based on short-term greed or fear,” says Buffett. “That is when the money is made.”12
Buffett recognizes that he is neither richer nor poorer because of the market’s short-term fluctuations in price, since his holding period is longer-term. Whereas most individuals cannot endure the discomfort associated with declining stock prices, Buffett is not unnerved, because he believes that he can do a better job than the market in valuing a company. Buffett figures that if you can’t do a better job as well, you don’t belong in the game. It’s like poker, he explains—if you have been in the game for a while and don’t know who the patsy is, you’re the patsy.
Absent rationality, investors easily default to System 1 thinking, which is adequate for simple and predictable tasks but not for the complexity that is the stock market. Absent rationality, investors become enslaved to the basic emotions of fear and greed. Absent rationality, investors are destined to become the patsy in the game called investing.
Notes
1. Andrei Shleifer and Robert Vishny, “The New Theory of the Firm: Equilibrium Short Horizons of Investors and Firms,” American Economic Review, Paper and Proceedings 80, no. 2 (1990): 148–153.
2. Ibid.
3. Keith Stanovich, What Intelligence Tests Miss: The Psychology of Rational Thought (New Haven: Yale University Press, 2009). Also see Keith Stanovich, “Rationality versus Intelligence,” Project Syndicate (2009-04-06), www.project-syndicate.org.
4. Keith Stanovich, “Rational and Irrational Thought: The Thinking That IQ Tests Miss,” Scientific American Mind (November/December 2009), 35.
5. Jack Treynor, Treynor on Institutional Investing (Hoboken, NJ: John Wiley & Sons, 2008), 425.
6. Ibid., 424.
7. Ibid.
8. Daniel Kahneman, Thinking Fast and Slow (New York: Farrar, Straus & Giroux, 2011), 4.
9. The bat costs $1.05 and the ball costs $0.05. It takes 5 minutes for 100 machines to make 100 widgets. It will take 47 days for the lily pad patch to cover half the lake.
10. D. N. Perkins, “Mindware and Metacurriculm,” in Creating the Future: Perspectives on Educational Change, comp. and ed. Dee Dickinson (Baltimore: Johns Hopkins University School of Education, 2002).
11. Ilia Dicher, Kelly Long, and Dexin Zhou, “The Dark Side of Trading,” Emory University School of Law, Research Paper No. 11, 95–143.
12. Carol Loomis, Tap Dancing to Work: Warren Buffett on Practically Everything, 1966–2012 (New York: Time Inc., 2012), 101.