Your beliefs become your thoughts, your thoughts become your words, your words become your actions, your actions become your habits, your habits become your values, your values become your destiny.
—MAHATMA GANDHI
DO YOU WANT TO BE RICH? Economists consider the question absurd, because the answer is so obviously YES! Unless the notion of building wealth appealed to you, I doubt you would be reading a book about investment decisions. Still, it’s unwise for me, or anyone, to assume too much about motives, beliefs, and decision-making. A key theme of this book is that in the investment world reality is not as it appears, and often the ideal differs from both appearances and reality. Nor do we actually choose in the rational way that we think we do. And our choices aren’t perfect—we all make decisions we later regret.
This book is about succeeding in investing by avoiding mistakes. The organizing framework of this book, in five parts, is that we will reap pleasing investment rewards if we (1) make decisions rationally, (2) invest in what we know, (3) work with honest and trustworthy managers, (4) avoid businesses prone to obsolescence and financial ruin, and (5) value stocks properly. While the stories in this book about my mistakes will be most readily grasped by readers who have made their own investment mistakes, I hope this book offers a wider audience an opportunity to learn from the mistakes of others and provides some entertainment value.
I have run the Fidelity Low-Priced Stock Fund (FLPSX) with an intrinsic value approach since 1989, and it has outperformed both the Russell 2000 and Standard & Poor’s 500 indexes by 4 percentage points a year. Over twenty-seven years, a dollar invested in FLPSX grew to $32, while a dollar invested in the index grew to $12.
However, the world of businesses and stocks changes constantly. What’s worked in the past may not continue to work. More importantly, investors are diverse, with different emotional constitutions, aptitudes, knowledge, motivations, and goals. One size decidedly does not fit all. And because we’ve just met, I shouldn’t leap to conclusions about you.
“What Happens Next?” and “What’s It Worth?”
Most investors seek to answer two questions: “What happens next?” and “What’s it worth?” Our minds naturally leap to reply to the first question, often before we realize that it was even posed. The stock price has been going up, so what happens next is that it will go up some more—unless, of course, it goes down. A company reports catastrophic financial results. Then earnings forecasts get slashed. The stock price dives—that is, unless the market knew it was going to be a bloodbath and is relieved that management’s guidance wasn’t more dismal. Unavoidably after whatever happens next, something else will happen, and you may not be ready for it. The question of what happens next is an endless treadmill of, “And then what?” Many of those answers will be wrong.
The longer your time horizon, the more likely you are to be a step ahead of other investors. Mindful investors will look out for at least a few iterations of what happens next. The answer to the second instance of “What happens next?” depends somewhat on the first, and the third on the second and possibly on the first too. And so it goes. Suppose, for example, a company has developed a marvelous new product. This often leads to strong sales and high profits. But high profits draw competitors, and that means…Sometimes, the first company to launch a product is the winner and takes it all. Other times, the pioneer is the one with arrows in its back, warning where not to go. Correct or not, I don’t know how to convert these answers into investment decisions.
“What’s it worth?” is an even more involved question. Many ignore the question of value because they think it’s too tough to answer. Others don’t ask it because they assume a stock’s price and value are the same. They suppose a stock is worth exactly what it can be sold (or bought) for. If you must sell in a hurry, you will receive market price, not value. However, the central idea of value investing—of which I am an advocate—is that price and value are not always equal, yet should be at some date in the future. Because the date is unknown, patience is mandatory.
Proof of worth arrives years later, long after the decision to buy or sell. Value can be shown only indirectly, never precisely, as it is based on projections of earnings and cash flows into the unfathomable future. Forecasts will always be guesses, not facts. In many cases, the actual outturn will depend more and more on what happens over time. If this year’s losses are particularly horrific and the firm goes under, well, it really was a terminal value. Most people don’t have the patience to muddle through anything as slow and sketchy as valuation.
Answering “What’s it worth?” demands patience and low turnover. but the seemingly easier path of constantly buying and selling based on “What happens next?” doesn’t work for most investors, even professionals. A portfolio’s turnover is defined as the lower of purchases or sales, as a percent of assets, so a portfolio with 100 percent turnover would change its holdings completely every year. Mutual funds are directed to file data on their holdings and turnover with the U.S. Securities and Exchange Commission, so their behavior is a matter of public record.
Broadly, most studies show that the higher the turnover, the worse the fund does (see table 1.1). Every study I’ve seen shows that mutual funds with portfolio turnover greater than 200 percent perform badly. Those with turnover above 100 percent fare a bit better, but not much. The studies don’t agree about whether the best level of turnover is moderate or as close to zero as humanly possible. Mutual funds with turnover below 50 percent are more likely to be using a reasoned, patient approach—like value investing.
Table 1.1
Mutual Fund Turnover and Excess Returns
| Turnover Quintile |
Avg. Turnover Rate |
Annual Excess Returns |
| High 1 |
128% |
− 0.24% |
| 2 |
81% |
− 0.31% |
| 3 |
59% |
+ 0.07% |
| 4 |
37% |
+ 0.33% |
| Low 5 |
18% |
+ 0.10% |
Source: Salim Hart (Fidelity), Morningstar-listed active equity funds with more than $0.5 billion in assets.
Folklore and Crowds
Historians, psychologists, and economists describe behavior in stock markets differently. For centuries, the folklore of stock exchanges has depicted them as crowded, anonymous carnivals of mass delusion and mayhem, with a whiff of sin. In a venue where avarice and envy are constants, no one expects decisions to be morally ideal. Financially, the greatest dangers stem from misunderstanding reality, which leads to endless cycles of boom and bust. These include the Dutch tulip mania, the South Sea Bubble, the Great Crash, Japan’s asset bubble, and dozens more—including, yes, the tech and housing bubbles. Investors believed they were taking part in adventures that would reinvent the world. When the bubbles popped, investors were left with wasted capital, scams, and crushing debt.
French polymath Gustave Le Bon wrote The Crowd in 1895 as a rant on French politics, but his observations also describe how stock market manias occur. Under the influence of crowds, individuals act bizarrely, in ways they never would alone. Le Bon’s key theme is that crowds are mentally unified at the lowest, most barbaric, common denominator of their collective unconscious—instincts, passions, and feelings—never reason. Being unable to reason, crowds can’t separate fact from fiction. Crowds are impressed by spectacle, images, and myths. Misinformation and exaggeration become contagious. Prestige attaches to true believers who reaffirm shared beliefs. Crowds will chase a delusion until it is destroyed by experience.
British investors couldn’t resist the image of cities of gold in the New World, inflating the South Sea Bubble. Today, El Dorado might be imagined as no-stick blood tests, colonies on Mars, or solar-powered driverless cars. Investors can be as ardent about stocks like Facebook, Amazon, Salesforce.com, or Tesla as about religion or politics. Professional fund managers should be less susceptible to pressures to fit in and conform than individuals, but…We have quarterly and annual critiques of our relative performance and deviations from benchmarks, and clients who yank their accounts when we are behind in the derby.
The South Sea Company was launched in 1711 as a scheme to privatize British government debt. The Crown granted South Sea exclusive rights to trade with South America. Holders of government annuities (bonds) could swap them for South Sea shares, and South Sea would collect the bond interest. Interest income was to be South Sea’s only source of net earnings. While international trading provided speculative sizzle, South Sea never made a profit from it, even after it added slaves to its cargo. Nonetheless, over half a year, its share price vaulted eightfold to a peak near £1,000 in June 1720. King George I was honorary governor of the company, and much of London society was sucked into the mania. Shares were offered on an installment plan. Others borrowed money to buy shares. South Sea shares plunged to £150 over a few months and dipped below £100 the following year, ruining many who had used leverage.
There were five categories of mistakes made during the South Sea Bubble, in which investors did the opposite of the five key tenets of this book. First, make decisions rationally. The decision to invest in the South Sea Company reflected a shared hallucination about cities of gold in South America. True, commerce with English-speaking North America had been lucrative, but South America was mostly Spanish territory. When the facts can’t be readily ascertained, we go with the (often erroneous) judgments of those in authority. The king’s share ownership and position at South Sea was surely counted as an endorsement. The fear of missing out (FOMO) sounds laughable until you’ve witnessed folks around you pocketing unearned windfalls. FOMO can be overwhelming! Sir Isaac Newton, the renowned physicist, is reported to have lost money on the South Sea Bubble and then to have said, “I can calculate the motions of the heavenly bodies, but not the madness of the people.”
Second, invest in what you know. Nothing in the experience of most investors in the South Sea Company equipped them to quantify the benefits of trade with South America. Ocean journeys were long and slow, and few had been outside England or spoke Spanish. Investors may not have grasped that it was in Spain’s interest to monopolize trade with its own colonies. Royals and the landed gentry were at the top of the social order, where too much familiarity with business was considered a demerit. The only English people who might have had any idea of how profitable voyages to South America might be were pirates.
Third, work with honest, capable management. The promoters of the South Sea Company had no experience at, or interest in, operating shipping routes and were bent on making money off of shareholders, not with them. Then, as now, government-granted monopolies eliminated competition and were typically lucrative—but some might sense a criminal aspect. Share options had been given to members of the ruling class, including King George I, his German mistresses, the Prince of Wales, the Chancellor of the Exchequer, and the Secretary to the Treasury. The promoters of the South Sea Company issued shares at inflated prices. In its largest offering, shares were swapped for government annuities with a notional value three times as great. In the aftermath, John Aislabie, the Chancellor of the Exchequer, and others were impeached and imprisoned, and dozens were disgraced.
Fourth, avoid competitive industries and seek stable financial structures. The nature of the South American trade and the financial structures around shareholdings made failure inevitable over time. The English Crown was not free to grant the monopoly, as it was in Spain’s interest to maintain control over trade with its colonies, and England was no ally. France had ambitions as well, leaving the long-run prospects for South Sea routes murky. Purchases of South Sea shares were also funded in ways not built to last. Many government officials received shares without paying cash up front, which could be seen as an option—or a bribe, as they could simply collect the net gain. Shares were offered publicly on installment terms, with an initial payment and two later payments, while others borrowed money to buy shares. When the bills came due, many sold shares to raise cash.
Finally, compare stock prices with intrinsic value. The market price of South Sea stock was totally disconnected from any realistic estimate of value. Intrinsic value is the “true” value of a stock, based on the dividends it is expected to pay over its entire remaining lifetime. Archibald Hutcheson, a Member of Parliament who opposed the scheme, calculated in the spring of 1720 that the shares were worth £150, while the market price was many times that. Hutcheson’s estimate of value was based largely on South Sea’s interest income. Over previous years, South Sea’s expeditions had produced losses (and would continue to do so in the future), so it might have been fair to say that those operations had no value. In 1720, South Sea paid a dividend that—unsustainably—exceeded its net income, making its yield an unreliable indicator of value.
The madness of crowds explains some of the misjudgments in the South Sea Bubble, but not all of them. On their own, people are perfectly capable of not knowing what they don’t know. As investors, we’re trying to assess the decisions and durability of organizations, which isn’t quite crowd psychology. The process of estimating a stock’s value requires reasoning with probability and statistics, and here we need a different sort of psychological knowledge.
Thinking Fast and Slow
How should we think about investing? In psychologist Daniel Kahneman’s stylized account of decision-making, there are two systems of mind: System 1, which thinks fast, and System 2, which thinks slowly and deeply. System 1 (called the “lizard brain” in popular science) recognizes patterns automatically, quickly, and effortlessly—telling you what will happen next. System 2 grudgingly allocates attention to complex thoughts like estimating a stock’s value, and understanding Kahneman. Although choice, agency, and attention are associated with System 2, our decisions often originate in System 1. We often believe that our decisions were arrived at rationally, using step-by-step logic, when actually they arrived through emotionally driven pattern recognition, that is, intuition. When those intuitions are about probability and statistics, we shouldn’t trust them.
System 2 would have nothing to work with if the lizard brain wasn’t constantly suggesting cause-and-effect relationships and inferring intentions, even though many hints turn out to be bogus. Because our intuition generates feelings and predispositions so effortlessly, it often provides the illusion of truth and unjustified comfort in its beliefs. Confidence comes more often from ignorance than from knowledge.
System 1 ignores ambiguity and muffles doubt with a tunnel-vision focus on the evidence that is immediately visible. Kahneman calls it What You See Is All There Is, or WYSIATI. Often, instead of answering a difficult question, our minds will answer an easier one using heuristics, or shortcuts. System 1 is more attentive to surprises and changes than to what’s normal, average and recurring. It overweights low probabilities, frames decisions narrowly, and is more sensitive to losses than to gains.
How Do Investors Really Behave?
Kahneman observed that humans don’t behave the way economists assume rational economic men do. As the word rational is commonly used, most decisions are reasonable. Economists add the requirements that choices are logically consistent and maximize economic well-being. No one I know, even the greediest of bastards, single-mindedly maximizes anything (except misery) in a logically consistent manner. The most rational might be Warren Buffett, the great value investor and CEO of Berkshire Hathaway. Rather than being so one-dimensional, most people trade off two or more opposed goals at the same time. They optimize. Consider return and risk: economic man isn’t risk averse, but I am. When I am baffled by the choices others are making, I consider other motives behind their decisions.
When I look at how economists assume economic man behaves, I am reminded that I am a flawed, fallible human, even though I strive constantly to improve.
• Perfect information: Everyone knows all relevant information about all securities, even if it’s hidden or private, and no misinformation.
• Perfect foresight: We know exactly how the future will turn out.
• People calculate and compare the odds and expected utility of everything.
• Everyone will interpret news correctly.
• Tastes do not change. (Investing in teen retailers is a snap!)
• Everyone is infinitely greedy. (Is it really rational to want more money than you need?)
• Hired hands will do the same things that owners would do.
Economists study investment risk from on high, tossing all sorts of risk into one pot. They take an outside view of the market, categorizing the outcomes for an entire group of statistical subjects, and so look for the net effect on the overall system, not individual outcomes. If, for example, oil prices rise, and the profits of airlines and truckers fall by the same amount as the rise in profits of oil companies, it doesn’t matter to the system—so there’s no net systemic risk. Risk has been diversified away. In this view, it does not matter whether risk stems from inept or crooked executives, obsolescence, or too much debt; it’s all “market risk.”
Investors, however perceive a multitude of types of risk—some more attractive than others, and greater risk overall. I am watchful of the risk of overpaying, but in the system view it doesn’t matter because my loss is your gain. The outside view is also unnatural because, unlike most securities analysts, it ignores the story and details of the case at hand and does not try to forecast its unique outcome. But the outside view can be useful in estimating a base rate of probability for the proper statistical reference class.
A base rate is the frequency of an attribute in a statistical population. For example, perhaps 2 percent of biotech research projects develop into a profitable drug. Going back to the features of the case, I might redefine the reference class as well-funded biotechs that are further on in the Food and Drug Administration approval process. By using too broad a reference class, the outside view can turn everything—including mixed games of chance and skill like tennis, chess, or investing—into pure games of chance.
Aren’t Markets Efficient?
The efficient market hypothesis (EMH) builds on a series of behavioral assumptions that are more true than not. In the real world, no individual has perfect information on all the securities in the market, and everyone is not equally well informed, but fairly good information is available for those who want it. Not everyone interprets the information identically, but many do. No one has perfect foresight, but the market does look ahead. Investors do try to rationally value stocks, but not all buyers are investors. People shouldn’t trade except when a stock is mispriced, but many do. Transactions costs are not zero, but have fallen to low levels. Anyone who takes the assumption of no taxes too seriously is going to have a problem with the Internal Revenue Service.
The EMH arrives at conclusions that are more true than not, such as: At all times stocks will be fairly priced, omnisciently reflecting all information everywhere. Prices will fluctuate randomly as news arrives or interest rates change. All stocks will offer the same risk-adjusted return. (So why pick stocks?) No one should expect any stock or portfolio to beat the market. While returns can’t be improved, volatility can be diversified away by holding a portfolio that tracks the entire market—an index fund. Your only lever for improving returns—in the real world, where there are fees and taxes—is to avoid those expenses. The EMH was so compelling that it led John Bogle, founder of mutual fund giant Vanguard, to launch the first low-fee S&P 500 index fund.
I see the EMH as a cautionary tale. It’s true that the average person will earn average results, but as in any other endeavor, some are more skilled and interested than others. In every competitive game, winners are paired with losers. That does not mean the game is not worth playing. However, looking at the average result for the entire category alone, everyone should “set it and forget it” with an index fund. Your competition is also smart and diligent, so you need more than that to have an edge.
Are you more economically rational and emotionally even-keeled than the average person? Do you have financial commitments that could limit your ability to be patient as your investments grow? Are you more interested in joining crowds in doing things that you don’t understand or in understanding why people do things? Your answers will help determine whether you belong in a different statistical group than the broadest category of investors.
Interest comes before ability, so if you see stock-picking as a great game of skill and the stock market as a fascinating puzzle with more angles than a Rubik’s Cube, I’m with you. Conversely, if investment research seems like a chore and the stock market a game of chance—then an index fund is best for you.
Index investors believe they are rewarded for taking overall market risk, while value investors think they are also paid for doing the opposite when others behave badly. If you aren’t interested in the question of what good and bad behavior might be, you won’t see it as a source of profit. It isn’t always either/or; some people find that owning an index fund and an actively managed fund and individual securities works for them.
Regrets
Whether you invest in individual stocks, an actively managed fund, or an index fund, the sources of your regrets are likely to fall into our five inverted (mistake) buckets, which we explore in this book:
1. Allowing emotions, not reason, to guide decisions
2. Thinking you know more than you actually do
3. Trusting capital to the wrong people
4. Choosing businesses prone to failure because of obsolescence, competition, or excessive debt
5. Overpaying for stocks, most frequently those with vivid, striking stories
In part I of this book, we explore how the impulsive lizard brain causes predictable decision biases, which become fatal when distinctions between investing, speculating, and gambling are poorly understood and when investors fail to learn from mistakes. People who don’t reflect before acting will fail to notice that there are some subjects which they know deeply, others which they don’t, and still others in which no one really has the answers.
In part II, we search for investment blind spots, which can be small details of the dynamics of investment advice, exotic securities, or certain industries. Or they can be cosmic questions about cross-cultural misunderstandings or how economic statistics relate (or not) to specific stocks. Study your own strengths and limitations, and you’ll understand those of the agents to whom you entrust your capital.
Part III is about assessing management’s honesty and capability. Skilled managers keep businesses focused on doing something uniquely valuable to customers, and apply capital where it will earn the best returns. Scammers do leave clues, many of which can be found in corporate accounts.
Even capable managers will struggle in tough businesses, so part IV explores why some industries are more durable and resilient than others. Proprietary products, few competitors, evolutionary change, and low debt all extend corporate longevity.
An asset’s value is a function of its income, growth, longevity, and certainty, so in part V, we put the pieces together. To estimate a discount rate, we examine historical return patterns for stocks. To be sure we are discounting the right cash flows, we look at earnings quality. Even when we have correctly identified a stock as undervalued, it often proceeds to become even more so.
Diversification and Indexes
So, should you pick stocks or diversify in a fund? Diversification can spread, reduce, and transform risks—more so for those related to the companies, less so for risks related to you. While an S&P 500 index fund is a very complete form of diversification, actively managed funds and portfolios of individual stocks are also diversified. If you are impulsively trading like a whirling dervish, it hardly matters whether you do it with the S&P 500 or with specific stocks. Diversification won’t help there, but it would avoid concentrated investments in areas that you don’t understand. Index investors can rely on more general rules and general economic knowledge than stock-pickers, who need to understand the growth and competitive picture of specific industries and companies.
An index fund takes an outside view of the risks of corporate fraud—waste, obsolescence, bankruptcy, and stock valuation. Some company management teams will include idiots or crooks. However small the average frequency of awful management is, you’ll get it with the index fund. But you’ll also get some brilliant innovators and exemplary stewards, in line with those base rates. Some industries are fading away and some companies are financially strapped; the index holds them in proportion to their market values. The index is bailed out by holding the rising stars and cash cows, also in proportion. Index investors don’t need to sweat the details, only whether the balance is more favorable than negative. Unless a country’s whole economic system is corrupt or outmoded, the net is usually positive.
The valuation and returns of an index fund are again sorts of group averages for the entire group of stocks, with spectacular bargains offsetting grotesquely overvalued blimps—that is, if you admit that bargains and bubbles exist, which the EMH denies. For those of us who aren’t true believers, it’s possible for the index itself to sell for more than its intrinsic value, and for expected stock returns to be comparatively unattractive. Here, I’d ask you to meditate on the expected returns of a broader opportunity set. You can put your money into domestic and foreign stocks, various classes of bonds, real estate, cash, art, gold, Spam™, and munitions. Typically, but not always, stocks are the savvy alternative.
Index investors will minimize regrets differently than stock-pickers, focusing most on curbing unnecessary activity and expanding their knowledge base. They tend not to dwell too much on intrinsic value, although I think they would have fewer regrets if they did. Fiduciary misconduct and financial failure are, for them, bolts from the blue. In contrast, concentrated stock-pickers can be blown up on any of these fronts: emotional decisions, gaps in understanding, working with bad dudes, unexpected disruption, too much debt, or just paying too much. Although they would love to minimize all of these risks simultaneously, they can’t. The good news is that stock-pickers can outperform simply by cutting out the stuff that drags down returns. They seek out undervalued stocks of companies they understand in growing industries with honest, capable management.
How to Think About Investing
In investing, everything begins with decisions. There’s a hall-of-mirrors quality to it as we are assessing the decisions of others. We’re dealing with the unknown future, and the facts are not in evidence. So, as social animals, we seek other opinions, which can be wrong, sometimes dramatically. As individuals, the best we can do is make decisions mindfully, using our System 2 (thinking slowly), aiming for fewer but better choices. Most directly, this means avoiding excessive turnover and trying to invest based on “What’s it worth?” rather than “What happens next?” It also means choosing a format for investing that works for you—whether stocks, index funds, actively managed funds, or something else altogether.