The things we admire in men, kindness and generosity, openness, honesty, understanding and feeling, are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest, are the traits of success. And while men admire the quality of the first they love the produce of the second.
—JOHN STEINBECK
Businesspeople and Investors
NEARLY ALL OF THE ENTREPRENEURS on Forbes magazine’s list of 400 richest billionaires founded firms that grew exponentially for decades. Think of Microsoft’s Bill Gates, Alphabet’s Larry Page, and Walmart’s Sam Walton on the one hand. Most top investors on the list are value investors who became businesspeople along the way. Think of Warren Buffett, Charlie Munger, and Carl Icahn. It seems paradoxical. Investors invest in businesses, so shouldn’t both entrepreneurs and investors benefit from growth or value? However, growth is not opposed to value. Rather, future growth is a component of value. While investors benefit from thinking like businesspeople, they play by different rules, define opportunity differently, and have distinct characteristics. This chapter explores the psychological traits of successful investors.
Entrepreneurs typically focus all their capital and energy on a single business venture. When that one business flourishes, it’s glorious. Investors diversify, either on their own or through mutual fund managers mandated to hold at least twenty securities. Anyone who gets on the Forbes list must have extraordinary skill and luck (or the right parents). Diversification reduces the effects of luck for investors. To magnify the effects of skill, investors must carefully select for outstandingly favorable odds, bet heavily on them, and skip mediocre opportunities. Concentrating portfolios also amplifies the effect of luck, but this can hurt or help.
Warren Buffett took the idea of focused portfolios to an extreme, proposing an investment punchcard limited to only twenty opportunities in a lifetime. Like marriage, ownership of a business is an enduring commitment. If investing worked the same way, investors would set lofty standards and patiently wait for the right one. Mutual fund managers use up all twenty punches on their first day by necessity. Still I am intrigued by the idea of a punchcard. Unless you consider his Berkshire Hathaway one big punch, Buffett has used his billions to buy a few more cards.
It is the natural order of things that the most extreme outliers will mostly be undiversified businesspeople. But there are also undiversified investors who failed big. Yale University’s endowment, for example, was wiped out in 1825 after it put almost the entire sum into Eagle Bank, which went under.
Shareholders need to appreciate how and why businesspeople think and act. That’s because they are betting on both the cards and the player and do not hold the hand themselves. Professional investors are also businesspeople, in that we sell advice and management services. We are also like movie critics who trash films that they could not have produced themselves; the best of us have reviewed enough superior productions to judge appropriately. And while entrepreneurs hunt for customers that competitors have neglected, investors look for value that others have missed, which is sometimes the same thing, but often not.
Of course, not all successful investors are value investors. There are countless ways to make money in the stock market, each favoring a different personality type. Lucky reckless speculators and gamblers can do well, too, but for how long? The traits that help value investors often hurt shrewd speculators, and vice versa. Unless you are a rare stock biathlete (I’m not), I’d caution against jumping between investment and speculation. One can’t play chess and tennis at the same time. But don’t force the value approach; if it doesn’t work for you, find one that does.
Patience is a virtue for investors, but speculators must worry about ideas and information going stale. It’s only worthwhile to be patient with businesses with enduring strengths, a topic we’ll come back to later. Calm emotional detachment helps investors, but speculators can make emotional sensitivity and worry work for them. Investors need a thorough, durable sort of decisiveness, while speculators need a more flexible kind.
Trained Intuition
In business, every personality type has a way to make money. But in successful investors, two traits stand out: what psychologists label as thinking and intuitive, or rational analysts. (Note that intuitive is not used here in the popular sense of “trust your gut.” Intuitive is defined as attuned to pattern recognition, meaning, abstract theory, and the invisible, including the future.) Thinking people tend to make decisions based on logic (that is using their System 2), as opposed to feeling people, who decide based on people and feelings. Everything about the stock market is abstract—trying to guess what the future will bring, and what it means. Without theory, you’ll get nowhere. I would call the combination of thinking and intuitive—grappling with the invisible in a logically consistent way—trained intuition.
Emotionally Aware But Let Reason Decide
Good analysts tend to favor thinking over feeling and to think rationally. They’re alert to the biases and distortions of the sort described in chapter 2 and make an effort not to see facts selectively, overemphasize their importance, or overgeneralize. Where they can, they test hypotheses. They don’t assume their prediction is an absolute fact.
Stoic detachment combined with emotional awareness is the perfect combination for stocks. Feel the fear, but let reason decide. The most frequent blunders come from those who believe everything their gut tells them. The biggest catastrophes come from people who are emotionally unaware when their gut is growling out a correct warning of something amiss. Worrying can be a good thing, if you don’t stress out or feel too intensely. As a value investor, I like to worry when things aren’t going wrong, because the emotional cost is lower. Most importantly, worry only if it will help you to work through the alternatives and find a better path. When the sky is predicted to fall and you can’t save it, relax. Reduce news intake. Be happy.
Curious Skeptics
Every skilled investor I’ve met has been curious and a lifelong learner. They read broadly and constantly. For anticipating the future, it’s more important to understand why things happen than what happened. By studying historical examples, I often find that some factors exert more, or less, influence than I would otherwise have thought. And when things happen that have never happened before, I study how others have handled unprecedented events in the past.
Curiosity needs to be balanced with skepticism. Everyone needs a spam filter and a crap detector—some way of classifying and throwing away redundant or wrong information. Things are often not as they seem in finance. Be skeptical and willing to challenge ideas others take for granted.
Independent Thinking
On the whole, students with high grade point averages achieve them through curiosity and diligence, but it’s also possible to get high marks by gaming the system, sucking up to professors, and regurgitating whatever they want to hear. In investing, where doing nothing often prevents blunders, a certain style of laziness is adaptive, but mental laziness isn’t, and not thinking independently is absolutely toxic. The entire game is about figuring out what others have missed. The largest prizes go to those who think differently and correctly. Some investing ideas will look stupid or crazy, and a few will be, but the alternative is mediocrity. Depending on the results, you will be called courageous, or arrogant and foolhardy. Don’t be ashamed of error, only of failing to correct it. While university courses are evaluated on, perhaps, three quizzes and a term paper, the stock market never tells you which questions to work on, how to approach them, and whether you’re out in left field.
Optimism for Solutions
Optimism is a powerful ally of entrepreneurs, but only one specific type helps investors: the optimism that with effort you will learn, grow, and find solutions to current dilemmas. In any endeavor in which you influence the outcome, optimism sustains you. Apple’s Steve Jobs would not have been Steve Jobs without his “reality distortion field.” If you believe that problems can be solved and solutions implemented, success will happen.
In many ways, investors do not control their fate, so overoptimism only blinds them to risks and uncertainties and distorts the relative estimates of payoffs. Investors can determine the time and amount of a purchase or sale but cannot determine the price, except adversely. Undue pessimism causes one to miss opportunities and is exhausting to boot. The typical optimism of value investors consists of the lame belief that for a specific stock the outlook is overcast but is priced for pitch black. Perversely, when widespread panic sets in, value investors’ sun comes out.
Discipline—What You Don’t Do
Discipline can be shown by what you don’t do or by what you must do. Investors need more of the first variety; speculators need more of the second. Staying within Warren Buffett’s twenty punches implies not acting on scores of fairly attractive opportunities. Dividing an adult life span by twenty, an investor would lounge for years doing nothing, which might disturb clients or employers. It would look like analysis paralysis—and for a speculator, it would be. Conversely, an event-based trader whose event fails to materialize must sell. Ditto for momentum traders who use a rule that stocks that have fallen 12 percent must be sold. They can’t convert to value investing for the day.
Successful investors flout the social convention that if people do not agree, they do not like each other. Social life generally flows more easily when viewpoints are shared. However, in investing and science, discovering the truth comes first, so friendship is not undermined by variant perceptions when the facts aren’t self-evident. You should also know that open-minded, analytical people will try out all sorts of quirky ideas that turn out to be bogus. They come around to the truth eventually.
Accepting Mistakes
Call it humility, call it honesty with yourself, but failing to admit to investment mistakes means failing investing. When you separate luck from skill, your skill improves. It’s better to be good than to look good. From some perspective, every investor makes mistakes all the time. When I hang tough with a long-term holding when a slump is predictable, I have to concede that a nimble speculator might have spotted my mistake. While speculators’ logic is usually short term, it may be correct for the long run. Psychopaths in investing benefit from not caring about other people, but usually their downfall is their inability to recognize when they are wrong. The ability to admit mistakes can be a barometer of overall truthfulness.
Shrewd speculators and investors study their experience to understand where their hits and misses are coming from and why they might win overall. For example, after being too adventurous with industries I didn’t understand, I now stay away from some and keep positions of others tiny until I know more. My gut identifies many more people as shifty than really are; when I study their corporate accounting, I’m much better at spotting the real bad dudes. Being a coal analyst made me avoid businesses prone to competitive dogfights and obsolescence. In investing, being a cheapskate, and not paying up, helps—a lot. So I win by focusing on simple businesses, with honest management and proprietary products, bought cheaply. But during raging, thematic momentum bull markets, I lag pathetically.
Fidelity generally hires very bright, hardworking, ambitious, analytical types with a track record of success so when analysts wash out, it’s rarely for technical reasons; usually it’s because the stock market isn’t a university and they haven’t yet learned to cope with failure. Even with grade inflation, 55 percent wouldn’t be a passing grade, but in the stock market, being right 55 percent of the time is as good as it gets. Stocks go down when they should go up and go up when down is forecast. For me, every market day brings a mosquito bite of failure, and some days, more serious bloodletting. I once suggested that we consider recruiting people with a track record of failure but was told there are better ways to hire resilient people with grit.
Comfort with Ambiguity
Good investors accept that they constantly work with ambiguous situations. Except for a few gifted finance professors, no one ever has perfect information. For someone to buy a stock, someone else must sell, presumably because that person thinks there’s something wrong with it. Who’s right? During bull markets, the air of mystery can be sexy and seductive, but during plunges, we assume the worst. It’s a difficult trick to keep a relatively steady, or even countercyclical, tolerance for ambiguity. At the moments when you are stinging from ambiguous situations that cratered, and shedding risk as fast as you can, superb opportunities appear under shrouds. When frolicsome ventures have paid off more than you deserved, curb your enthusiasm and tilt toward well-defined earnings streams.
The Right Stuff
While investors must understand businesses and businesspeople, and often are in business themselves, they diversify across many holdings and must think probabilistically. The most successful investors tend to be rational, analytical sorts—intuitive and thinking in the psychological typology. The future can be understood only theoretically, because it is not yet reality. Reason is a better guide to stock decisions than emotions, so an emotionally detached but aware approach works best. Investors need to be resilient, because the stock market dishes out a lot of failure. They need to think independently, be willing to stand outside the crowd, and agree to disagree. The market rewards tolerance for ambiguity most when it is in short supply, so investors should aim to keep a constant or countercyclical tolerance.