Friday, September 20, 2013

Deadly Sins of Investing - Part II

A follow up to this post.

In that prior post, I covered the first three of what this Wall Street Journal article calls The Seven Deadly Sins of Investing.

Deadly Sins of Investing

Here's the final four:

4 Wanting to Join the Club

The Wall Street Journal article relates this investing "sin" to envy.

Well, here's how Warren Buffett looks at envy:

"Being envious of someone else is pretty stupid. Wishing them badly, or wishing you did as well as they did -- all it does is ruin your day. Doesn't hurt them at all, and there's zero upside to it."

He adds that, if anything, better to pick a sin "like lust or gluttony. That way at least you'll have something to remember the weekend for."

Not surprisingly, Charlie Munger shares a similar view.*

Some might be drawn to an investment because it feel exclusive. Well, envy is at the very least a contributor to this. Access to an exclusive club that, at least in perception, is making lots of money apparently draws in more than a few investors.

That, in part, might help explain hedge fund industry growth over the past twenty five years or so -- from $ 40 billion in the late 1980s to apparently something like $ 2.3 trillion these days -- and maybe even some of the recent Ponzi schemes.

Yet, considering the amount of evidence that hedge funds overall haven't performed all that well, it becomes just a bit harder to understand why they'd be considered such a prestigious place to put money. From this Bloomberg Businessweek article:

"As their returns have fallen, the biggest hedge funds have started to seem more like glorified mutual funds for the wealthy, and those rich folks might start to take a harder look at whether they're getting their money's worth."

Of course, there are a number of fine professional money managers. It's just not always easy to tell beforehand who's actually doing a great job of managing the risk of permanent capital loss relative to the returns being generated.

Also, there's also just no way around the typically high expenses among hedge funds.

What matters is the likelihood of at least satisfactory returns relative to the risks of permanent capital loss.

What matters is whether the investment is understandable to a particular investor.

Prestige and exclusivity should never enter the equation.

Envy just leads to trouble.

Sir Isaac Newton made what was then a good chunk of money, and rather quickly, early on during the South Sea Bubble. He bought early, sold early, and earned quite a nice amount. Well, in case some might think IQ is the most important factor in investing, Sir Isaac ended up later losing what he'd made early on plus not a small chunk of his fortune basically because he couldn't stand to see his friends getting rich quickly while he was not.**

The end result? Well, he put a whole lot more money in -- including some that was borrowed -- during what turned out to be the later stages of that bubble and got financially crushed when the bubble burst.

Isaac Newton, The Investor

Chart: Isaac Newton's Nightmare

As the Wall Street Journal article points out, this tendency also applies to things like exuberance toward getting in on the next hot initial public offering.

Related: Hedge Funds Severely Underperforming This Year

5 Failing to Admit Failure

This partly comes down to loss aversion or what is an innate preference for the avoidance of losses compared to gains. Psychologically, studies seem to suggest that losses are twice as forcefully felt as the equivalent gains. Loss aversion is just one of many cognitive biases that can have an adverse impact on investment results. Awareness of this particular bias (and others) then understanding how to manage the embedded wiring can lead to more rational investment decision-making.

Unchecked, it can cause an investor to hold onto something that was a bad decision that should be sold. They hold in an attempt to get their money back to avoid the pain of admitting mistakes and taking on the associated losses.
(Not temporary drops in price where one is justifiably confident in estimated value. Instead, it's when value was misjudged or too high a price was paid.)

On CNBC yesterdayMeryl Witmer (a Berkshire Hathaway board member) talked about what some successful investors she knows had in common (including Warren Buffett, of course). Among other things Witmer highlights confidence, humility, optimism, the ability to change one's own mind when new information comes in and, yes, to admit when mistakes have been made.

"I think they're all confident but they're humble. And I think they're humble because they're very logical. so, you know, they -- they're confident, and they look at the facts, they have opinions, but when they're presented with new information, they're willing to change their minds, which, another way you could put that is they're willing to say they're wrong. And that's a pretty rare trait amongst people. A lot of people they stake out a claim, they'll defend it until they fail." - Meryl Witmer

Rigidity and loss aversion combined turn small mistakes into big ones.

6 Living For Today

Putting off savings an investment for even a relatively small amount of time -- in the context of long-term investing that is -- can be very costly. A one time $ 10,000 investment today that ends up returning 7% per year will be worth a bit over $ 200,000 in 45 years. That same amount of investment invested ten years later with otherwise the same annual return will grow to more like just over $ 100,000. So the same amount invested but half as much at retirement. Creating a sound approach early on that works for an investor's necessarily unique circumstances makes a huge difference. Sooner than later pays off in not small ways.

"Remember that money is of the prolific, generating nature. Money can beget money, and its offspring can beget more, and so on. Five shillings turned is six; turned again it is seven and threepence, and so on till it becomes a hundred pounds." - Benjamin Franklin in Advice to a Young Tradesman

The magic of compounding. For an investment portfolio, there's just no more powerful tailwind longer term. What's difficult in the short run becomes incredibly less so when this force is put to work.

7 Following The Herd

The tendency to do what the crowd is doing contributed to what happened in the tech bubble and, on the other end of the spectrum, during the height of the financial crisis. Buying, en masse, when stocks were expensive in the late 1990s; selling, en masse, when stocks were cheap during the scariest days of the financial crisis.

As Warren Buffett once said: "You can't buy what's popular and do well."

Buffett certainly has some other quotes along these lines.
Awareness of the above investing "sins" along with the right response can counteract the damage they tend to inflict on investment portfolios. This may take some work but is well worth the trouble. Taken seriously, it might even go a long way toward avoiding disastrous investment results or, at least, not missing the chance to benefit from the magic of compounding.

"Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

The above hardly represents a comprehensive list but at least some of these pitfalls aren't a bad place to start if one would like to eliminate the "standard stupidities".

So what's in these two posts isn't exhaustive by any means.

Instead, in the context of attempting to achieve at least satisfactory long-term results, it's more of a simple framework to cover some of what tends to get in the way of meeting investment objectives.


* During this CNBC interview back in 2010, Becky Quick asked Warren Buffett about envy. First, something that Charlie Munger had said in a separate interview was played:

MUNGER: Envy is a much more serious mischief-maker than greed.

BECKY: How so?

MUNGER: There's something in human nature that just can't stand even if you are making $5 million a year, that dumb bastard down the street is making 7.

BECKY: So those were his comments. He thinks envy is the biggest problem, not greed.

BUFFETT: Yeah. We saw a lot of that at Solomon. I mean you'd say how could a guy that's making $3 or $4 million a year be unhappy? And he's not unhappy until he finds the guy next to him who he thinks he's smarter than making a few dollars more. And as I always said, envy seems to me the silliest of the seven deadly sins. The other guy doesn't feel it. You just feel worse. You are sitting there with your stomach churning because you are envious. It doesn't make a lot sense.

I have always said, you know, if you are going to pick some sins from the seven deadly sins, go with gluttony and lust and you can have a hell of a weekend.

** Sir Isaac apparently lost what would be roughly $ 4 million to $ 5 million in current terms or practically all (if not quite all) of his stake in the South Sea Company. While the losses he suffered from the South Sea Company was enormous compared to his total wealth, he apparently still did not end up poor by any means. So the investment in South Sea Company itself was, give or take, basically wiped out (something like roughly 90% of his stake) but did not destroy Newton's entire fortune.

That's my understanding of what happened but whether he lost a bit more or less specifically isn't necessarily of the greatest importance. It's just a good lesson in (and example of) how human nature can get the best of a very smart man.

Newton should have known better -- the basic arithmetic needed to figure out the extreme valuation wasn't hard at all compared to the complex mathematics (calculus) he at least helped to invent -- but envy and other aspects of his nature apparently led to a huge misjudgment.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.