Wednesday, March 11, 2015

Investment Sins

"The fault, dear Brutus, is not in our stars, but in ourselves." - William Shakespeare in Julius Caesar

Warren Buffett, in his latest Berkshire Hathaway (BRKa) letter to shareholders*, explained the consequences of volatility being viewed, mistakenly, as a meaningful indication of risk.

In fact, he writes that such a view can "ironically" cause the investor to "end up doing some very risky things." 

Buffett then adds to remember "the pundits who six years ago bemoaned fall stock prices and advised investing in 'safe' Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement."

Since then the S&P 500 has roughly tripled. The extreme volatility that occurred during that time was more opportunity than risk.

So, unfortunately, due to the "fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."

Charlie Munger once pointed out that some of this comes down to temperament:

"A lot of people with high IQs are terrible investors because they've got terrible temperaments."

In the letter Buffett goes on to say:

"Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

The commission of the investment sins listed above is not limited to 'the little guy.' Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool's game."

Some investment pros are naturally very capable but Buffett points out it's tough to know, at least in the near-term, "whether a great record is due to luck or talent."

He also says that professional advisors mostly "are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle's The Little Book of Common Sense Investing."

Buffett then refers to the Shakespeare quote included at the beginning of this post.

Those who trade frequently, try to be clever about market timing, diversify insufficiently (with the right amount being necessarily unique for each investor), incur lots of frictional costs, and use leverage to purchase equities shouldn't be surprised if they end up with a rather not so great outcome.

The ability to recognize where one's own behavior and limitations might get in the way of satisfactory (or better) returns can be a big advantage.

I'd add that choosing to make a specific investment based upon what someone else thinks is asking for trouble.

As Buffett says: "Anything can happen anytime..."

Well, if prices decline, it will be tough to hang in there (assuming hanging in there makes sense longer term) when an investment isn't truly well understood. Intrinsic worth, within a narrow range, has to be clear to the investor well before the market storm clouds arrive.

When price action goes south, who can maintain a justifiably positive view about something if it's been purchased based upon what someone else thinks? Real conviction in an investment comes from doing the necessary work then reaching one's own (hopefully sensible) conclusions. Listening to others is a recipe for inopportune selling.

Most investments -- even the one's that are very sound -- inevitably require that lots of warranted conviction will be needed from time to time.


Long position in BRKb established at much lower prices

Related posts:
Stocks and Risk
Munger on Focus Investing
Buffett on Risk and Reward

* The excerpts from the letter included in this post can be found on pages 18 and 19.
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