“The investor’s chief problem – and even his worst enemy – is likely to be himself” Benjamin Graham
Looking into the fund management industry from the outside it’s not always clear what it takes to be a great fund manager. The general public assume that investors like Warren Buffett or Seth Klarman are born and not made, endowed with some kind of superior intellect. Even as an insider it took me a long time to work out the simple truth that Benjamin Graham set out 80 years ago. The key advantage they have is almost entirely down to emotional discipline. Once you realize this basic point, the behavioral errors that overwhelm the vast majority of fund managers start to become painfully obvious:
In my experience, herding behavior is one of the most pervasive and powerful biases. You might imagine that herding behavior occurs primarily at market tops (like the dotcom boom) or at market bottoms (like in March 09). Seasoned investors recognize that it’s far more ubiquitous than that.
It’s a hard one to resist because it can actually be painful to resist – it causes us severe emotional discomfort. Psychological experiments have shown that social exclusion generates activity in the part of the brain that processes physical pain. From an evolutionary standpoint there is a good reason for this – when we lived and hunted as a pack animals being part of the herd was critical to our survival. No wonder it feels so uncomfortable to stand apart.
Herding is even harder to resist when we are placed together with colleagues in the center of a concentrated financial hub like London or New York. This is one of the reasons why great investors like Warren Buffett and Bruce Berkowitz have chosen to locate themselves in locations far away from these hubs (Omaha and Miami respectively)
Fear and Greed
Because our brains were evolved for survival on the savannah, we remain guided by fear and greed. When we spot an opportunity (like a wildebeest or an IPO) our brain tells us we should be pursuing that opportunity and our greed kicks in. When we are faced with danger (like a lion or a stock market crash), our brain tells us to run in the opposite direction. When these emotions take control, all that time and effort we spent on reasoned analysis is summarily dismissed. It’s quite something to witness an otherwise level headed family man (it seems to impact men more than women), thrown back into a primeval state by a set of quarterly numbers.
The “Narrative Fallacy” is a term coined by Nassim Nicholas Taleb and it’s dangerous because it is so addictive. I’ve seen investors succumb to a chronic condition of this, where literally every investment is reduced to a simplified narrative. And the better the story, the more confident the investor feels. Usually these stories are created by sell-side brokers (can you blame them?) and are then picked up and propagated by gullible fund managers. As the narrative gains momentum, facts get pushed aside and a form of “confirmation bias” sets in (see below). When the evidence against the narrative becomes overwhelming the fund manager finally abandons it in utter despair, usually blaming an external factor for their own mistake.
“The fallacy is associated with our vulnerability to over-interpretation and our predilection for compact stories over raw truths. It severely distorts our mental representation of the world” Nassim Nicholas Taleb, Fooled by Randomness
Once we have taken a view, we are wired to look for evidence that confirms that initial view. This bias is compounded when we have significant spent time and effort researching a view that resulted in an investment decision. Our tendency is to ignore information that runs counter to our thesis and even to distort conflicting data so that it fits our view.
“Time and again, psychologists have found that confidence and biased assimilation perform a strange tango. It appears the more sure people were that they had the correct view, the more they distorted new evidence to suit their existing preference, which in turn made them even more confident” James Montier, The Little Book of Behavioral Investing
Good investors need to constantly test their thesis in the light of existing and new information. Robert Williams, one of the many successful students of Julian Robertson, said of his mentor “Julian Robertson was always adamant about seeking out the opposite point of view and then being completely honest with yourself in deciding whether your analysis overrides that”
Bruce Berkowitz’s approach is to try to “Kill the Company”
“We spend a lot of time thinking about what could go wrong with a company – whether it’s a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can’t kill it, maybe we’re onto something”
“Never underestimate the value of doing nothing” Winnie-the-Pooh
Investors often feel the need to “do something”, particularly in reaction to events. In a corporate environment, we confuse activity with work. We are impressed by the fund manager who trades constantly because we assume they are doing lot’s of work and we assume the fund manager with low turnover is lazy.
Hyperactivity is often driven by a thirst for “excitement”. Many retail investors equate excitement to watching Jim Cramer on CNBC and then trading enthusiastically on the back of that particular day’s news (which seems important at the time but is usually irrelevant).
If you’re serious about making a return from your investment then you need to abandon your search for excitement and instead accept that it will involve hard work, lots of analysis, and patience. Those who are looking for excitement should instead try their hand at the casino.
Taking the emotion out of Investing
Research indicates that there are two systems at work in our brains. The first one, called the X-system, evolved earlier and is adapted for our survival on the savannah. It allows us to make rapid decisions, and is emotional in nature rather than logical. In contrast the C-system of our brain evolved later and represents our ability to analyze the facts of a situation and come to a logical conclusion.
Most of the time we rely on the X-system, because it is the default system for processing information. It requires no effort and is semi-automatic. When we watch CNBC, or when we react emotionally to a profits warning we are letting our X-system do the work for us. It takes a conscious effort to resist this and engage our C-system instead.
It’s futile to try to suppress your emotions entirely. But just being aware of these biases that impact us is half the battle.
“I consider myself as prone to foolishness as anyone I know, despite my profession and the time spent building my expertise on the subject. But here is the exception; I know that I am very, very weak on that score. My humanity will try to foil me; I have to stay on my guard” Nassim Nicholas Taleb, Fooled by Randomness
In “The Little Book of Behavioral Investing”, James Montier advocates focusing on your process as a way to circumvent your emotions. You can’t always control the outcome of your decisions and you can’t control how you’ll react to these outcomes, he says, but process is the one thing you can control. It turns out you can’t actually slay your demons, but you can tame them and put them in a box.
For those wanting to read further into the subject, I can highly recommend the book mentioned above by James Montier, which includes many more anecdotes taken from the real world of investing. If you’ve had your own experiences in this field then please feel free to share them with us here