Of Sound Mind - Tilson Fundsinvestment world, however, they often do, so making decisions solely on...

Of Sound

MindHuman nature often conspires against informed,

rational decision-making, a state of affairs the best investors

take quite seriously. Value Investor Insight takes it seriously

as well, regularly exploring the many biases and influences

that can derail thoughtful decisions and offering

concrete insight on how to avoid them.

From our archives, here is a selection of articles that

offer timeless wisdom for facing the never-ending

challenges to the investing mind.

Sincerely,

Whitney Tilson and John HeinsCo-Editors, Value Investor Insight

www.valueinvestorinsight.com

Playing the OddsO F S O U N D M I N D

Value Investor Insight 2Fall 2009 www.valueinvestorinsight.com

“Games of chance must be distin-guished from games in which skill makesa difference,” writes Peter Bernstein inAgainst the Gods, his historic review ofrisk taking. “With one group the outcomeis determined by fate, with the othergroup, choice comes into play. There arecard players and racetrack bettors whoare genuine professionals, but no onemakes a successful profession out ofshooting craps.”

Like playing poker and betting onhorses, investing is a game of skill similar-ly focused on assessing the odds of uncer-tain future events. “At the end of the day,investing is inherently a probability exer-cise,” says Legg Mason strategist MichaelMauboussin. “Most investors acknowl-edge this point but very few live by it.”

Why is it difficult for investors to thinkin terms of probabilities when assessing acompany’s future performance and stockprice? “It isn’t human nature to view thefuture in terms of a wide range of possi-bilities,” says Abingdon Capital’s BryanJacoboski, who was featured last summerin Value Investor Insight (August 29,2005). “We naturally think in terms ofwhat is most likely to occur and implicit-ly assess the probability of that scenariooccurring at 100%. That may soundreckless, but it’s what most people do andisn’t a bad way to think as long as lesslikely, but still plausible, scenarios don’thave vastly different outcomes. In theinvestment world, however, they oftendo, so making decisions solely on themost likely outcome can cause severedamage.”

Anchoring on the most likely outcomeis a natural attempt to reduce the com-plexity involved in making investmentdecisions, but also can reflect the danger-ous overconfidence with which manyinvestors ply their trade. Former TreasurySecretary and Goldman Sachs Co-Chairman Robert Rubin, who made his

name on Wall Street as an arbitrage trad-er, warns against this “excessive certain-ty” in his book In an Uncertain World:“[It] seems to me to misunderstand thevery nature of reality – its complexity andambiguity – and thereby provides a ratherpoor basis for working through decisionsin a way that is likely to lead to the bestresults.”

The first basic step in incorporatingprobabilities into investment decisions isto explicitly consider several potentialoutcomes. Abingdon Capital’s Jacoboskilooks at each of his holding’s businessfundamentals under four to six distinctscenarios, calculating an intrinsic valueunder each scenario and applying a sub-jective probability to each. The final esti-mate of intrinsic value is the intrinsicvalue of each scenario weighted by itsprobability of occurring. “A key is to cap-ture low-probability but high-impact sce-narios, primarily to see where the vulner-abilities are,” he says. He decided not to

short Amazon.com a couple years ago,for example, after taking into considera-tion what he considered to be the unlike-ly event that Amazon’s scale would starttranslating into the profitability gains themarket was expecting. In fact, that is thescenario that began to play out, and thestock rose 180% in the following year.

An added benefit to thinking in termsof probabilities is that it helps makeexplicit the actual risks under considera-tion. If given the choice between purchas-ing a $350 non-refundable plane ticket toattend a future event that could possiblybe cancelled vs. waiting to buy a last-minute ticket for $1,200, many peoplewould choose to wait. Nobody wants toblow $350. But in pure expected-valueterms, it pays to buy the ticket now unlessyou believe the risk of cancellation isabove 71%. Framing the question in thisway may not change the decision, but canincrease the chances that a more informeddecision is made.

Anything’s PossibleMost investors know that investing is an exercise in probability. But knowing it and actually living by it can be two separate things.

http://www.valueinvestorinsight.com

Playing the OddsO F S O U N D M I N D


In studying the common traits ofthose most successful at games of skill –across disciplines – researchers havefound a clear tendency to focus more onprocess than individual outcomes. Pokerlegend Amarillo Slim has described itthis way: “The result of one particulargame doesn’t mean a damn thing, andthat’s why one of my mantras has alwaysbeen ‘Decisions, not results.’ Do theright thing enough times and the resultswill take care of themselves in the longrun.” Adds Legg Mason’s Mauboussin:“By definition, poor decisions will peri-odically result in good outcomes andgood decisions will lead to poor out-comes. The best in their class focus onestablishing a superior process, with theunderstanding that outcomes will followover time.”

That’s not to say that process can’t beimproved. Making explicit – and writingdown – the probabilities used in making

investment decisions can provide valuablelearning. After all, if you judge an eventto have had a 60% chance of occurring –and it doesn’t occur – you don’t know ifyou were right or wrong. The only trueway to know is by tracking the same orsimilar events to see if they, over time,happen 60% of the time. Weather fore-casters and bookmakers keep track ofsuch things to refine their ability to judgeprobabilities. Investors should do thesame – even if it’s with much less preci-sion – to calibrate their probability-set-ting skills.

While necessary, skillfully assessing theprobabilities of various outcomes for acompany is not sufficient to making asound investment. Stock prices havefuture expectations already built in – thetrick is to find the gaps between thoseexpectations and your own.

“Perhaps the single greatest error in theinvestment business is a failure to distin-

guish between knowledge of a company’sfundamentals and the expectations impliedby the stock price,” says Mauboussin.Driving home this point is Steven Crist,chairman of the Daily Racing Form: “Theissue is not which horse in the race is themost likely winner, but which horse orhorses are offering odds that exceed theiractual chances of victory. There is no suchthing as “liking” a horse to win a race,only an attractive discrepancy between hischances and his price.”

Even with a framework to assess ambi-guity, the right decision in the face ofgreat uncertainty is often just to pass.Warren Buffett refers to it as placingsomething in the “too-hard pile.” WritesPeter Bernstein: “Once we act, we forfeitthe option of waiting until new informa-tion comes along. As a result, not actinghas value. The more uncertain the out-come, the greater may be the value ofprocrastination.” VII

It's not surprising that stock investingwith a long-term perspective, as a con-cept, has been taking it squarely on thechin. In a scathing assessment of hisinvestment-industry brethren, investmentadvisor John Mauldin recently wrotethat platitudes about investing for thelong run “are often brought up as rea-sons to leave your money with a currentmanagement that has just incurred largelosses.” One successful hedge fund man-ager recently questioned (anonymously)his own long-term approach in an inter-view with Vanity Fair: “We have greatconfidence in our analytical ability, andwhen the world is panicking, we standup,” he says. “In retrospect, we shouldhave panicked.”

It's too easy, of course, to criticize anyinvesting approach that wasn't movingaggressively to cash or taking a big shortposition starting in late 2007. But it’s

perfectly fair to take a fresh look at thefundamental value-investing principle ofplacing bets based on company's devel-opment over time, particularly in light ofthe market’s recent turmoil. Have therules of the game changed enough that along-term strategy is passé?

Jumping to the punch line, our con-clusion is no. The fundamental principlessupporting a long-term investingapproach – based on expectations morethan a year in the future, say – are sound.But as with any broad strategy, the devilis in the details. A simplistic applicationof any long-term strategy is likely to bedoomed to failure.

One key belief of most long-terminvestors is that trying to time the marketis futile and exceedingly difficult, so thebetter approach is to invest with theexpectation of a thesis playing out overtime. As Thomas Gayner of Markel

Gayner Asset Management puts it: “Ihave a ready answer when people ask mewhy I'm such a long-term investor, whichis because I failed miserably as a short-term investor. I'm not against makingmoney in the short term, I just don'tknow how to do it.”

Value investors in particular also tendto take a long-term approach because inorder to see an eventual payoff, they haveto. Perceived undervaluations typicallyresult from market neglect, temporaryoperating troubles or an out-of-favorindustry – all of which are more likely topersist for an inconveniently long timethan to go away quickly. In such cases, aslong as one ends up being right about theeventual turn of events, patience is clear-ly a virtue.

The most compelling justification fordisregarding the immediate future inmaking investment choices is that it

The Long and Short of ItTrumpeting your long-term perspective as an investor can sound like an excuse when markets are as bad asthey have been. Have the rules of the game changed so much that a long-term approach is now passé?


Time HorizonO F S O U N D M I N D


works. Contrarians love that a long-termapproach is turning into somewhat of alost art. While the average holding period30 years ago for a stock on the New YorkStock Exchange was five years, today it'sdown to six months. “The obsession withthe short term creates an opportunity,”says Société Générale equity strategistJames Montier. “If everyone else is dash-ing around pricing assets on the basis ofthe next three months, then they are like-ly to misprice assets for the longer term.So an opportunity for time arbitrage aris-es for the investor with a longer horizon.”

There's every reason to expect thistrend toward relative hyperactivity on thepart of investors to persist. Decliningtrading costs make it easier to trade, forexample, and the short-term incentives ofboth corporate management and profes-sional investors make it likely they'll con-tinue to act with near-term prospects atthe top of their minds.

At the same time, the explo-sion in the quantity and avail-ability – if not the quality – ofinvesting-related informationis also likely to increase thealready pervasive tendency forinvestment decisions to reflect“recency bias,” the human ten-dency to estimate future prob-abilities not on the basis oflong-term historical experi-ence, but rather on a handfulof the latest outcomes.Michael Mauboussin, ChiefInvestment Strategist of LeggMason, considers recency bias“one of the most reliablesources of inefficiency in themarket,” offering a key expla-nation for why research consis-tently shows that doing theopposite of what easily swayedindividual investors are doingproves to be a hard-to-beatinvesting strategy.

While a patient investing approach isby no means outdated, any notion thatpatience should beget inaction hasbecome increasingly suspect. The latestmarket downdraft, for example, hasmade very clear how cycles – in the econ-omy, in credit, in sentiment – are ignoredby investors at their peril. As OaktreeCapital CEO Howard Marks put itrecently in a letter to his investors:

In my opinion, there are two key conceptsthat investors must master: value and cycles.For each asset you're considering, you musthave a strongly held view of its intrinsicvalue. When its price is below that value, it'sgenerally a buy. When its price is higher, it'sa sell. In a nutshell, that's value investing.

But values aren't fixed; they move inresponse to changes in the economy. Thus,cyclical considerations influence an asset's

current value. Value depends on earnings,for example, and earnings are shaped by theeconomic cycle and the price being chargedfor liquidity.

Changing intrinsic values highlightanother key aspect of enlightened long-term investing: the need for disciplinedreview processes for positions moving upas well as down. Share-price declines of agiven magnitude often trigger a clean-slate look at a company’s business andprospects. Share-price increases oftenresult in automatic sales as a stockapproaches or reaches estimated intrinsicvalue. “Value investors should complete-ly exit a security by the time it reaches fullvalue,” wrote Seth Klarman in his prefaceto the latest edition of Graham & Dodd'sSecurity Analysis. “Owning overvaluedsecurities is the realm of speculators.”Two or three years ago it was common to

hear investors describe howthey were relaxing their sellingdisciplines as stocks hit fairvalue, as a result of having toofrequently sold stocks thatkept going up. It's a safe betthat we won’t be hearing againabout such relaxed selling dis-ciplines for that reason any-time soon.

Other relevant lessons hithome by the growling bearmarket: Investors who aspireto ride out near-term marketfluctuations should assiduouslyavoid leverage. At the sametime, long-term investorsshould regularly re-read BenGraham’s discussion in TheIntelligent Investor about mar-gin of safety, which hedescribed as being “availablefor absorbing the effect of mis-calculations or worse thanaverage luck” – both of whichhave been in ample supply. VII


Seth KlarmanO F S O U N D M I N D


Editors’ Note: With the possible excep-tion of Warren Buffett, no investor plyingthe trade today commands more respectthan Baupost Group’s Seth Klarman.Since founding his investment partnershipin 1983, Klarman has not only producedpeerless returns, but he has also from timeto time offered wise and timeless com-mentary on markets and the craft ofinvesting. With his permission, we repro-duce here various excerpts from his latestannual letter, published late last month.

Erratic Mr. Market

It is easy for the volatility of one’sthinking to match the volatility of prevail-ing conditions. Time horizons have short-ened even more than usual, to the pointwhere the market’s 4:00 p.m. close seemsto many like a long-term commitment. Tomaintain a truly long-term view, investorsmust be willing to experience significantshort-term losses; without the possibilityof near-term pain, there can be no long-term gain. The ability to remain aninvestor (and not become a day-trader ora bystander) confers an almost unprece-dented advantage in this environment.The investor’s problem is that this per-spective will seem a curse rather than ablessing until the selloff ends and somesemblance of stability is restored.

The greatest challenge of investing inthis environment is neither the punishingprice declines nor the extraordinaryvolatility. Rather, it is the sharply declin-ing economy, which makes analysis ofcompany fundamentals extremely diffi-cult. When securities decline, it is crucialto distinguish, as possible causes, legiti-mate reaction to fundamental develop-ments from extreme overreaction. AtBaupost, we are always on the lookout forsuch overreactions, whether due to thedisappointing earnings of a failed growthstock, a ratings downgrade of a bond, thedeletion of a stock from an index or itsdelisting from an exchange, or the forced

sale resulting from a margin call. Usually,fearful overreaction equals opportunity.

In today’s market, however, wherealmost everything is down sharply, distin-guishing legitimate reaction from emo-tional overreaction is much more diffi-cult. This is because there is a vicious cir-cle in effect (the reverse of the taken-for-granted virtuous circle that buoyed themarkets and economy in good times).This vicious circle results from the feed-back effects on the economy of lowersecurities and home prices and a severecredit contraction, and, in turn, effects ofa plunging economy on credit availabilityand securities and home prices.

With residential and commercial realestate prices collapsing and global stockmarkets down 40%, 50%, and more thisyear alone, tremendous damage has beendone to individual and institutionalwealth. Suddenly, new corporate, univer-sity, and hospital facilities are on hold,and big ticket items like automobiles,consumer electronics, and luxury goodsare going unsold. The worsening econo-my and rising unemployment portend apossibly protracted period of falling salesvolumes, with industry overcapacity lead-ing to pricing pressures, and thus sharplylower earnings and cash flows. Consumerspending declines could be more secularthan cyclical; consumption patterns mayhave changed in semi-permanent ways.Some of the lost demand simply may notcome back. Municipal governments facea severe crunch as tax receipts fall whileentitlement spending rises. Ultimately,this vicious cycle will be broken and nei-ther securities prices nor the economy willgo to zero, just as they did not go to infin-ity when the virtuous cycle was in place.But throughout 2008, prudent investorssifting through the rubble for opportuni-ty were repeatedly surprised by the mag-nitude of the selling pressure, and, inmany cases, by the extent to which thedeterioration in business fundamentals

has come to justify the lower marketprices. Many forced sellers, through theirearly exits, inadvertently achieved betteroutcomes than the value-oriented bargainhunters who bought from them.

Warren Buffett has said – and othershave endlessly repeated – that you can’ttell who is swimming naked until after thetide goes out. This turns out to be onlypartially true. The tide has receded, andmost portfolios are down. But not alldeclines are equal. Some investors havelost money and locked in those losses bygoing to cash. Some have made invest-ments in failed or failing banks, brokers,and homebuilders, or toxic subprimemortgage securities; these losses are large-ly permanent and irreversible. But theinvestment baby has been thrown outwith the bathwater, and some who invest-ed wisely aren’t naked, it just seems thatway. Buying early on the way down looksa great deal like being wrong, but it isn’t.It turns out you won’t be able to accurate-ly tell who’s been swimming naked untilafter the tide comes back in.

As Benjamin Graham and David Doddtaught us, financial markets are manic andbest thought of as an erratic counterpartywith whom to transact, rather than as anarbiter of the accuracy of one’s investmentjudgments. There are days when the mar-ket will overpay for what you own, andother days when it will offer you securitiesat a great discount from underlying value.If you look to “Mr. Market” for advice, orif you imbue him with wisdom, you aredestined to fail. But if you look to Mr.Market for opportunity, if you attempt totake advantage of the emotional extremes,then you are very likely to succeed overtime. If you see stocks as blips on a tickertape, you will be led astray. But if youregard stocks as fractional interests inbusinesses, you will maintain proper per-spective. This necessary clarity of thoughtis particularly important in times ofextreme market fluctuations.

The Value of Not Being SureIn these excerpts from his latest annual letter, Seth Klarman describes the biggest challenge in investing today,how he’s responding to the market’s turmoil and why he considers fear of the unknown such a great motivator.


Seth KlarmanO F S O U N D M I N D


Age-Old Showdown

There have been days recently wherefear has completely dominated greed.While business fundamentals remainawful, the moment will arrive when someof the cash on the sidelines will creepback into the markets, rejecting infinites-imal yields and seeking better returns.The contrast between the exceptionallyattractive yield and low purchase pricefor “risky” corporate debt or mortgagesecurities, and the extremely low yieldsand very full price for “safe” U.S.Government bonds, is yet anotherdemonstration of Mr. Market’s manicbehavior. When economic recovery isanticipated, when investors decide to takea bit more risk, “safe” government bondswill fall significantly in price and fright-ened investors who overpaid for safetywill be tallying their losses. As 2009 getsunder way, we expect a steady diet ofbear market rallies and financial marketvolatility, as economic woes and contin-ued deleveraging vie with governmentintervention and bargain-hunting in acontinuation of the age-old showdownbetween greed and fear.

Timing the Market

Baupost built numerous new positionsas the markets fell in 2008. While it isalways tempting to try to time the marketand wait for the bottom to be reached (asif it would be obvious when it arrived),such a strategy has proven over the yearsto be deeply flawed. Historically, littlevolume transacts at the bottom or on theway back up and competition from otherbuyers will be much greater when themarkets settle down and the economybegins to recover. Moreover, the pricerecovery from a bottom can be very swift.Therefore, an investor should put moneyto work amidst the throes of a bear mar-ket, appreciating that things will likely getworse before they get better.

Process, Not Outcome

Especially in today’s difficult environ-ment, money managers must keep firmlyin mind that the only things they reallycan control are their investment philoso-phy, investment process, and the nature of

their client base. Controlling your processis absolutely crucial to long-term invest-ment success in any market environment.James Montier, Société Générale’s marketstrategist, recently pointed out that whenathletes were asked what went throughtheir minds just before competing in theBeijing Olympics, the consistent responsewas a focus on process, not outcome. Thesame ought to be true for investors.

It is so easy for one’s investmentprocess to break down. When an invest-ment manager focuses on what a clientwill think rather than what they them-selves think, the process is bad. When aninvestment manager worries about theirfirm’s viability, about possible redemp-tions, about avoiding loss to the exclusionof finding legitimate opportunities, theprocess fails. When the manager’s timehorizon becomes overly short-term, theprocess is compromised. When tempersflare, recriminations abound, and secondguessing proliferates, the process cannotwork properly. When investment man-agers worry about maximizing the valueof their firm – or, if publicly traded, itsshare price – rather than the long-termbest interest of clients, the process is cor-rupted. Investing is hard enough. Successvirtually requires that a process be inplace that enables intellectual honesty,rigor, creativity, and integrity.

In Defense of Uncertainty

Successful investing requires resolve.When taking a contrary approach, onehas to be able to stand one’s ground, beunwavering when others vacillate, andtake advantage of others’ fear and panicto pick up bargains. But successfulinvesting also requires flexibility andopen-mindedness. Investments are typi-cally a buy at one price, a hold at a high-er price, and a sale at a still higher price.You can never be sure if the economy willgrow or shrink, whether the markets willrise or sink, or whether a particularinvestment will meet your expectations.Amidst such uncertainty, people who aretoo resolute are hell-bent on destruction.Successful investors must temper thearrogance of taking a stand with a largedose of humility, accepting that despite

their efforts and care, they may in fact bewrong.

Robert Rubin once observed that somepeople are more certain of everythingthan he is of anything. We feel the sameway. One can see the investment universeas full of certainties, or one can see it asreplete with probabilities. Those whoreflect and hesitate make far less in a bullmarket, but those who never questionthemselves get obliterated when the bearmarket comes. In investing, certainty canbe a serious problem, because it causesone not to reassess flawed conclusions.Nobody can know all the facts. Instead,one must rely on shreds of evidence, ker-nels of truth, and what one suspects to betrue but cannot prove. One must also bal-ance one’s own perception of the truthwith one’s best assessment of what othersbelieve. In investing, other people’s per-ception of reality influences price morethan any underlying truth; your ownassessment, even if correct, is valueless ifit is already reflected in the market price.

It is much harder psychologically to beunsure than to be sure; certainty buildsconfidence, and confidence reinforces cer-tainty. Yet being overly certain in anuncertain, protean, and ultimatelyunknowable world is hazardous forinvestors. To be sure, uncertainty breedsdoubt, which can be paralyzing. Butuncertainty also motivates diligence, asone pursues the unattainable goal of elim-inating all doubt. Unlike premature orfalse certainty, which induces flawedanalysis and failed judgments, a healthyuncertainty drives the quest for justifiableconviction.

Always remembering that we might bewrong, we must contemplate alternatives,concoct hedges, and search vigilantly forvalidation of our assessments. We alwayssell when a security’s price begins toreflect full value, because we are neversure that our thesis will be precisely cor-rect. While we typically concentrate ourinvestments in the most compelling situa-tions measured by reward compared torisk, we know that we can never be fullycertain, so we diversify. And, in the end,our uncertainty prods us to work harderand to be endlessly vigilant. VII


EnvyO F S O U N D M I N D


Coveting Thy Neighbor's [Fill in the Blank]There are many reasons why, as Warren Buffett says, “It is not greed that drives the world, but envy.” The rami-fications of that range from the mildly beneficial to – as the current crisis attests – the downright calamitous.

One of the more infamous pronounce-ments from a financial executive as thecredit crisis has unfolded – and there havebeen many – was former Citigroup chair-man Charles Prince’s explanation for whythe banking giant continued to lendaggressively as trouble loomed last year:"As long as the music is playing, you'vegot to get up and dance."

While Prince’s sentiment, in retrospect,sounds ridiculous, it’s obvious that“doing it because everyone else is” was acore rationale behind any number of cor-porate and individual actions that havebrought the global financial system to itsknees. It’s an oversimplification to blameeverything on reaching for the bigger car,the bigger house and the bigger bonusthat “everyone” else has, but it most cer-tainly played a key role. “Humans have astrong desire to be part of a group, whichmakes us susceptible to fads, fashions andidea contagions,” writes Legg Masonequity strategist Michael Mauboussin in aresearch paper dissecting investor deci-sion-making. “People also have a prefer-ence for being an accepted part of amajority over being part of the correctminority. Numerous market bubblesdemonstrate this point.”

Given the central role they play in thedevelopment of market bubbles (and avariety of other ills), it’s worth askinghow envy and social comparison havecome to so drive human behavior. As withmost aspects of human nature, the rootsgo way back, as financial journalist JasonZweig describes in his latest book, YourMoney and Your Brain: “In a hunter-gatherer society, dominant individualsdominated precisely because they werebetter at getting and keeping scarceresources. Social comparison probablyserved early man well; by observing thosewho had more, our ancestors learnedhow to get more themselves.”

This highlights what can be the posi-tive aspect of being motivated by compar-

ing ourselves with others. Writes Zweig:“Suffering a mild case of ‘comparisoncomplex’ can be beneficial: it motivatesyou to work hard, gives you hope for thefuture, keeps you from being a totalmiser, and prompts you to clean up thehouse before visitors arrive.”

Research into the brain’s function indi-cates that our instinct to compare andconform also has a physiological basis.Gregory Berns of Emory University askedresearch subjects to answer questionsboth before and after seeing how “peers”(who were part of the research team) hadanswered the same questions. When sub-jects went against the judgment of theirpeers, and knew it, brain scans foundintense activity in the same area of thebrain that becomes active in response tophysical pain. In other words, it actuallyhurts to not go along with crowd. Thiswould help explain why researchers havealso found that the desire to conformincreases in the presence of puzzlement orstress – already uncomfortable states thatwould only be amplified by going againstthe grain.

Apart from the financial damage thatcan be done when “winning” becomesmore of a relative concept than anabsolute one, the psychological damagecan be keen as well. BerkshireHathaway’s Charlie Munger, a student ofhistory who has written and spoken oftenon the subjects of envy and jealously,described the impact that a life of con-stant comparison had on WolfgangAmadeus Mozart: “Mozart’s was anexample of a life ruined by nuttiness. Hewas consumed with envy and jealousy ofother people who were treated better thanhe felt they deserved and he was filledwith self-pity. Nothing could be stupider.Envy, huge self-pity, extreme ideology,intense loyalty to a particular identity –you've just taken your brain and startedto pound on it with a hammer.”

In his essay, “The Psychology ofHuman Misjudgment” – published inPoor Charlie’s Almanack – Mungerlaments how infrequently envy is publiclyor privately identified as a driver ofbehavior. “When did any of you lastengage in any large group discussion ofsome issue wherein adult envy/jealouslywas identified as the cause of someone’sargument?” The reason, he writes, is that“calling a position ‘envy-driven’ is per-ceived as the equivalent of describing itsholder as a childish mental basket case.”While the taboo against doing that isunderstandable, Munger says, it helpsperpetuate envy’s hold on the collectivepsyche.

Sadly, there’s no twelve-step process foreradicating envy from your life. The bestadvice for investors is probably Sir JohnTempleton’s admonition: “It is impossibleto produce superior performance unlessyou do something different from themajority.” On a more personal level, we’llleave the last word to Charlie Munger:“Learn how to ignore the examples fromothers when they are wrong, because fewskills are more worth having.” VII


Chasing the Big ScoreO F S O U N D M I N D


In Roughing It, his description of sixyears living and traveling in the 19th-cen-tury American West, Mark Twaindescribed feeling “as if an electric batteryhad been applied to me” when he and apartner thought they'd struck a huge lodeof silver in Nevada in 1862. Though theclaim was denied within days, Twainreferred often to such euphoria in his laterwritings and appears to have sought toreclaim it in chasing unsuccessful get-rich-quick schemes over the rest of his life.

Neuroscientists have found that the“high” Twain felt at the prospect of sud-den wealth has a biological origin. AsJason Zweig describes in his new book,Your Money and Your Brain, the expecta-tion of making money causes dopamineto be released and to “fire up” the emo-tional circuitry located in the lower frontregion of the brain. This response is simi-lar to what happens when one anticipatesbasic pleasures like food, drink and sex.

The big downside for investors of thisnatural response is that the fired-up partsof the brain that anticipate a reward –namely, a rapidly increasing stock price –are much more sensitive to the size of thepotential gain than the probability of itactually occurring. “The magnitude of along-shot reward is going to drive yourbehavior far more than the probabilities,which are likely miniscule,” says Stanfordneuroeconomist Brian Knutson.

This phenomenon goes a long waytoward explaining the collective irra-tionality that can grip investors duringinflating market bubbles. Alan Greenspandescribed it well in testimony beforeCongress in 1999:

“What lottery managers have known forcenturies is that you could get somebody topay, for a one-in-a-million shot, more thanthe value of that chance. In other words,people pay more for a claim on a very bigpayoff. That's where the profits from lotter-ies have always come from. That means thatwhen you are dealing with certain stocks –

the possibilities of which are it’s either goingto be valued at zero or some huge number –you can get a premium in stock prices, whichis exactly the price-evaluation process thatgoes on in a lottery. The more volatile thepotential outlook, [the higher the potential]lottery premium in the stock.”

This lottery premium doesn't justreveal itself during market bubbles. Afteranalyzing 1.3 million stock returns over a36-year sample period, researchersThomas Downs and Quan Wen in a 2001study published in the Journal ofPortfolio Management concluded: “Thelottery premium, (which) we define as thesacrifice in average return that investorspay for a chance to earn a huge, althoughremote, return, is persistent and signifi-cant. It is greater in up markets than indown markets, and it is higher in therecent past than in the remote past.”

While smart investors would be well-served to avoid the pervasive temptationto pay lottery premiums, that's not to saythat aspiring to hit the occasional home-run is not a worthwhile goal. RalphWanger, the retired highly-successfulmanager of what is now the Columbia

Acorn Fund, described it this way in a2007 Money interview: “Investing, espe-cially in small companies, is a home-run-hitter's game. The point is, 99% of whatyou do in life I classify as laundry – it'sstuff that has to be done, but you don'tdo it better than anybody else, and it'snot worth much. Once in a while, though,you do something that changes your lifedramatically. You decide to get married,you have a baby – or, if you're aninvestor, you buy a stock that goes uptwenty-fold.” If that sound reckless andflip, Wanger's style was anything but,based on rigorous research to identifylong-term trends and disciplined analysisto identify attractively priced companiespositioned to benefit from those trends.

How can investors counteract the neg-ative ramifications of being wired tochase the big score? Never make snapinvestment decisions, instead putting allpotential investment ideas through a sim-ilar process checklist. Be wary of “story”stocks and of situations that are reminis-cent of previous big investment successes,both of which can lead to costly analyti-cal shortcuts. Focus on being what JamesMontier of Societe Generale calls an“empirical skeptic” – rather than accept-ing that earnings can grow 30% annuallyfor ten years or a given level of return oncapital can persist, look at the distribu-tion of outcomes from a large historicalsample to see how reasonable such esti-mates are. Finally, as Steven Romickdescribes in his interview in this issue,spend as much time defining what thedownside can be as the upside, and lookto make highly asymmetrical bets.

“The game of professional investmentis intolerably boring and over-exacting toanyone who is entirely exempt from thegambling instinct; whilst he who has itmust pay to this propensity the appropri-ate toll,” wrote John Maynard Keynes.Keeping that toll as low as possible is aprerequisite to sound investing. VII

Chasing the Big ScoreIt's human nature to metaphorically swing for the fences when making investment decisions. But like manyaspects of human nature, this trait is one that smart investors should try to keep firmly in check.

“If I knew how to get rich

quick, would I be sitting on a

mountain-top all day?”


Your Money and Your BrainO F S O U N D M I N D


The Brain’s Hot Button

Deep in your brain, level with thetop of your ears, lies a small,almond-shaped knob of tissue

called the amygdala. When you confront apotential risk, this part of your reflexivebrain acts as an alarm system – generatinghot, fast emotions like fear and anger thatit shoots up to the reflective brain likewarning flares. (There are actually twoamygdalae, one on the left side of yourbrain and one on the right, just as officeelevators often have one panic button on

either side of the door.)The amygdala helps focus your atten-

tion, in a flash, on anything that’s new, outof place, changing fast, or just plain scary.That helps explain why we overreact torare but vivid risks. After all, in the pres-ence of danger, he who hesitates is lost; afraction of a second can make the differ-ence between life and death. Step near asnake, spot a spider, see a sharp object fly-ing toward your face, and your amygdalawill jolt you into jumping, ducking, or tak-ing whatever evasive action should get youout of trouble in the least amount of time.

This same fear reaction is triggered bylosing money – or believing that youmight. However, when a potential threat isfinancial instead of physical, reflexive fearwill put you in danger more often than itwill get you out of it. A moment of paniccan wreak havoc on your investing strate-gy. Because the amygdala is so attuned tobig changes, a sudden drop in the markettends to be more upsetting than a longer,slower – or even a much bigger – decline.On October 19, 1987, the U.S. stock mar-ket plunged 23% – a deeper one-day dropthan the Crash of 1929. Big, sudden, and

Mind Over Money“The 100 billion neurons that are packed into that three-pound clump of tissue between your earscan generate an emotional tornado when you think about money,” says author Jason Zweig. Hisnew book offers advice on how to best ride out such storms.

Killing time between flights a few

years ago, Jason Zweig bought an

issue of Scientific American and

was quickly drawn to an article describ-

ing how people who had had the right

and left halves of their brains severed as

a radical treatment for epilepsy began to

calculate probabilities differently than

they had before. As a long-time investing

columnist and author (he wrote the com-

mentary for the 2003 revised edition of

Ben Graham’s The Intelligent Investor),

he says, “I knew immediately that this

was something I had to learn more

about.”

The result of Zweig’s curiosity is the

recently published Your Money and Your

Brain, an in-depth look at what the

emerging science of neuroeconomics –

a hybrid of neuroscience, economics and

psychology – is uncovering about how

the brain’s hard-wiring drives investing

behavior. “The more you can learn about

the circuitry,” he says, “the better you can

understand the outcomes.”

For perfectly logical evolutionary rea-

sons, the human brain constantly trig-

gers immediate physical and emotional

responses to external events. While

these may work beautifully for choosing

a mate or avoiding danger, they can

also form the basis for behavioral bias-

es that get investors into trouble – help-

ing to explain, for example, why we’re

often more likely to sell when we should

be buying or why we’re unjustifiably

prone to overconfidence. As Zweig

writes in his introductory chapter: “To

counteract impulses from cells that

originally developed tens of millions of

years ago, your brain has only a thin

veneer of relatively modern analytical

circuits that are often no match for the

blunt emotional power of the most

ancient parts of your mind.”

Is all hope lost, then? Happily, no,

says Zweig, who argues that nurture can

help trump nature when it counts.

“Training and discipline and repetition

and practice – that’s nurture – can help

counter some of the problems caused

by nature,” he says. “Many of the practi-

cal lessons from this research are about

setting up policies and procedures as

checks against the insidious natural

biases that investors have.”

This is not to say, however, that

investors should be dispassionate

automatons. “There’s an unfortunate

belief that great investing is about being

rational like Star Trek’s Mr. Spock, where

you feel nothing and are just an evalua-

tion machine,” he says. “I think that’s

wrong. Investors like Warren Buffett and

Charlie Munger are very attuned to the

emotions rippling through markets and

I’d argue that one of the things that sets

them apart is that they’re ‘inversely’ emo-

tional. When they sense pain and fear in

the market, they likely feel pleasure at the

value being created. They’re essentially

taking the other side of the trade on

other people’s emotions.”

In the excerpt below from Your

Money and Your Brain, Zweig explores

how the brain responds to actual and

perceived risks posed by falling stock

prices, and gives practical advice for

avoiding those “what-was-I-thinking”

regrets. “Most of us believe we can

counter our weaknesses with willpow-

er,” he says. “In times of stress, willpow-

er alone is not enough.”




inexplicable, the Crash of 1987 was exact-ly the kind of event that sparks the amyg-dala into flashing fear throughout everyinvestor’s brain and body. The memorywas hard to erase: In 1988, U.S. investorssold $15 billion more shares in stockmutual funds than they bought, and theirnet purchases of stock funds did notrecover to pre-crash levels until 1991. The“experts” were just as shell-shocked: Themanagers of stock funds kept at least 10%of their total assets in the safety of cashalmost every month through the end of1990, while the value of seats on the NewYork Stock Exchange did not regain theirpre-crash level until 1994. A single drop inthe stock market on one Monday inautumn disrupted the investing behaviorof millions of people for at least the nextthree years.

The philosopher William James wrotethat “an impression may be so excitingemotionally as almost to leave a scar uponthe cerebral tissues.” The amygdala seemsto act like a branding iron that burns thememory of financial loss into your brain.That may help explain why a marketcrash, which makes stocks cheaper, alsomakes investors less willing to buy themfor a long time to come.

Fighting Your Fears

When you confront risk, your reflexivebrain, led by the amygdala, functionsmuch like a gas pedal, revving up youremotions. Fortunately, your reflectivebrain, with the prefrontal cortex in charge,can act like a brake pedal, slowing youdown until you are calm enough to make amore objective decision. The best investorsmake a habit of putting procedures inplace, in advance, that help inhibit the hotreactions of the emotional brain. Here aresome techniques that can help you keepyour investing cool in the face of fear:

Get it off your mind. You’ll never findthe presence of mind to figure out what todo about a risk gone bad unless you stepback and relax. Joe Montana, the greatquarterback for the San Francisco 49ers,understood this perfectly. In the 1989Super Bowl, the 49ers trailed theCincinnati Bengals by three points with

only three minutes left and 92 yards –almost the whole length of the field – togo. Offensive tackle Harris Barton felt“wild” with worry. But then Montanasaid to Barton, “Hey, check it out – therein the stands, standing near the exit ramp,there’s John Candy.” The players allturned to look at the comedian, a distrac-tion that allowed their minds to tune outthe stress and win the game in the nick oftime. When you feel overwhelmed by arisk, create a John Candy moment. Tobreak your anxiety, go for a walk, hit thegym, call a friend, play with your kids.

Use your words. While vivid sights andsounds fire up the emotions in your reflex-ive brain, the more complex cues of lan-guage activate the prefrontal cortex andother areas of your reflective brain. Byusing words to counteract the stream ofimages the markets throw at you, you canput the hottest risks in cooler perspective.

In the 1960s, Berkeley psychologistRichard Lazarus found that showing afilm of a ritual circumcision triggeredinstant revulsion in most viewers, but thatthis disgust could be “short-circuited” byintroducing the footage with anannouncement that the procedure was notas painful as it looked. Viewers exposed tothe verbal commentary had lower heartrates, sweated less, and reported less anx-iety than those who watched the filmwithout a soundtrack. (The commentarywasn’t true, by the way – but it worked.)

More recently, disgusting film clips –featuring burn victims being treated andclose-ups of an arm being amputated –have been shown to viewers by the aptlynamed psychologist James Gross.(Although I do not recommend watchingit on a full stomach, you can view theamputation clip at http://psychology.stan-ford.edu/~psyphy/movs/surgery.mov.) Hehas found that viewers feel much less dis-gusted if they are given written instruc-tions, in advance, to adopt a “detachedand unemotional” attitude.

If you view a photograph of a scaryface your amygdala will flare up, settingyour heart racing, your breath quickening,your palms sweating. But if you view thesame photo of a scary face accompaniedby words like angry or afraid, activation

in the amygdala is stifled and your body’salarm responses are reined in. As the pre-frontal cortex goes to work trying todecide how accurately the word describesthe situation, it overrides your originalreflex of fear.

These discoveries show that verbalinformation can act as a wet blanket flungover the amygdala’s fiery reactions to sen-sory input. That’s why using words tothink about an investing decision becomesso important whenever bad news hits. Tobe sure, formerly great investments can goto zero in no time; once Enron andWorldCom started to drop, it didn’t payto think analytically about them. But forevery stock that goes into a total melt-down, there are thousands of other invest-ments that suffer only temporary setbacks– and selling too soon is often the worstthing you can do. To prevent your feelingsfrom overwhelming the facts, use yourwords and ask questions like these:

�Other than the price, what elsehas changed?

�Are my original reasons to investstill valid?

�If I liked this investment enoughto buy it at a much higher price,shouldn’t I like it even more nowthat the price is lower?

�What other evidence do I need toevaluate in order to tell whetherthis is really bad news?

�Has this investment gone downthis much before? If so, would Ihave done better if I had sold out– or if I had bought more?

Track your feelings. In Chapter Five,we learned the importance of keeping aninvesting diary. You should include whatneuroscientist Antoine Bechara calls an“emotional registry,” tracking the upsand downs of your moods alongside theups and downs of your money. Duringthe market’s biggest peaks and valleys, goback and read your old entries from sim-ilar periods in the past. Chances are, yourown emotional record will show you thatyou tend to become overenthusiasticwhen prices (and risk) are rising, and tosink into despair when prices (and risk)




go down. So you need to train yourself toturn your investing emotions upsidedown. Many of the world’s best investorshave mastered the art of treating theirown feelings as reverse indicators:Excitement becomes a cue that it’s time toconsider selling, while fear tells them thatit may be time to buy. I once asked BrianPosner, a renowned fund manager atFidelity and Legg Mason, how he sensedwhether a stock would be a moneymaker.“If it makes me feel like I want to throwup,” he answered, “I can be pretty sureit’s a great investment.” Likewise,Christopher Davis of the Davis Funds haslearned to invest when he feels “scared todeath.” He explains, “A higher percep-tion of risk can lower the actual risk bydriving prices down. We like the pricesthat pessimism produces.”

Get away from the herd. In the 1960s,psychologist Stanley Milgram carried outa series of astounding experiments. Let’simagine you are in his lab. You are offered$4 (about $27 in today’s money) per hourto act as a “teacher” who will help guidea “learner” by penalizing him for wronganswers on a simple memory test. You sitin front of a machine with thirty toggleswitches that are marked with escalatinglabels from “slight shock” at 15 volts, upto “DANGER: SEVERE SHOCK” at 375volts, and beyond to 450 volts (markedominously with “XXX”). The learner sitswhere you can hear but not see him. Eachtime the learner gets an answer wrong, thelab supervisor instructs you to flip thenext switch, giving a higher shock. If youhesitate to increase the voltage, the labsupervisor politely but firmly instructsyou to continue. The first few shocks areharmless. But at 75 volts, the learnergrunts. “At 120 volts,” Milgram wrote,“he complains verbally; at 150 hedemands to be released from the experi-ment. His protests continue as the shocksescalate, growing increasingly vehementand emotional . . . At 180 volts the victimcries out, ‘I can’t stand the pain’ . . . At285 volts his response can only bedescribed as an agonized scream.”

What would you do if you were one ofMilgram’s “teachers”? He surveyed morethan 100 people outside his lab, describ-

ing the experiment and asking them atwhat point they thought they would stopadministering the shocks. On average,they said they would quit between 120and 135 volts. Not one predicted continu-ing beyond 300 volts.

However, inside Milgram’s lab, 100%of the “teachers” willingly deliveredshocks of up to 135 volts, regardless of thegrunts of the learner; 80% administeredshocks as high as 285 volts, despite thelearner’s agonized screams; and 62% wentall the way up to the maximum (“XXX”)shock of 450 volts. With money at stake,fearful of bucking the authority figure inthe room, people did as they were told“with numbing regularity,” wroteMilgram sadly. (By the way, the “learner”was a trained actor who was only pretend-ing to be shocked by electric current;Milgram’s machine was a harmless fake.)

Milgram found two ways to shatter thechains of conformity. One is “peer rebel-lion.” Milgram paid two people to jointhe experiment as extra “teachers” – andto refuse to give any shocks beyond 210volts. Seeing these peers stop, most peoplewere emboldened to quit, too. Milgram’sother solution was “disagreementbetween authorities.” When he added asecond supervisor who told the first thatescalating the voltage was no longer nec-essary, nearly everyone stopped adminis-tering the shocks immediately.

Milgram’s discoveries suggest how youcan resist the pull of the herd:

�Before entering an Internet chatroom or a meeting with your col-leagues, write down your viewsabout the investment you are con-sidering: why it is good or bad,what it is worth, and your reasonsfor those views. Be as specific aspossible – and share your conclu-sions with someone you respectwho is not part of the group.(That way, you know someoneelse will keep track of whetheryou change your opinions to con-form with the crowd.)

�Run the consensus of the herdpast the person you respect themost who is not part of the group.

Ask at least three questions: Dothese people sound reasonable?Do their arguments seem sensi-ble? If you were in my shoes,what else would you want toknow before making this kind ofdecision?

�If you are part of an investmentorganization, appoint an internalsniper. Base your analysts’ bonuspay partly on how many timesthey can shoot down an idea thateveryone else likes. (Rotate thisrole from meeting to meeting toprevent any single sniper frombecoming universally disliked.)

�Alfred P. Sloan Jr., the legendarychairman of General Motors,once abruptly adjourned a meet-ing this way: “Gentlemen, I takeit we are all in complete agree-ment on the decision here. Then Ipropose we postpone further dis-cussion of this matter until ournext meeting to give ourselvestime to develop disagreement andperhaps gain some understandingof what the decision is all about.”Peer pressure can leave you withwhat psychologist Irving Janiscalled “vague forebodings” thatyou are afraid to express. Meetingwith the same group over drinksin everyone’s favorite bar mayloosen some of your inhibitionsand enable you to dissent moreconfidently. Appoint one personas the “designated thinker,”whose role is to track the flow ofopinions set free as other peopledrink. According to the Romanhistorian Tacitus, the ancientGermans believed that drinkingwine helped them “to disclose themost secret motions and purposesof their hearts,” so they evaluatedtheir important decisions twice:first when they were drunk andagain when they were sober.

From YOUR MONEY AND YOURBRAIN by Jason Zweig. Copyright ©2007 by Jason Zweig. Reprinted bypermission of Simon & Schuster, Inc.

VII


ExpertiseO F S O U N D M I N D


One of the more talked about booksamong investment theorists in recentyears has been University of California atBerkeley professor Philip Tetlock's ExpertPolitical Judgment: How Good Is It?How Can We Know? Based on detailedlong-term research, Tetlock scrupulouslyexplains exactly how bad experts are atmaking political and macroeconomic pre-dictions. Not only are experts no betterthan non-experts in predicting futureevents, they're worse on average thaneven crude computer algorithms thatextrapolate the past.

Given that investing is all about mak-ing accurate predictions – for example,about financial performance, companies'strategic choices and industry dynamics –is this indictment of expertise relevant tothe investment process? Is the quest forever more specialized knowledge, at best,not really worth it and, at worst, coun-terproductive?

Common practice – and, to a certainextent, common sense – would indicateotherwise. Most investment firms organ-ize analyst functions by specialty, out ofthe belief that a media expert has a betterchance to accurately handicapNews Corp.'s businessprospects than someone whoknows the banking businessinside and out. Expert energyconsultants are doing a land-office business counseling pro-fessional investors these days,as are firms like GersonLehrman Group, which servesits largely finance-industryclientele with a network of“150,000 subject-matterexperts” across a wide varietyof industries. Lee Ainslie ofMaverick Capital addressedthe current state of affairs in arecent interview (VII,December 22, 2006): “Withthe specialization of the people

we're competing against today, I think it'svery difficult to have a meaningful edgewithout significant depth and expertise.We should know more about every one ofthe companies in which we invest thanany other non-insider.”

As important as specialized knowledgeis for investors, it brings with it severalpotential impediments to sound decisionmaking that should be avoided. While theaverage person is typically overconfidentin his or her ability, experts have beenshown to be even more overconfident, adangerous trait for an investor.Overconfidence not only promotes reck-lessness, it can also limit learning.“Expertise may not translate into predic-tive accuracy, but it does translate into anability to generate explanations for pre-dictions that experts themselves find socompelling that the result is massive over-confidence,” writes Tetlock. It's hard tolearn much from mistakes if you don'tthink you're ever wrong.

Cognitive studies have also shownthat specialization can hinder one's abili-ty to detect change. This is a classic can't-see-the-forest-from-the-trees problem

and explains why industry experts innewspapers, film photography and musicretailing were by and large not the first tofully understand the dramatic changesroiling their industries. Wedded to theirin-depth knowledge, experts can find itdifficult to think about issues in newways. As historian Daniel Boorstin oncesaid, “The greatest obstacle to discoveryis not ignorance – it is the illusion ofknowledge.”

A final danger of an over-reliance onspecialized knowledge: more informa-tion doesn't always mean better deci-sions. One classic academic study askedM.B.A. students in an advanced finan-cial statement analysis course to makeindividual-company earnings forecastsusing three different sets of information:1) “baseline” data, consisting of the pastthree quarters' net sales, share price andearnings per share; 2) the same baselinedata, plus redundant or irrelevant addi-tional information, and 3) the baselinedata, plus non-redundant informationthat should have improved forecastingability.

The result? Forecasting errors wereequally and significantly high-er when additional informa-tion above the baseline wasprovided, whether redundantor relevant. At the same time,confidence levels in the fore-casts rose significantly withany additional information.

“Usually two to three vari-ables control most of the[investment] outcome,” saystwo-time Value InvestingCongress speaker MohnishPabrai in a recent interviewwith The Motley Fool. “Therest is noise. If you can hand-icap how those key variablesare approximately likely toplay out, then you have abasis to do something.” VII

Expert Opinion?Is specialized industry, product or other knowledge overrated as an input to investing success? Let's hear what the … ahem … experts have to say.


ConfidenceO F S O U N D M I N D


Confidence GameIt’s far better to remind yourself to avoid the pitfalls of investor overconfidence than to have the market do it for you.

There’s no question that confidence inone’s investing abilities is a prerequisite tosuccessful investing. To commit your ownand others’ hard-earned capital requiresconviction, and conviction requires confi-dence. But as with fine scotch or pepper-oni pizza, too much of a good thing cancause problems.

Social scientists have confirmed time andagain that people generally overestimatetheir abilities and knowledge. More than80% of drivers think they’re among thesafest 30% of those driving. More than85% of the Harvard Business School class of1994 say they are better looking than theiraverage classmate. When asked at confer-ences to write down how much money theythought they would have at retirement vs.the amount the average person in the roomwould have, money managers and businessexecutives consistently judge that they’llhave about twice the average – also animpossibility, of course.

Healthy self-confidence is generally posi-tive, as it can lead to great achievement andcertainly contributes to a happier life. Butwhen it comes to managing money, a consis-tent dose of humility is an invaluable asset.The market can be unforgiving when over-

confidence results in too much trading, slop-py analysis, lack of follow-through andexcessive risk-taking.

Brad Barber and Terrance Odean of theUniversity of California, Davis, in extensivestudies of individual trading behavior, foundthat investors generally overestimate boththe precision of their knowledge about asecurity’s value, as well as the probabilitytheir assessment is more accurate than theassessments of others. The result, they say, ismore active trading – “I’ve got to act on theadvantage I have” – but not better perform-ance. In fact, “those who trade the mostrealize, by far, the worst performance,”Barber and Odean conclude.

Overconfidence can also lead to analyti-cal short-cuts. A recent study by Lin Peng ofBaruch College and Wei Xiong of PrincetonUniversity found that overconfident, time-pressed investors put too much weight onmarket- or sector-level information and notenough on firm-specific data. The authorsargue that this was a key contributor to theInternet-stock bubble, as investors ignoredcompany specifics and made judgmentsalmost solely on the industry as a whole –much to their eventual chagrin.

Complacency about existing holdings

is another risk. It’s natural, of course, tobecome more certain about any given idea’ssoundness as the investment thesis plays out.But if this certainty results in less-diligentongoing analysis and monitoring of yourholdings, you can be left unprepared whencircumstances change. “I’ve learned not tofall in love with either the idea or my seem-ing brilliance,” says MLF Investments’ MattFeshbach (see interview, page 1). “I’ve donethat in a few instances at great cost.”

The best guards against investor hubris?Benjamin Graham’s discipline of investingwith a significant “margin of safety” is agreat start. The consequences of overesti-mating a company and your ability to ana-lyze it are greatly diminished when you’repaying a lot less for it than your analysisshows it’s worth.

Second opinions are also critical, so testyour thinking out on as many informed anddispassionate listeners as possible. In addi-tion to the obvious benefits of hearing alter-native viewpoints or questions you didn’tthink of, the simple act of articulating anidea is a powerful check on the thorough-ness of your analysis.

Make sure to have a disciplined investingapproach and stick with it. Many greatinvestors have a written checklist they gothrough in analyzing ideas: Is this within mycircle of competence? Is this a good busi-ness? Do I give management high marks? Isthe stock really cheap? If you’re already in astock, don’t waver in your approach as theprice moves up or down. “I try to keep aneutral attitude and stay rational whetherthe stock is going up or down,” advises MattFeshbach. “I’m constantly assessing risks inthe business model … [and] whether it’s[right now] an opportunity or a mistake.”

Above all, counsels Amit Wadhwaney ofThird Avenue Management (see interview,page 1), stay within yourself: “Just avoidwhat you can’t totally get your mindaround,” he says. “It’s just not worth it.There will be plenty of other things to investin – keep the cash for then.” VII“When I said none of us were infallible, I didn’t mean you sir.”


Self-InterestO F S O U N D M I N D


Whose bread I eat, his song I singA heightened sensitivity to the biases inherent in pursuing self-interest –one’s own and others’ – is a valuable trait of successful investors.

“I think I’ve been in the top five per-cent of my age cohort almost all myadult life in understanding the power ofincentives,” says Berkshire Hathaway’sCharlie Munger in the recently pub-lished Poor Charlie’s Almanack, “andyet I’ve always underestimated thatpower.”

The power of self-interest in businessand economics is, of course, well estab-lished. "It is not from the benevolence ofthe butcher, the brewer, or the baker thatwe expect our dinner,” wrote AdamSmith in The Wealth of Nations, “butfrom their regard to their own interest.”Michael Douglas, as corporate raiderGordon Gekko in the movie Wall Street,opined somewhat more coarsely: “Greedis good. Greed works. Greed clarifies,cuts through and captures the essence ofthe evolutionary spirit. It's all aboutbucks. The rest is conversation."

As established as the concept is thatincentives motivate behavior, investorsare frequently blind to the excesses thatcan develop. How else to explain thedeafening silence from invest ors as com-panies awarded ever more extravagant

perks and stock-option packages tomanagers and employees during the1990s? How else to explain the wide-spread basing of investment decisions onthe opinions of ever more compromisedWall Street analysts during the Internetboom? More recently, how else toexplain the explosive growth of intere-stonly, little-or-no-money-down mortgageloans pushed by mortgage lenders to buyresidential real estate at ever-inflatedprices? When prices are rising, sensitivityto conflicts of interest falls – with oftenunfortunate results.

Successful investors tend to bewellattuned to the power, and biases, ofselfinterested behavior. In his interviewin this issue (see p. 1), Legg Mason’s BillMiller recounts how early in his career apotential client rejected one of hisinvestment ideas because Miller could-n’t explain why the stock would outper-form the S&P 500 over the followingnine months. The prospective clientexplained: “There’s a lot of performancepressure in this business, and performingthree to five years down the road doesn’tcut it. You won’t be in business then.Clients expect you to perform rightnow.” To profit from this bias to per-form in the short-term that persiststoday, Miller focuses his attention onbets that are expected to fully play outmore than a year hence. “The market isless efficient beyond the next 12months,” he says.

This is not to say that money-man-agers’ fixation on short-term perform-ance is irrational or not in their selfinter-est. In fact, funds with the greatest netnew asset growth at any given time tendto be those with top 12-month records.But this only reinforces the mispricingthat can result from a short-term bias,creating other opportunities to findvalue.

For example, investors with shortertime horizons are more likely to react to

bad news by selling than are long-terminvestors. Resulting less-than-rationalprice declines can provide buying oppor-tunities – as Warren Buffett counsels, “begreedy when others are fearful.”

Equally important for investors is aclear understanding of the incentives ofmanagers in their portfolio companies.“It’s almost impossible to understate theimportance of having the right incentivesin business,” says Mark Sellers of SellersCapital LLC (see interview, p.1). “Thewrong incentives can cripple a business.”Though not always readily available, themore knowledgeable investors are aboutthe incentives of those running the com-panies in which they own a stake, themore informed the investment decisionthey make. What percentage of top man-agement’s total compensation is salary vs.bonus vs. equity? What is the relativefocus on short-term vs. longterm in deter-mining pay? How closely tied is incentivecompensation to metrics over which man-agers truly have control? What account-ing policies and controls are in place topromote and monitor specific corporatebehaviors?

While change is slow in coming, pro-gressive companies are instituting incen-tives that better align with the long-termcreation of shareholder wealth. BerkshireHathaway avoids all incentives based onshort-term targets. Restricted-stock pro-grams at Microsoft and Amazon.comlimit the threats of misbehavior fosteredby wildly lucrative stock-option plans.White Mountains Insurance awards stockoptions with strike prices that continue toincrease a set percentage every year.Morningstar pays bonuses based on divi-sional returns on capital in excess of thecost of capital.

No system can do away with theinevitable excesses that occur from advi-sors, investors and managers acting intheir self-interest. Forewarned, however,is forearmed. VII

“This is no time to be thinking

about ourselves, Matthews.

So, I’ll see you at the meeting

on Monday?”


StoriesO F S O U N D M I N D


Value investors, rightly so, have anaversion to what are colloquially called“story stocks.” These are investmentspredicated far more on generalities andhype – think Internet stocks in the late1990s – than on facts and substance. Thatthe Internet was “changing the world”wasn’t necessarily wrong, just an insuffi-cient premise upon which to base soundinvestment decisions.

Stories, however, do play a central rolein how we make decisions, investment orotherwise. Social psychologists call it“explanation-based decision making,”which involves summarizing disparateand often jumbled facts into story form –a coherent, logical sequence, with inferredcausal linkages as the “glue” holding thestory together. The story then becomes thebasis for making the final decision, ratherthan the original raw evidence.

Given our natural tendency to explainthings in terms of stories, it’s not surpris-ing that they can be powerful decisionmotivators. In one landmark study, par-ticipants acting as jurors were asked todeliver a guilty or not-guilty verdict in amurder trial, based on a 100-sentence summary of the trial.Half the 100 statements weremade in support of the prosecu-tion and half for the defense.

Each jury in the study heardall 100 statements of evidence,the only difference beingwhether the statements werepresented in logical story orderor in the order in which witness-es were called. When the prose-cution evidence was presented instory order and the defense evi-dence in witness order, 78% ofjurors returned a guilty verdict.When the presentation style wasreversed – again, with the exactsame evidence – only 31% ofjurors voted guilty!

In an investment context, the relianceon building stories can fuel one of themore pervasive behavioral biases that dis-rupts rational decision making: the ten-dency to seek out and rely on only infor-mation that confirms pre-existing opin-ions or decisions. (Caltech social scientistLeeat Yariv calls it the “I’ll see it when Ibelieve it” phenomenon.) The earlier astory is constructed to fit the facts, thegreater the risk contradictory evidencewill be ignored or explained away.

Cornell marketing professor J. EdwardRusso showed the insidiousness of theconfirmatory bias in a study in which heoffered students a choice between tworestaurants. The first group of studentsheard a complete description of eachrestaurant, crafted intentionally so thatroughly equal numbers of students wouldprefer each one. The second group of stu-dents was presented the exact same infor-mation, but the equivalent features of thetwo restaurants were given one pair at atime. After each piece of information (forexample, that one is a seafood restaurantand the other is a steakhouse), the stu-

dents were asked to list their preference.In this group, the students showed muchmore distinct differences of opinion, withthe decisive factor being how they ratedeach restaurant on the very first compari-son given – overall preferences matchedthe preference on the first pair of features84% of the time. In even the smallestdecisions, people anchor on their earliestconclusions and are loathe to budge.

How to benefit from a well construct-ed investment “story,” without the down-side? Here are a few recommendations:

Avoid plot gaps. The best investorsoften employ checklists for each idea, toensure that no data-gathering shortcutsare made. General impressions alsoshould not be mistaken for facts – “As thesaying goes,” says Legg Mason’s MichaelMauboussin, “the plural of anecdote isnot evidence.”

Pursue alternative story lines. The sim-ple act of reframing the investment ques-tion from “Why should I buy this stock?”to “Why should I not buy this stock?” canbe a helpful device to insure more com-plete analysis. Looking just for reasons to

buy often leads to an emphasis onpositives over negatives – a potentialrecipe for investment disaster.

Don’t forget the epilogue.Investors, to their detriment, oftenignore second- and third-order conse-quences. An investment thesis is notcomplete without an understandingof how a consequent change ofbehavior by competitors, regulatorsor even employees could impactfuture events.

Don’t rush to a happy ending.Speed in arriving at conclusions is notnecessarily a virtue. As BenjaminGraham put it in The IntelligentInvestor: “While enthusiasm may benecessary for great accomplishmentselsewhere, on Wall Street it almostinvariably leads to disaster.” VII

The Whole StoryIt’s perfectly natural to create “stories” to facilitate investment decision-making. The problem comes when the story-telling gets in the way of relevant facts.

“Don’t bother me with facts. Tell me what I want to hear.”


CreativityO F S O U N D M I N D


Thomas Edison’s famous quote that“Genius is 1% inspiration and 99% per-spiration” is a sentiment shared by manywhen it comes to investing. As keys tosuccess, investors tend to credit discipline,focus and analytic rigor over creativity.“Investing is a simple business and everytime we try to overcomplicate it we havelower returns,” says one of the bestmoney managers we know, off the record.“Being creative just to be creative canwaste research time, liquidity andresources.”

Is investing a creative process? Hard-charging money managers resist definingwhat they do in terms usually reserved forartists. But if one defines a creative person– as does the American Heritage diction-ary – as “one who displays productiveoriginality,” there’s little doubt that suc-cessful investors and many others fit themold. “Clearly, creativity is not limited toartists,” writes business historian MauryKlein in his book on the greatest entrepre-neurs in history, The Change Makers.“The scientist displays it in connectingideas or observations and transformingthem into insights or actions; so do inven-tors, philosophers, mathematicians, busi-nessmen and athletes.”

Charlie Munger’s use of “multiplemental models” to draw investing insightfrom the acquired wisdom in many disci-plines is an example of such creativity atwork. As Munger has described it: “Youhave to realize the truth of biologistJulian Huxley’s idea that, ‘Life is just onedamn relatedness after another.’ So youmust have the models and you must seethe relatedness and the effects from therelatedness.”

Legg Mason’s Bill Miller is anotherstrong proponent of using more than justanalytical firepower to drive investmentsuccess. That’s why he is fascinated bythings like the adaptive learning of bees,or what the fossil record explains abouthow organisms evolve. As he explained in

our interview with him earlier this year,“If you just do what other people do, youget the results that other people get.”

Fostering creativity requires effort, ofcourse. Because the ability to discoveruseful patterns typically improves withthe number of observations made, thefirst step is to devote time to diverse linesof inquiry. As equity strategist MichaelMauboussin of Legg Mason has said:“There is strong evidence that the leadingthinkers in many fields – not just invest-ing – benefit from input diversity.”Investors should allocate specific time toexploring new ideas, he says, “even at therisk of wasting time on intellectual cul-de-sacs.” Charlie Munger counsels readingeverything you can: “In my whole life, Ihave known no wise people who didn’tread all the time – none, zero.”

Keeping an open mind about newobservations is key. Humans naturallyorganize experiences and the relation-ships among them as efficiently as possi-ble, to minimize the energy used in pro-cessing, storing and recalling informa-tion. Writes applied psychologist Edwardde Bono in his pioneering book on devel-oping individual and collective creativity,

Six Thinking Hats: “From the past wecreate standard situations. We judge intowhich ‘standard situation box’ a new sit-uation falls. Once we have made thisjudgment, our course of action is clear.Such a system works very well in a stableworld [but] in a changing world the stan-dard situations may no longer apply. Weneed to be thinking about ‘what can be,’not just ‘what is.’”

Processing novel ideas that requirebreaking down the “standard situationboxes” we’ve constructed isn’t particular-ly easy or natural, which is why manyideas get dismissed out of hand – short-circuiting the process of creative thought.“Creativity starts with some problem orneed and moves in various ways througha series of stages, consisting of informa-tion gathering, digestion of the material,incubation, sudden inspiration, and,finally, implementation,” writes StanfordBusiness School professor Michael Ray inhis book Creativity in Business. Withoutplenty of ideas “incubating,” break-through thinking is much less likely.

Business innovators often cite an addi-tional requirement for creativity, which,for lack of a better description, is “quiettime.” Albert Einstein often mused abouthis getting his best ideas in the morningwhile shaving. In fact, researchers havefound that the presence of a calm mind –uncluttered by the constant processingrequired by daily life – is far more likelyto produce “eureka” moments of inspira-tion than a busy one.

And what of Edison’s quote aboutgenius? To be sure, creativity isn’t possi-ble without perseverance, effort and, ofcourse, the right attitude. Edison wentthrough more than 9,000 experiments inhis quest to create the incandescent lightbulb. When derided by colleagues forwhat they perceived to be the foolishquest, he responded: “I haven’t evenfailed once; 9,000 times I’ve learned whatdoesn’t work.” VII

Inspiration or Perspiration?Successful investing is as much a creative process as it is a disciplined, analytical one – even if some investors don’t want to admit it.


INSIGHT

TACKLING UNCERTAINTY WITH CREATIVE INSIGHT

In our recent interview with him, Yale economist Robert Shiller hadthis sage advice for investors: "One key lesson is to acknowledge thecomplexity of the world and resist the impression that you easilyunderstand it. People are too quick to accept conventional wisdom,because it sounds basically true and it tends to be reinforced by boththeir peers and opinion leaders, many of whom have never looked atwhether the facts support the received wisdom."

The superstar investors featured in Value Investor Insight haveproven time and again their ability to buck conventional wisdomand tackle complexity with diligent and creative research, whichthey generously share in each of our issues. To invest successfully inuncertain times requires just such deep insight, and Value InvestorInsight delivers it every month.

See for yourself and subscribe today! In addition to monthlyissues of VII, you’ll also receive Bonus e-mails containing articles,research, investor letters and other information that we believe canhelp you make better-informed investment decisions.

We look forward to welcoming you to Value Investor Insight!

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