Big Mistakes: The Best Investors and Their Worst Investments (Bloomberg)
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By three methods may we learn wisdom: First, by reflection, which is noblest; second, by imitation, which is easiest; and third by experience, which is the bitterest. —Confucius
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The most important thing successful investors have in common is worrying about what they can control. They don't waste time worrying about which way the market will go or what the Federal Reserve will do or what inflation or interest rates will be next year. They stay within their circle of competence, however narrow that might be. Warren
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Buffett said, “What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know.”
CHAPTER 1: Benjamin Graham
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In my nearly fifty years of experience in Wall Street I've found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do; and that's a pretty vital change in attitude. —Benjamin Graham
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These rules all boil down to what Graham referred to as a “margin of safety.” Graham defined this as “the discount at which the stock is selling below its minimum intrinsic value.”
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Graham taught his students and his readers that prices fluctuate more than value, because it is humans who set price, while businesses set value.
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In the four years from 1929 to the bottom in 1932, Graham lost 70%. If such a careful and thoughtful analyst can lose 70% of his money, we should be very careful to understand that while value investing is a wonderful option over the long term, it is not immune to the short‐ term vicissitudes of the market.
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It's critically important to be aware of value, but it's more important not to be a slave to it. Graham taught us that there are no iron‐ clad laws in finance and that cheap can get cheaper.
CHAPTER 3: Mark Twain
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Our natural tendency is to hold onto the losers longer than we should, because in doing so, we are deferring defeat and keeping our ego intact.
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“There are two times in a man's life when he should not speculate, when he can't afford it, and when he can.”
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The best way to avoid the catastrophic losses is to decide before you invest how much you're willing to lose, either in percentage or dollar terms. This way, your decisions will be driven by logic rather than fear—or some other emotional attachment to a position.
CHAPTER 4: John Meriwether
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Investment success accrues not so much to the brilliant as to the disciplined. —William Bernstein
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In 1720, as shares of the South Sea Company began to rise and hysteria swept the streets of London, Newton found himself in a precarious situation. He bought and sold the stock, earning a 100% return on his investment. Except shares of the South Sea Company rose eightfold in under six months, and they did not stop going higher just because he decided to collect his profits. Unable to cope with the feelings of regret, Newton jumped back into the stock with three times the amount of his original purchase. He reentered as shares approached their apex and instead of doubling his money, he would lose nearly all of it. When the bubble burst, it took just four weeks for prices to plummet 75%. This left Newton despondent, and it is said that he could not stand to hear the words “South Sea” for the rest of his life. He got an expensive lesson in just how far intelligence goes when attempting to turn money into even more money. When asked about the direction of the markets, Newton replied, “I can calculate the motions of the
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heavenly bodies, but not the madness of the people.” Isaac Newton actually was one of the smartest people to ever walk the earth, and not even he was able to resist the sight of other people getting rich without him.
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One of the problems many investors face is that we all feel we have a little Isaac Newton in us. We all feel we're above average.
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As Charlie Munger once said, “The iron rule of life is that only 20% of people can be in the top fifth.”
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This means that there are between four and five million brilliant adults living in the United States alone that would qualify for this prestigious society. When you go to your computer screen to buy or sell a stock, there are a lot of these super humans waiting to take the other side of your trade.
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This is one of the hardest things for newer investors to come to grips with, that markets don't compensate you just for being smart. Raw brainpower is only one prerequisite to even give yourself a chance of having a positive investment experience. Being smart alone does not determine investment results because markets are not linear. Most formulas eventually fail, if they ever even work at all.
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Long‐ Term Capital Management opened their doors in February 1994 with $ 1.25 billion, the largest hedge fund opening ever up until that point in time. Their performance was strong right out of the gate. In the first 10 months that they were open, they earned 20%. 10 In 1995, the fund returned 43%, and in 1996, they earned 41% in a year in which their profits totaled $ 2.1 billion:
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At one point, they had $ 1.25 trillion in open positions and they were levered 100: 1. This leverage would lead to one of the largest disappearing acts of wealth the world has ever seen.
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Their biggest mistake was trusting that their models could capture how humans would behave when money and serotonin are simultaneously exploding. Peter Rosenthal, Long‐ Term's press spokesman once said,
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“Risk is a function of volatility. These things
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obvious: Intelligence combined with overconfidence is a dangerous recipe when it comes to the markets.
CHAPTER 6: Michael Steinhardt
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Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else. —Seth Klarman
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One of the keys to successfully managing your money is to accept, like Buffett did, that there will be times when your style is out of favor or when your portfolio hits a rough patch. It's when you start to reach for opportunities that you can do serious damage to your financial well‐ being. Michael Steinhardt and his investors learned this lesson in 1994.
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The temptation to veer off your path never disappears because there is always something going up that you wish you owned, and something going south that you wish you didn't own. For example in 2008 when US stocks fell nearly 40%, long‐ term US government bonds were up 26%. This is why the behavior gap, the idea that investors underperform not only the market but also their own investments, can shrink but will never fully close.
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Bad behavior is one of the greatest dangers investors face, and traveling outside your circle of competence is one of the most common ways that investors misbehave. It's not important how wide your circle of competence is, but what is critically important is that you stay inside it. Knowing what you don't know and having a little discipline can make all the difference in the world.
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This isn't to say you should never venture outside your comfort zone, after all, if you never expand your horizons, you'll never
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learn. But if you are going to invest in areas that you're less familiar with, read the fine print, keep your investments small at first, and limit your losses to fight another day.
CHAPTER 7: Jerry Tsai
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Humphrey B. Neill, author of The Art of Contrary Thinking, said it best: “Don't confuse brains with a bull market.” The idea that we confuse our ability to select above‐ average stocks in a market that lifts all boats is so pervasive that there's a name for it, attribution bias.
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“Attribution bias refers to the tendency of people to attribute their successes to their own ability and their failures to external ‘unlucky’ forces.”
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A rising market lifts all ships, and Tsai's investors learned a very important lesson: Don't confuse brains with a bull market!
CHAPTER 8: Warren Buffett
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It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. —Mark Twain
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When it comes to the future, which is by definition unpredictable, we tend to believe we know more than we actually can. One of the ways that this manifests itself in investing is in something called the endowment effect. After consumers or investors make a purchase, we value this new possession more than we did before it was ours.
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Imagine you're wagering on a football game in which the two teams competing are of no rooting interest to you. It's a coin toss. You go back and forth several times, but finally decide to pull the trigger on the team with the less talented quarterback but a stronger defense. After you've walked to the counter and placed your bet, you'll immediately feel much better about your decision than before you parted with your dollars. Kahneman, Knetsch, and Thaler documented this in an experiment in their 1991 paper, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias.” 1
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The main effect of this “endowment,” the authors found, “is not to enhance the appeal of the good one owns, only the pain of giving it up.”
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Confidence grows exponentially once you've decided on something you were previously unsure about.
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Overconfidence is so ingrained in our DNA that even if we're aware of it, shielding ourselves from it becomes supremely difficult. Robert Shiller has written, “Our satisfaction with our views of the world is part of our self‐ esteem.” 2 This applies to everyone, but especially to people in the financial business. David Dreman shows how overconfident financial analysts are in his book, Contrarian Investment Strategies: Analysts were asked for their high and low estimates of the price of a stock. The high estimate was to be the number they were 95 percent sure the actual price would fall below; the low estimate was the price they were 95 percent sure the stock would remain above. Thus, the high and low estimates should have included 90 percent of the cases, which is to say that if the analysts were realistic and unbiased, the number of price movements above and below the range would be 10 percent. In fact, the estimates missed the range 35 percent of the time, or three and a half times as often as estimated.
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Psychologists Dale Griffin and Amos Tversky wrote, “Intuitive judgments are overly influenced by the degree to which the available evidence is representative of the hypothesis in question.”
CHAPTER 9: Bill Ackman
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I once saw the Nobel Prize–winning psychologist Daniel Kahneman say, “Ideas are part of who we are. They become like possessions. Especially publicly. I mean, flip flopping is a bad word. I love changing my mind!” This attitude stands in stark contrast to most investors, who loathe to do few things more than kill a previously held belief. Our inability to process information that challenges our ego is one of the biggest reasons why so many investors fail to capture market returns.
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Most of the gains in the stock market come from the giant winners. In fact, most stocks downright stink. Four out of every seven common stocks in the United States have underperformed one‐ month Treasury bills.
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The key to successful investing, especially when you're a contrarian, is to have people agree with you later.
CHAPTER 10: Stanley Druckenmiller
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In a winner's game the outcome is determined by the correct actions of the winner. In a loser's game, the outcome is determined by mistakes made by the loser. 1 —Charlie Ellis
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Charlie Ellis wrote this in his 1998 classic, Winning the Loser's Game.
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The behavior gap is pervasive because the amateur investor gets fooled by averages. They're bombarded with information and literature suggesting that they can or should expect average returns, and they mistake average return for expected return. We frequently hear “stocks typically return between eight and ten percent a year.” Well, over multiple decades, you could say they'll compound at between 8 and 10%, but the last time the Dow returned between 8 and 10% was 1952. There is a lot of space between what you expect the market to do and what it actually does, and this is where unforced errors lurk.
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Stocks tend to swing in a wide range, spending a lot of time at the fringe and little time near the average, delivering maximum frustration. This sort of erratic behavior transfers money from the amateur's pocket and into the professional's.
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The amateur investor is most likely to make unforced errors at market tops and bottoms
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because, at the point of maximum optimism or pessimism, the story will have permeated throughout every corner of popular culture.
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Great investors do things differently than the rest of us. They buy what others don't want and sell what others crave. They're intimately familiar with the similarities between buying stocks and betting on the ponies. Michael Mauboussin says, “Fundamentals are how fast the horse runs and expectations are the odds.” 4 This is what Howard Marks refers to as second‐ level thinking, and it escapes most of us. The casual investor thinks a good company makes for a good stock, without giving consideration to the fact that the majority of investors share a similar opinion. Perhaps, like‐ minded investors have pushed the price of a good company into that of a great company, making it less than it appears at first blush.
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Druckenmiller reportedly earned 30% a year for 30 years by throwing conventional wisdom in the trash can: The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I'm here to tell you I was a pig. And I strongly believe the only way to make long‐ term returns in our business that are superior is by being a pig. 8
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There is a big difference between a lousy investment and an unforced error. Your
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thesis was wrong, or what you thought was already in the price; things like this are all part of the game. But oftentimes, we'll act impulsively, even when we “know” what we're doing is a mistake. Few people are spared from unforced errors, and the way they usually manifest themselves is because we can't handle people making money while we aren't. Munger once said: The idea of caring that someone is making money faster [than you] is one of the deadly sins. Envy is a really stupid sin because it's the only one you could never possibly have any fun at. There's a lot of pain and no fun. Why would you want to get on that trolley? 24
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Druckenmiller knew exactly what he was doing –he just couldn't stop himself. “I bought $ 6 billion worth of tech stocks, and in six weeks I had lost $ 3 billion in that one play. You asked me what I learned. I didn't learn anything. I already knew that I wasn't supposed to do that. I was just an emotional basketcase and couldn't help myself. So maybe I learned not to do it again, but I already knew that.”
CHAPTER 11: Sequoia
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Your six best ideas in life will do better than all your other ones. —Bill Ruane
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There's an old adage in finance, “Concentrate to get rich, diversify to stay rich.”
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Every investment strategy that doesn't deviate from its core tenets, whether its value or trend following or anything else, will have long periods of time where it looks and feels foolish.
CHAPTER 12: John Maynard Keynes
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With investing, the odds are determined by investor's expectations, and they're not published on any website. They're not quantifiable because they're subject to our manic highs and depressive lows. You can have all the information in the world, but humans set prices, and decisions are rarely made with perfect information.
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Few people understood the disconnect between what the market should do and what it actually does better than one of the most infamous names in all of finance, John Maynard Keynes. He once said that: Professional investment may be likened to those newspaper competitions in
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which the competitors have to pick out the six prettiest faces from a hundred photographs… each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors… We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.
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Keynes's The General Theory of Employment, Interest and Money is one of the most influential things ever written in finance. Jack Bogle wrote, “That chapter, laced with investment wisdom, made a major impact on my 1951 senior thesis… Keynes the investor, not the economist, has been the inspiration for my central investment philosophy.” 7 Warren Buffett said, “If you understand chapters 8 and 20 of The Intelligent Investor and chapter 12 of The General Theory, you don't need to read anything else and you can turn off your TV.” 8 George Soros wrote, “I fancied myself as some kind
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Anybody who has ever tried his or her hand in the market has had the feeling that Keynes did in the 1920s. We open up a newspaper and start constructing top‐ down views of how the world is functioning.
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But figuring out how interest rates affect currencies and how labor affects prices and how all of this affects our investments is tantamount to putting together a three dimensional puzzle where the pieces are always moving.
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Everybody likes to think they're long‐ term investors, but we don't pay enough attention to the fact that life is lived in the short term. In A Tract on Monetary Reform, Keynes wrote, “This long run is a misleading guide to current affairs. In the long run we are all dead.”
CHAPTER 13: John Paulson
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“Did the stock double for reasons you thought it would? What was the basis of your decision!?!” Money earned by luck is indistinguishable from money earned by skill.
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Investing is a fierce game of brains and desire. The people you're competing with have endless resources and unlimited access to information, so it's far more likely for you to get lucky than it is to consistently run faster than the competition.
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There are a few problems, problems that all of us hope for, when you win big in the market. After a huge score, ordinary gains no longer move the emotional needle. Paulson, like most people who experience gigantic success, quickly went searching for his next big trade. “It's like Wimbledon. When you win one year, you don't quit; you want to win again.” 15 The other issue is that it's virtually impossible to have fantastic success and keep your ego in check. We're all overconfident to begin with, and huge gains make our feet levitate off the ground.
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The 50 largest hedge funds do 50% of all NYSE listed stock trading, and the smallest one spends $ 100 million annually buying information.
CHAPTER 14: Charlie Munger
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He is fond of inverting the problem, reverse engineering, and thinking things backward. For example, “All I want to know is where I'm going to die so I'll never go there.” At the 2002 annual Berkshire Hathaway shareholder's meeting he said, “People calculate too much and think too little.”
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“we have three baskets: in, out, and too tough.” 1 Investors would be wise to follow his advice: “If something is hard, we move onto something else. What could be simpler than that?” 2
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The best lesson investors can learn from one of the best to ever do it is that there are no good times without the bad times. Big losses are in the fabric of long‐ term investing. And if you're not willing to accept them, you will not harvest the long‐ term returns that the market has to offer. Munger once said: If you're not willing to react with equanimity to a market price decline of 50 percent or more two or three times a century, you're not fit to be a common shareholder and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations. 6
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You must react to losses with equanimity. The time to sell an investment is not after it has declined in price. If this how you invest, you're destined for a long life of disappointing returns. Learn from one of the best whoever did it, and do not attempt to avoid losses. It cannot be done. Instead, focus on making sure that you're not putting yourself in a position of being a forced seller. If you know that stocks have gotten cut in half before, and undoubtedly will again in the future, make sure you don't own more than you're comfortable with.