The mistake family is so large that there is always one of them around
We need to touch on Kahneman’s Illusion of Skill or Illusion of Validity, before we go further. The idea is that a person or group of people with supposed experience and special knowledge can convince themselves that they possess skill and expertise even when they don’t. Kahneman has a special section in one chapter devoted to The Illusion of Stock-Picking Skill. (Kahneman, Thinking Fast and Slow, 2011)p.212.
He makes it clear that the only measure of true skill or expertise is ‘persistent achievement’. The achievement of money managers can be measured against a variety of benchmarks. The most popular benchmark for a balanced and diversified stock portfolio is the S&P 500. However, most professionals in the investment industry underperform against the S&P 500. Kahnemans thinks of this as a real puzzle; that “a major industry appears to be built largely on an ‘illusion of skill’. (Kahneman, 2011)p.212.
As we know, almost all investors seeking to take advantage of outperformance of stocks against other asset classes over the long haul would be well advised not to put their money with a professional active money manager but put it in an unmanaged index fund.
Aim for superior results
What should our ambition be? Ben Graham wrote in The Intelligent Investor: “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” (Graham, 1973) p. 287. Inexpensive index funds will provide ‘satisfactory’ returns.
The individual investor with an ambition to achieve ‘superior results’ should take this to heart. Not only is it extremely difficult to develop the skill to beat the market, but (and this is crucial), the subjective confidence we have in our personal level of skill is absolutely no guide as to whether we actually have the skill. Kahneman tells us that we typically construct a coherent story which leads to our self-confidence and we are blinded to objective evidence of our true expertise. The investment industry is in this mode. Individual investors are also prone to it.
This is why it is so important to track one’s performance and compare it to benchmarks. If an investor can’t beat the market they are further ahead to invest in inexpensive index tracking funds.
My tentative conclusion at this point is that superb judgment in investing, such as possessed by John Templeton, can be developed over many years by deliberate practice. But, many investors, including many professionals are convinced they have a high level of expertise which, in fact, they do not possess, even if they firmly believe it.
What does successful investing require?
In a speech in 1974 Ben Graham remarked that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.”
Understanding and internalizing investment psychology is an important component. I have written some 14 posts about the impact of behavioral biases and cognitive errors on investing. See here for the introductory post and links to the others. Overcoming those hurdles in investing is one of the critical steps to developing the skill and expertise to achieve superior returns. I believe that the investor who can manage their own psychological foibles and take advantage of Mr. Market’s foibles will have an investing edge to achieve superior returns.
I am convinced that investors can become expert by 1) reading the very best books about investing including behavioral finance, and 2) deliberate and careful practice in the real world – in the school of hard knocks.
So we might ask ourselves whether we can all become Warren Buffetts if we work at it hard enough; highly unlikely. But that doesn’t matter. Our objective is to achieve superior returns. That is certainly achievable. But we have to take some lumps in the real world as we progress.
As Confucius said: “By three methods we may learn wisdom: First, by reflection, which is noblest; second, by imitation, which is easiest; and third by experience, which is the bitterest”.
The bitterest way to learn
It is worthwhile reflecting on the ‘bitterest’ way to learn. It applies in spades in investing. Make no mistake, in investing we do make mistakes
In 1923 Edwin Lefevre, a newspaper reporter, published a book called Reminiscences of a Stock Operator. In the book the operator was named Larry Livingston. In real life he was Jesse Lauriston Livermore, one of the most extraordinary stock market and commodities speculators of all time. The book is a delight to read and one of the most popular investment books of all time.
It was republished by John Wiley & Sons Inc. in 1993. It contains many gems of investment wisdom that are equally applicable to investing as they are to trading. The quotes are so colorfully expressed that they make their points memorably. Lefevre was a gifted reporter and while I refer to what Lefevre wrote, the words captured so naturally are really those of Jesse Livermore. (Lefevre, 1923,1993)
Wisdom from Jesse Livermore
Lefevre wrote, in the words of Livermore: “The recognition of our mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a licking, you do not hanker for a second dose, and, of course, all stock-market mistakes wound you in two tender spots – your pocketbook and your vanity.”
“Of course, if a man is both wise and lucky, he will not make the same mistake twice. But he will make any one of the ten thousand brothers or cousins of the original. The Mistake family is so large that there is always one of them around when you want to see what you can do in the fool-play line.” (Lefevre, 1923,1993)p.119.
“All my life I have made mistakes, but in losing money I have gained experience and accumulated a lot of valuable don’ts.” (Lefevre, 1923,1993)p.36.
“After my May ninth mishap I plugged along, using a modified but still defective method. If I hadn’t made money some of the time I might have acquired market wisdom quicker.” (Lefevre, 1923,1993)p.43.
“Every time I found the reason for a loss or the why and how of another mistake, I added a brand-new Don’t! to my schedule of assets.” (Lefevre, 1923,1993)p.70.
These quotes exemplifies an approach to life. Many people treat every failure as evidence that they just can’t succeed. The resilient investor will look at every mistake as a learning opportunity.
Failure and the great investors
Proctor writes about John Templeton: “To some people such failures are regarded as defeat, whereas to others they have become challenges and opportunities to learn. John Templeton falls into this latter category.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.122.
Phillip Fisher, who Warren Buffett credits with being a major influence in his, Buffett’s, approach to investing wrote:
“Making some mistakes is as much an inherent cost of investing for major gains as making some bad loans is inevitable in even the best run and most profitable lending institution. The important thing is to recognize them as soon as possible, to understand their cause, and to learn how to keep from repeating the mistakes.” (Fisher, 1958,1996)p.276.
Repeating the same mistakes
Of course one of the toughest things is to periodically learn the same lesson over again. The lesson here is that we will often repeat mistakes. But, that is simply Human. How often do we slap ourselves and self-talk that we have learned that lesson before? At such moments swearing is permitted.
The best time to learn a lesson from bitter experience is while the experience is fresh in our memory. The subprime crisis that came to a head in 2008, with layered-on credit crunch and sovereign debt default threat, was traumatic but also a great time to learn! The covid-19 pandemic is a crisis but investors can learn from it.
Lefevre wrote: “If somebody had told me my method would not work I nevertheless would have tried it out to make sure for myself, for when I am wrong only one thing convinces me of it, and that is, to lose money. And I am only right when I make money.” (Lefevre, 1923,1993)p.38.
This assertion is not really true as we will see in the chapter on luck in investing. Your method can be wrong and still make money sometimes, with luck. It is a normal human tendency to blame bad luck for losses and attribute gains to superior skill. Our losses are squarely our responsibility, whether caused by good or bad luck. It is through taking responsibility that we can learn from every experience.
Lefevre wrote in the context of trading, although this lesson is perfectly applicable to investing:
The loss is simply the tuition fee
“To learn that a man can make foolish plays for no reason whatever was a valuable lesson. It cost me millions to learn that another dangerous enemy to a trader is his susceptibility to the urgings of a magnetic personality when plausibly expressed by a brilliant mind. It has always seemed to me, however, that I might have learned my lesson quite as well if the cost had been only one million. But Fate does not always let you fix the tuition fee. She delivers the educational wallop and presents her own bill, knowing you have to pay it, no matter what the amount may be. Having learned what folly I was capable of I closed that particular incident. Percy Thomas went out of my life.” (Lefevre, 1923,1993)p.155.
The tuition fee for Livermore would have been less if he had known about Daniel Kahneman’s Halo Effect.
Joy of a short memory
One of the lessons an investor must learn early on is to put his mistakes behind him. The investor has to have a long memory for mistakes so as not to repeat them but a short memory as well so as to not agonize over them. One must be able to move on.
Lauren Templeton recalls when John Templeton decided to pursue an emerging markets strategy that included shorts. “However, after implementation we found that employing the necessary shorts was difficult since the emerging markets are not nearly as broad or deep as the U.S., and so we quit the strategy rather than plow deeper. He was quick to admit we had been wrong, and we simply moved on to the next idea. In that sense, he was a great experimenter or a tinkerer. He was always looking for new ideas and testing the ones he liked. When he found investment ideas that worked he would focus on those and add more resources, and when he found a mistake he simply move on in methodical fashion and was not affected at all by the loss as far as I could tell.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.389.
I would bore the reader to recite all my mistakes along the way that I have learned from. It would be useless anyway. Readers will only be able to learn from their own mistakes not from mine.
At this point the conclusion seems to be that people are not born with superior investing judgment and investing skill. Through experience, deliberate practice, learning through reading and learning from our mistakes we can develop expertise which leads to sound judgment.
This topic is one of several aimed at individual investors contained in Part 3: Thoughts for the Individual Investor
This Part contains the following chapters:
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