Artificial human dumbness
Investing is a tough game. Done right it can be very rewarding. Over the years it has, in some ways, become a tougher game. Without an edge you are toast or should I say, the patsy.
In this post I will look the best source of an enduring edge.
Game is getting tougher
Many think the competition is getting tougher as the years go by. The thought is well expressed by Michael Mauboussin and Dan Callahan in a July 15, 2013 report from Credit Suisse titled Alpha and the Paradox of Skill .
“In many competitive realms, including investing, the skills of the participants have improved on an absolute basis but have shrunk on a relative basis. Today’s investor has vastly more resources and training than his or her predecessor from years past. The problem is that investors, broadly speaking, have gotten much better which means that the difference between the skill of the best and the average participant isn’t as great as it used to be.”
They also point to the rise of passive investing as having an impact:
“The investors who are shifting from active to passive are less informed than those who stay. This is equivalent to the weak players leaving the poker table. Since the winners need losers, this can make the market even more efficient, and hence less attractive, for those who remain.”
On this point let’s look at a quote from Warren Buffett. This from his 1987 Letter to Shareholders in the Berkshire Hathaway Annual Report: “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’”
The patsy syndrome (not knowing who the patsy is) stems from the fact that, like in poker, a lot of investors overrate their skill. It also stems from not having an edge.
Need for an edge
If you have better analytical skills than the other players, you have an edge. If you have better information than the other players, you have an edge. But, the chances of having these is essentially nil.
Investment edge – people doing dumb things
The argument that the stock market has become more efficient over the last five decades is based on sports analogies where the average skills of the participants has increased but shrunk on a relative basis. The evidence is that runners’ or batters’ skills have increased. At the same time, the gap between the stars and the journeymen has closed. But sports don’t go through bull and bear markets. In bull and bear markets prices swing more than their underlying fair value. This is where the sports analogy tends to break down.
For stock market investors, there is one thing that hasn’t changed over the years. That’s human nature.
At the 2023 Berkshire Hathaway AGM, Warren Buffett put it this way:
“New things coming along don’t take away the opportunities. What gives you opportunities is other people doing dumb things. In the 58 years we’ve been running Berkshire, I would say there’s been a great increase in the number people doing dumb things. And they do big, dumb things. And the reason they do it, to some extent, is because they can get money from other people so much easier than when we started.” (Emphasis added)
See CNBC’s stream of Berkshire Hathaway’s 2023 annual meeting here.
Rising prices are a narcotic
One big source of investors doing dumb things is stock prices. Warren Buffett is reported to have told Congress on June 2, 2010: “Rising prices are a narcotic that affect the reasoning power up and down the line.” (Marks, The most important thing illuminated: uncommon sense for the thoughtful investor, 2013) p.101 (Emphasis added)
George Soros puts it simply: “Rising prices often attract buyers and vice versa.” (Soros, The Crash of 2008 and What it Means, 2008,2009) p.56. (Emphasis added)
Howard Marks explains: “We learn in Microeconomics 101 that the demand curve slopes downward to the right; as the price of something goes up, the quantity demanded goes down. In other words, people want less of something at higher prices and more of it at lower prices. Makes sense; that’s why stores do more business when goods go on sale.
It works that way in most places, but far from always, it seems, in the world of investing. There, many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy.” (Marks, 2013) p.27. (Emphasis added)
So, there we have it. Rising and falling prices act as narcotics and depressants and easy money on credit from other people makes the merry go round. As I noted above, in bull and bear markets prices swing more than their underlying fair value.
We can flip our poker table analogy. There are times when many of the other players “tend to fall further in love with the thing they’ve” been dealt and their cards “are a narcotic that affect the reasoning power up and down the line.”
Artificial human dumbness
Investors today have access to a lot more data and tools to analyze that data. Stepping back, we can say that a lot of technology has arrived on the scene in the last 200 years. The Dutch tulip bulb mania predated the telegraph and the telephone. The 1929 bubble and crash predated the computer. The internet and social media have perhaps increased the speed at which crazy things happen. My guess is that even with AI, somehow humans will retain the ability to do dumb things.
My main theme in this post has been to reflect on whether the competition investors face in the stock market is getting tougher and what the consequences of this are. New finance grads are probably better trained than their predecessors. But true skill in investing can only be acquired over time and only through the school of hard knocks. Every successful investor relentlessly continues their education. There is no standing still. Perhaps the average skill level is increasing. So that suggests more competition. The playing field is fairly level when it comes to access to information and data. What has not changed over the years is human nature and humans’ ability to do dumb things. Countering that is the source of the successful investor’s edge.
Check out these posts to dig a little deeper into how individual investors can do well against the pros:
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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