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Common and Costly Mental Mistakes

By Whitney Tilson November 2006

T2 Partners LLC, November 2006

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What is Behavioral Finance?


Peter Bernstein in Against the Gods states that the evidence reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. Behavioral finance attempts to explain how and why emotions and cognitive errors influence investors and create stock market anomalies such as bubbles and crashes. But are human flaws consistent and predictable such that they can be: a) avoided and b) exploited for profit?

Why is Behavioral Finance Important?


Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQOnce you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. -- Warren Buffett
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Common Mental Mistakes


1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) 15) 16) 17) 18) 19) 20) 21) 22) 23) 24) 25) Overconfidence Projecting the immediate past into the distant future Herd-like behavior (social proof), driven by a desire to be part of the crowd or an assumption that the crowd is omniscient Misunderstanding randomness; seeing patterns that dont exist Commitment and consistency bias Fear of change, resulting in a strong bias for the status quo Anchoring on irrelevant data Excessive aversion to loss Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money Allowing emotional connections to over-ride reason Fear of uncertainty Embracing certainty (however irrelevant) Overestimating the likelihood of certain events based on very memorable data or experiences (vividness bias) Becoming paralyzed by information overload Failing to act due to an abundance of attractive options Fear of making an incorrect decision and feeling stupid (regret aversion) Ignoring important data points and focusing excessively on less important ones; drawing conclusions from a limited sample size Reluctance to admit mistakes After finding out whether or not an event occurred, overestimating the degree to which one would have predicted the correct outcome (hindsight bias) Believing that ones investment success is due to wisdom rather than a rising market, but failures are not ones fault Failing to accurately assess ones investment time horizon A tendency to seek only information that confirms ones opinions or decisions Failing to recognize the large cumulative impact of small amounts over time Forgetting the powerful tendency of regression to the mean Confusing familiarity with knowledge
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T2 Partners LLC, November 2006

Overconfidence
1) 2) 3) 4) 19% of people think they belong to the richest 1% of U.S. households 82% of people say they are in the top 30% of safe drivers 80% of students think they will finish in the top half of their class When asked to make a prediction at the 98% confidence level, people are right only 60-70% of the time 5) 68% of lawyers in civil cases believe that their side will prevail 6) Doctors consistently overestimate their ability to detect certain diseases 7) 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed 8) Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The average guesses were 27.4 days, 33.9 days, and 48.6 days, respectively. The actual average turned out to be 55.5 days. 9) Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement and how much the average person in the room would have. The average figures were $5 million and $2.6 million, respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1 10) 86% of my Harvard Business School classmates say they are better looking than their classmates

Can lead to straying beyond circle of competence and excessive leverage, trading & portfolio concentration
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Information and Overconfidence


Sometimes additional information can lead to worse decisions, overconfidence and excessive trading
Heuer study of 8 professional handicappers (set betting odds at horse races) Moving from 5 most important pieces of data to 40 slightly decreased handicapping accuracy But doubled their confidence Similar results with doctors and psychologists Conclusion: Experienced analysts have an imperfect understanding of what information they actually use in making judgments. They are unaware of the extent to which their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information. Analysts use much less available information than they think they do." Andreassen study on information overload leading to excessive trading

T2 Partners LLC, November 2006

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Herd-Like Behavior
A social proof phenomenon From 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have made nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying and holding an S&P 500 index fund. Over the same period, the average bond mutual fund returned 9.7% annually, while the average investor in a bond mutual rose earned 8% annually A far narrower gap than equity funds Bonds are easier to value and thus bond markets are not as susceptible to bubbles and crashes

T2 Partners LLC, November 2006

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A Key Factor in Bubbles Forming: Conforming With the Crowd


Conforming with the crowd: the Solomon Asch experiment 35% of the subjects conformed to the groups judgment, even though they knew it was wrong, because they were uncomfortable being a minority facing an overwhelming majority The size of the group didnt matter But if even one person gave the correct answer, the subject was far more likely to also give the correct answer

Source: Solomon E. Asch, Effects of group pressure upon the modification and Distortion of judgment, in h. Guertzkow, ed., Groups, leadership, and men (Pittsburgh, PA: Carnegie press, 1951).

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More on Bubbles
Overconfidence, social proof, misunderstanding random bunching, overweighting vivid & recent data lollapalooza effect Wall Street Journal, 4/30/04: Speculators do know that it's important to get out, however -- that's the lesson they took away from the cratering of the dot-com highfliers. And they appear to believe that they will be able to get out before a stock craters, as illustrated by numerous trading experiments conducted by Vernon Smith, a professor at George Mason University who shared in the 2002 Nobel Prize for economics. In these experiments, participants would trade a dividend-paying stock whose value was clearly laid out for them. Invariably, a bubble would form, with the stock later crashing down to its fundamental value. Participants would gather for a second session. Still, the stock would exceed its assigned fundamental value, though the bubble would form faster and burst sooner. "The subjects are very optimistic that they'll be able to smell the turning point," says Mr. Smith. "They always report that they're surprised by how quickly it turns and how hard it is to get out at anything like a favorable price." But bring the participants back for a third session, and the stock trades near its fundamental value, if it trades at all, the professor's studies show.

T2 Partners LLC, November 2006

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Loss Aversion
People feel pain of loss twice as much as they derive pleasure from an equal gain Case study: two six-sided dice, A and B. A is marked 1-1-1-1-1-13. B is marked 2-2-2-2-2-2. People prefer B, though expected value of A is higher (3 vs. 2)
Helps to be brain damaged

Case study: Refusal to sell at a loss


Philip Fisher, Common Stocks and Uncommon Profits: There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.
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Commitment
A study done by a pair of Canadian psychologists uncovered something fascinating about people at the racetrack: Just after placing a bet, they are much more confident of their horses chances of winning than they are immediately before laying down that bet. The reason for the dramatic change isour nearly obsessive desire to be (and to appear) consistent with what we have already done. Once we have made a choice or taken a stand, we will encounter personal and interpersonal pressures to behave consistently with that commitment. Those pressures will cause us to respond in ways that justify our earlier decision. Influence Leads to information distortion. "Information that is consistent with our existing mindset is perceived and processed easily. However, since our mind strives instinctively for consistency, information that is inconsistent with our existing mental image tends to be overlooked, perceived in a distorted manner, or rationalized to fit existing assumptions and beliefs. Thus, new information tends to be perceived and interpreted in a way that reinforces existing beliefs. Grizelda and Beth study Example of commitment and also brains have a remarkable talent for reframing suboptimal outcomes to see setbacks in the best possible light. You can see it when high-school seniors decide that colleges that rejected them really weren't much good. Case study: I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I. Warren Buffett, 2003 Berkshire Hathaway annual report One of the great dangers of speaking/writing publicly about ones positions.
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Anchoring
Anchoring on purchase price When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. Weve missed billions when Ive gotten anchored. I cost us about $10 billion [by not buying enough Wal-Mart]. I set out to buy 100 million sharers, pre-split, at $23. We bought a little and it moved up a bit and I thought it might come back a bit who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot. -- Buffett Selling Dennys at different prices Anchoring on historical price (or typical price) Refusal to buy a stock today because it was cheaper last year or has a high price per share (Berkshire Hathaway) Refusal to sell because it was higher in the past Anchoring on historical perceptions Dell is a commodity box maker or MBIA is a triple-A company Anchoring on initial data/perceptions Restaurant descriptions experiment Anchoring on meaningless numbers Taversky and Kahneman study: spin the wheel and estimate the percentage of countries in the UN that are African
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Learning the Wrong Lessons by Misunderstanding Randomness


Confusing making money with making a good decision Chris Daviss 5-bagger mistake Mungers example of oil executives congratulating themselves Confusing losing money with making a bad decision Calculated risks are OK Bob Rubins example of politics (from In an Uncertain World) Pecking pigeon experiment

T2 Partners LLC, November 2006

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Other Mistakes
Mental accounting Invest speculatively with found money or small amounts of money Holocaust payments There is no such thing as house money Emotional connections Paying more for a new car when upgrading I like McDonalds food; Cantalupos gift to my children Discount on Cutter & Buck clothing (reciprocity) Becoming friends with management Fear of uncertainty Embracing certainty (however irrelevant) The future is uncertain and hard to predict, where as the past is known Focus on stock charts (irrelevant)

T2 Partners LLC, November 2006

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Other Mistakes (2)


Vividness bias People tend to underestimate low probability events when they havent happened recently, and overestimate them when they have. Buffett Panic after WorldCom and Enron blew up Projecting the immediate past into the distant future Buffett: Driving while looking into the rear-view mirror instead of through the windshield. Cisco in March 2000, McDonalds in March 2003 Worrying about what others will think Klarman: As a money manager, its potentially embarrassing and painful to have to explain to your investors why you own a name that went into bankruptcy. So the temptation is to just get rid of it. Paralysis resulting from too many choices Experiment: Selling jams in a supermarket My failure to act in July and October, 2002 and finally acting in March 2003 The near-miss phenomenon Slot machines Lynch: Long shots almost never pay off
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Other Mistakes (3)


Status quo bias and endowment effect Inheritance study Thalers coffee mugs experiment $5.25 vs. $2.75 for a $6 mug Picking cards out of a deck experiment Valuing a card worth $1.92 for $1.86 or $6.00 or $9.00 Self-interest bias Descarte: Man is incapable of understanding any argument that interferes with his revenue Mutual fund scandal Munger: Its as if someone approached you and said, Lets murder your mother and split the life insurance proceeds 50/50. Hedge funds swinging for the fences Failing to consider second- and third-order consequences Legislation mandating small class sizes Regret aversion Failing to act (see next slide)
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Failing to Act
Failing to Buy Status quo bias Regret aversion Choice paralysis Information overload Hope that stock will go down further (extrapolating recent past into the future; greed) or return to previous cheaper price (anchoring) Regret at not buying earlier (if stock has risen) Office Depot at $8 (vs. $6) Failing to Sell Status quo bias Regret aversion Information overload Endowment effect Vivid recent evidence (if stock has been rising) Dont want to sell at a loss (if stock has been falling) If I didnt own it, would I buy it? Or, If the stock dropped 25%, would I enthusiastically buy more?

Not to decide is a decision


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Tips to Applying Behavioral Finance


Be humble Avoid leverage, diversify, minimize trading Be patient Dont try to get rich quick A watched stock never rises Tune out the noise Make sure time is on your side (stocks instead of options; no leverage) Get a partner someone you really trust even if not at your firm Have written checklists; e.g., my four questions: Is this within my circle of competence? Is it a good business? Do I like management? (Operators, capital allocators, integrity) Is the stock incredibly cheap? Am I trembling with greed? Actively seek out contrary opinions Try to rebut rather than confirm hypotheses; seek out contrary viewpoints; assign someone to take opposing position or invite bearish analyst to give presentation (Pzenas method) Use secret ballots Ask What would cause me to change my mind?
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Tips to Applying Behavioral Finance (2)


Dont anchor on historical information/perceptions/stock prices Keep an open mind Update your initial estimate of intrinsic value Erase historical prices from your mind; dont fall into the I missed it trap Think in terms of enterprise value not stock price Set buy and sell targets Admit and learn from mistakes but learn the right lessons and dont obsess Put the initial investment thesis in writing so you can refer back to it Sell your mistakes and move on; you dont have to make it back the same way you lost it But be careful of panicking and selling at the bottom Dont get fooled by randomness Understand and profit from regression to the mean Mental tricks Pretend like you dont own it (Steinhardt going to cash) Sell a little bit and sleep on it (Einhorn)
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Recommended Reading
(in rough order of priority)

Poor Charlies Almanack Influence, Robert Cialdini Why Smart People Make Big Money Mistakes, Belsky and Gilovich The Winners Curse, Thaler Irrational Exuberance, Shiller Against the Gods: The Remarkable Story of Risk, Bernstein See overview of the field at http://www.investorhome.com/psych.htm

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Investing on Instinct
Should following ones gut play a central role in making investment decisions? Probably not if you really think about it.
One of the more interesting and thought-provoking books published in recent years was Malcolm Gladwells The Tipping Point. Through vivid anecdotes, Gladwell described the underpinning of social epidemics, from the decline in New York City crime to the explosive sales growth of Airwalk sneakers. Its the rare book that casts a fresh look on, well, just about everything. Gladwells latest book, Blink, is equally fascinating and, though not written specifically for investors, has many insights for the investment process. Subtitled The Power of Thinking Without Thinking, Blink explores the psychology and science of decision-making, focusing largely on first impressions and instinct. The conclusion: Under the right circumstances, decisions made very quickly can be every bit as good as decisions made cautiously and deliberately. No argument there. Weve all learned to listen to our instincts in making decisions, whether in making a hire, picking a mate or picking a stock. First impressions matter, at the very least as a filtering mechanism. Great decision makers arent those who process the most information or spend the most time deliberating, writes Gladwell, but those who have perfected the art of thin-slicing filtering the very few factors that matter from an overwhelming number of variables. The Warren Harding Error Most instructive to investors, however, are the books descriptions of where first impressions err. Take, for example, The Warren Harding Error. Voters took immediately to the dashingly handsome Harding, who radiated common sense and dignity and all that was presidential. This emotional connection blinded them to the fact that his policies were hollow and his record in public office undistinguished. Harding eventually served two years before dying of a stroke, and most historians list him as one of the worst presidents in American history. Behavioral finance experts cite just such emotional connections, particularly when they override alternative information and input, as a pervasive investor mistake. While Fidelitys Peter Lynch famously made a small fortune by investing in Dunkin Donuts stock after falling in love with its coffee, investors who make investment decisions on what they like are generally disappointed witness Krispy Kreme, for example. Another classic investor error is anchoring too quickly on select data or information that turns out to be flawed. This is the mistake Coca-Cola made with its disastrous launch of New Coke. The primary driver of this decision was the fact that Coke consistently lost to Pepsi in head-to-head blind taste tests. The tests were simple: subjects were asked to take a sip of each soft drink and report their preference. But the tests had a fatal flaw. Taking a sip in a taste test is a very different experience from sitting and drinking an entire can. Consumers tend to like a sweeter product, which Pepsi is, initially, but for many, the sweetness becomes overpowerwww.valueinvestorinsight.com

ing and less appealing as more of the product is consumed. So Coca-Cola nearly destroyed the worlds greatest brand by relying too heavily on initial data that proved to be incorrect. Combating the ill effects of such anchoring requires discipline on the part of investors. Rich Pzena, whose interview is featured in this issue, uses one interesting technique before buying any stock: He invites the Wall Street analyst who is most bearish on the stock to come into his offices and make the bearish case a direct challenge to Pzenas most firmlyheld convictions. A final lesson from Blink: Intuition tends to break down under duress. In 1999, four New York City police officers fired 41 shots at Amadou Diallo, killing him as he reached for his wallet. Diallo posed no threat, but the first impressions formed by both Diallo and the officers led to the fatal series of events over a matter of seconds. The police officers were under a great deal of stress it was dark and they were in a high-crime neighborhood and likely expecting trouble which undoubtedly contributed to the failure of their intuition. Adrenaline risk Its a stretch, of course, to equate the Diallo shooting with anything experienced by investors, but the key point is that adrenaline is not a friend to good decisionmaking. A dramatic move in the market or a given stock price can trigger a visceral Ive got to do something reaction in even the most experienced investor. Numerous studies have shown time and again, however, that such visceral reactions are usually costly. In such cases, careful analysis, reflection and patience are often virtues. How good peoples decisions are, concludes Gladwell, is a function of training, rules and rehearsal. Not very sexy, but a very sound recipe for investment success. VII
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But I CAN be spontaneous...just give me a couple of days.


February 22, 2005

OF SOUND MIND

Deficient Markets Hypothesis


Would securities mispricings and the ability to profit from them disappear if everyone became a securities analyst?
Seth Klarman has a fabulous record as an investor and market commentator. His Baupost Group partnerships have returned nearly 20% per year (net) since 1983 vs. less than 14% for the S&P 500, and his letters to shareholders are legendary for their insight and wit. In this essay from his 2004 letter, Seth explores whether market efficiency is at hand. With all the money pouring into hedge funds, you might wonder if this is what market efficiency looks like. Conditions are certainly more competitive than they have typically been, and bargains are hard to find. The efficient market hypothesis suggests that all information about a security will immediately be reflected in its pricing. New developments trigger prompt repricings. With so many hedge funds, so many people diligently looking to identify mispricings, and so much capital desperate to crowd into even marginally mispriced situations, an observer might conclude that market efficiency is now at hand. True market efficiency would obviously be an enormously discouraging development. On a personal basis, a 25-year career of successfully investing in mispriced securities would be at an end. For all of us, our net worths would cease growing ahead of the return on the market as a whole; worse still, we would have to significantly ratchet up the risk we incur simply to match the market return. Historically successful investment firms would undoubtedly close their doors a job once well done, but no longer worth attempting (for no degree of effort would make any difference). But any prediction of the death of fundamentalbased investing is highly premature. We offer a simple thought experiment. Imagine that every adult in America became a securities analyst, full-time for many, parttime for the rest. Every citizen would scour the news for fast-breaking corporate developments. Some would run spreadsheets and crunch numbers. Others would analyze competitive factors for various businesses, assess managerial competence, and strive to identify the next new thing. Now, for sure, the financial markets would have become efficient, right? Actually, no. The reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The Internet will not make the market efficient, even though it makes far more information available, faster than ever before, right at everyones fingertips. Markets are inefficient because of human nature innate, deep-rooted, permanent. People dont consciously choose to invest with emotion they simply cant help it. So if the entire country became securities analysts, memorized Benjamin Grahams Intelligent Investor and regularly attended Warren Buffetts annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. Even if they somehow managed to be long-term value investors with a portion of their capital, people would still find it tempting to day-trade and perform technical analysis of stock charts. People would, in short, still be attracted to short-term, get-rich-quick schemes. People would notice which of their friends and neighbors were becoming rich and they would quickly find out how. When others
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were doing well, people would find it irksome and begin to copy whatever was working at that moment. There is no salve for the hungry investor like the immediate positive reinforcement that comes from making money this very moment. Smart people, dumb decisions A country of security analysts would still overreact. They would shun stigmatized companies, those experiencing financial distress or accounting problems. They would still liquidate money-losing positions as they were making new lows. They would avoid less liquid securities, since those are the last to participate in a rally and hard to get out of when things go wrong. To reduce worrisome volatility, they would overdiversify, utilize technically-based and irrational risk reduction techniques such as stop-loss orders, and avoid certain fundamentally attractive but volatile investments. In short, even the best-trained investors would make the same kind of mistakes that investors have been making forever, and for the same immutable reason that they cannot help it. Hedge funds may have a more extensive toolkit at their disposal, in that they can go long and short, utilize leverage, and incur greater illiquidity. They have the resources to hire the cream of every crop. But going long and short involves risks, and leverage can be deadly. Not all hedge fund managers will turn out to be skilled craftsmen; the use of some of these tools will inevitably exacerbate rather than mitigate problems. Really smart people can make really dumb investment decisions witness the Nobel Laureates at Long-Term Capital Management. Hedge funds are big business, and virtually every investment business, whether the stodgiest of old line investment firms or the savviest hedge fund, faces short-term pressure to perform. In short, we believe market efficiency is a fine academic theory that is unlikely ever to bear meaningful resemblance to the real world of investing. VII
Value Investor Insight 19

None of that steady income and security crap! I just want to make a big fat killing and check out
March 23, 2005

OF SOUND MIND

Lights, Camera Inaction!


Why is it that even the best investors sometimes get caught with their bat on their shoulder when a fat pitch floats by?
As investor mistakes go, sins of omission would appear to be relatively benign. After all, foregoing an opportunity to buy what turned out to be a ten-bagger will never show up in anybodys performance report. But ask investors those miscues that drive them most crazy, and the answer more often than not is the missed opportunity. The main mistakes weve made, lamented Warren Buffett at Berkshire Hathaways 2004 annual meeting, have been 1) When we didnt invest at all, even when we understood [something] was cheap; and 2) When we started in on an investment and didnt maximize it. Why investors fail to act, against their better judgment, is often the result of internal psychology rather than poor analysis. Consider anchoring for example. Value investors are just genetically wired to buy as the price is going down, says Fairholme Capital Management founder Bruce Berkowitz. They get anchored on the last price they paid. The stock goes up, you stop buying. Buffett admitted as much at the 2004 meeting: When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. Weve missed billions when Ive gotten anchored. Another reason investors fail to act is by overweighting recent or vivid data, even if its unimportant to the investment thesis. One New York hedge-fund manager missed a dramatic rise in shares of Claires Stores when he decided not to buy after being unimpressed after meeting one of the company Chairmans daughters in late 2001. He explains: Id done all of the analysis and was ready to take a big position, but the meeting shook my confidence. It was inexcusable because even if the daughter was a less-than-stellar manager, it was irrelevant because she wasnt running the company her father was. Even if she was as she is now, by the way the stock was cheap enough and the business good enough that the stock would have done great. Regret aversion can also play a powerful role in investor inaction. Most people want to avoid the pain of regret and the responsibility for negative outcomes, write Gary Belsky and Thomas Gilovich in their outstanding 1999 book, Why Smart People Make Big Money Mistakes. And to the extent that decisions to act decisions to change the status quo impart a higher level of responsibility than decisions to do nothing, people are naturally averse to sticking their necks out and setting themselves up for feelings of regret. The irony is that such regret aversion, in addition to possibly causing lucrative opportunities to be missed, doesnt even do a good job of averting regret. As Belsky and Gilovich explain: Research indicates that people experience more regret over their mistakes of action in the short term, while regrets of inaction are the ones that are more painful in the long run. This confirms the insight of Mark Twain, who once said, Twenty years from now you will be more disappointed by the things you didnt do than by the ones you did do. Fear of regret can also play a big role in investors failing to sell a stock that has declined. Of course, sometimes when a stock falls its a great opportunity to increase the investment at an even more
Value Investor Insight 19

I didnt actually catch anything, but I do feel I gained some valuable experience.
April 27, 2005 www.valueinvestorinsight.com

OF SOUND MIND

attractive price, but even in cases when investors have made an obvious mistake and, logically, should sell immediately, behavioral research shows that they will often hang on, thereby suffering even greater losses. Why? Because by selling, they have permanently locked in the loss and then have to confront the pain and regret of having made a bad investment, including the potential embarrassment of disclosing the loss to family, investors, etc. The argument that losers in your portfolio will outperform in the future doesnt generally hold up to close scrutiny. After analyzing the trading records of 10,000 disFROM THE TRENCHES

count-brokerage accounts, Terrance Odean, now of the University of California, Berkeley, concluded that Investors who sell winners and hold losers because they expect the losers to outperform the winners in the future are, on average, mistaken. Odean found that sold winners those that had increased in price before being sold beat a market index over the next two years after sale by 6.5%. Interestingly, the losing investments that were sold also beat the market index over the two-year period so be careful to not sell in a panic but by only 2.9%. So what can an investor do to avoid

costly and annoying errors of omission? Approach investment decisions from as neutral a position as possible. Ignore all sunk costs. Dont overvalue your current positions pretend that you dont own them and ask, If I didnt own this stock today, would I buy it? If the answer is no, you should think hard about selling. And, finally, dont compound past mistakes for fear of embarrassment. In the end, the best advice is to learn from mistakes and move on. If every shot you hit in golf was a hole-in-one, youd lose interest, Warren Buffett has said. You gotta hit a few in the woods. VII

My Most Memorable Whiff


Missing a wonderful opportunity to buy or sell, of course, is not always the result of some grand flaw in an investors psyche. Its also often simply the result of errant judgment of an industry, a company or a management. Three highly-successful value investors and Berkshire Hathaway roundtable-discussion participants share with us their most memorable gaffes of omission, and the valuable lessons learned:
Matthew Sauer, Oak Value Capital Management

if the company was hitting new highs, leaving everybody else holding the bag. This taught me a couple things. In a highly leveraged situation, no matter how close you think you are, if youre not dealing with exactly the right people its going to bite you, because youre not going to know fast enough if something goes wrong. And, now when I hear anybody say they love ever-increasing smooth earnings, I dont want to have anything to do with it.
Thomas Russo, Gardner Russo & Gardner

I can cite a whole industry I underestimated, the gaming industry. I remember looking at all the data in 1990-91 when the Mississippi gambling riverboats were coming on line, and being convinced that there was too much supply for the demand. There are rare industries, like gaming, where no matter how much supply comes on the market it gets soaked up. I kept thinking something will happen to drive [gaming] shares down and provide a buying opportunity Im still waiting.
Bruce Berkowitz, Fairholme Capital Management

At the peak of the Internet bubble, [check manufacturer] Deluxe Corp. shares had collapsed because everybody knew there would never be anything but electronic bill pay going forward. I didnt quite buy it, because I held out strongly against the view that technology would transform everything. I thought it was a rich area to pursue, since common fear often leads to excessive pessimism. I went to an investor presentation by the company in St. Paul, Minnesota in which they described, in fact, that the Internet was going to flatter, not tarnish the check business. So I was pretty excited. Then the CEO launched into a big discussion about how he was going to convert his core franchise to a new platform he called Internet gift sales, and that they were going to lose $50 million a year on it. I went away and didnt buy the stock, disgusted with that idea. What I learned from this, however, was that really dumb ideas like this one actually have a habit of meeting an early death. In fact, it turned out to be such a dumb idea that it died quite quickly, leaving the business to flourish under its core dynamics, unburdened by ill-considered strategic moves. That was a big lesson.

We had a very large position in Household Financial and we did very well with it really understood the industry, the people, and really got to know the CEO very well. It became clear the company was smoothing earnings, though nothing dramatic. I discounted it because I thought I knew the company and the dynamics well enough that Id be able to see any fundamental changes. The bottom line was I couldnt, and I didnt, and the company had a funding issue. The stock went down and the CEO bailed, selling out and taking a golden parachute that made him as much money as

April 27, 2005

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Confidence Game
Its far better to remind yourself to avoid the pitfalls of investor overconfidence than to have the market do it for you.
Theres no question that confidence in ones investing abilities is a prerequisite to successful investing. To commit your own and others hard-earned capital requires conviction, and conviction requires confidence. But as with fine scotch or pepperoni pizza, too much of a good thing can cause problems. Social scientists have confirmed time and again that people generally overestimate their abilities and knowledge. More than 80% of drivers think theyre among the safest 30% of those driving. More than 85% of the Harvard Business School class of 1994 say they are better looking than their average classmate. When asked at conferences to write down how much money they thought they would have at retirement vs. the amount the average person in the room would have, money managers and business executives consistently judge that theyll have about twice the average also an impossibility, of course. Healthy self-confidence is generally positive, as it can lead to great achievement and certainly contributes to a happier life. But when it comes to managing money, a consistent dose of humility is an invaluable asset. The market can be unforgiving when overconfidence results in too much trading, sloppy analysis, lack of follow-through and excessive risk-taking. Brad Barber and Terrance Odean of the University of California, Davis, in extensive studies of individual trading behavior, found that investors generally overestimate both the precision of their knowledge about a securitys value, as well as the probability their assessment is more accurate than the assessments of others. The result, they say, is more active trading Ive got to act on the advantage I have but not better performance. In fact, those who trade the most realize, by far, the worst performance, Barber and Odean conclude. Overconfidence can also lead to analytical short-cuts. A recent study by Lin Peng of Baruch College and Wei Xiong of Princeton University found that overconfident, timepressed investors put too much weight on market- or sector-level information and not enough on firm-specific data. The authors argue that this was a key contributor to the Internet-stock bubble, as investors ignored company specifics and made judgments almost solely on the industry as a whole much to their eventual chagrin. Complacency about existing holdings is another risk. Its natural, of course, to become more certain about any given ideas soundness as the investment thesis plays out. But if this certainty results in less-diligent ongoing analysis and monitoring of your holdings, you can be left unprepared when circumstances change. Ive learned not to fall in love with either the idea or my seeming brilliance, says MLF Investments Matt Feshbach (see interview, page 1). Ive done that in a few instances at great cost. The best guards against investor hubris? Benjamin Grahams discipline of investing with a significant margin of safety is a great start. The consequences of overestimating a company and your ability to analyze it are greatly diminished when youre paying a lot less for it than your analysis shows its worth. Second opinions are also critical, so test your thinking out on as many informed and dispassionate listeners as possible. In addition to the obvious benefits of hearing alternative viewpoints or questions you didnt think of, the simple act of articulating an idea is a powerful check on the thoroughness of your analysis. Make sure to have a disciplined investing approach and stick with it. Many great investors have a written checklist they go through in analyzing ideas: Is this within my circle of competence? Is this a good business? Do I give management high marks? Is the stock really cheap? If youre already in a stock, dont waver in your approach as the price moves up or down. I try to keep a neutral attitude and stay rational whether the stock is going up or down, advises Matt Feshbach. Im constantly assessing risks in the business model [and] whether its [right now] an opportunity or a mistake. Above all, counsels Amit Wadhwaney of Third Avenue Management (see interview, page 1), stay within yourself: Just avoid what you cant totally get your mind around, he says. Its just not worth it. There will be plenty of other things to invest in keep the cash for then. VII
Value Investor Insight 19

When I said none of us were infallible, I didnt mean you sir.


May 22, 2005 www.valueinvestorinsight.com

OF SOUND MIND

Whose bread I eat, his song I sing


A heightened sensitivity to the biases inherent in pursuing self-interest ones own and others is a valuable trait of successful investors.
I think Ive been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, says Berkshire Hathaways Charlie Munger in the recently published Poor Charlies Almanack, and yet Ive always underestimated that power. The power of self-interest in business and economics is, of course, well established. "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, wrote Adam Smith in The Wealth of Nations, but from their regard to their own interest. Michael Douglas, as corporate raider Gordon Gekko in the movie Wall Street, opined somewhat more coarsely: Greed is good. Greed works. Greed clarifies, cuts through and captures the essence of the evolutionary spirit. It's all about bucks. The rest is conversation." As established as the concept is that incentives motivate behavior, investors are frequently blind to the excesses that can develop. How else to explain the deafening silence from investors as companies awarded ever more extravagant perks and stock-option packages to managers and employees during the 1990s? How else to explain the widespread basing of investment decisions on the opinions of ever more compromised Wall Street analysts during the Internet boom? More recently, how else to explain the explosive growth of interestonly, little-or-no-money-down mortgage loans pushed by mortgage lenders to buy residential real estate at ever-inflated prices? When prices are rising, sensitivity to conflicts of interest falls with often unfortunate results. Successful investors tend to be wellattuned to the power, and biases, of selfinterested behavior. In his interview in this issue (see p. 1), Legg Masons Bill Miller recounts how early in his career a potential client rejected one of his investment ideas because Miller couldnt explain why the stock would outperform the S&P 500 over the following nine months. The prospective client explained: Theres a lot of performance pressure in this business, and performing three to five years down the road doesnt cut it. You wont be in business then. Clients expect you to perform right now. To profit from this bias to perform in the short-term that persists today, Miller focuses his attention on bets that are expected to fully play out more than a year hence. The market is less efficient beyond the next 12 months, he says. This is not to say that money-managers fixation on short-term performance is irrational or not in their selfinterest. In fact, funds with the greatest net new asset growth at any given time tend to be those with top 12-month records. But this only reinforces the mispricing that can result from a short-term bias, creating other opportunities to find value. For example, investors with shorter time horizons are more likely to react to
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This is no time to be thinking about ourselves, Matthews. So, Ill see you at the meeting on Monday?
June 19, 2005

bad news by selling than are long-term investors. Resulting less-than-rational price declines can provide buying opportunities as Warren Buffett counsels, be greedy when others are fearful. Equally important for investors is a clear understanding of the incentives of managers in their portfolio companies. Its almost impossible to understate the importance of having the right incentives in business, says Mark Sellers of Sellers Capital LLC (see interview, p.1). The wrong incentives can cripple a business. Though not always readily available, the more knowledgeable investors are about the incentives of those running the companies in which they own a stake, the more informed the investment decision they make. What percentage of top managements total compensation is salary vs. bonus vs. equity? What is the relative focus on short-term vs. longterm in determining pay? How closely tied is incentive compensation to metrics over which managers truly have control? What accounting policies and controls are in place to promote and monitor specific corporate behaviors? While change is slow in coming, progressive companies are instituting incentives that better align with the long-term creation of shareholder wealth. Berkshire Hathaway avoids all incentives based on short-term targets. Restricted-stock programs at Microsoft and Amazon.com limit the threats of misbehavior fostered by wildly lucrative stock-option plans. White Mountains Insurance awards stock options with strike prices that continue to increase a set percentage every year. Morningstar pays bonuses based on divisional returns on capital in excess of the cost of capital. No system can do away with the inevitable excesses that occur from advisors, investors and managers acting in their self-interest. Forewarned, however, is forearmed. VII
Value Investor Insight 20

OF SOUND MIND

Youre Overreacting
The Internet, TV and various nifty new portable devices put the latest company and market information at your fingertips 24/7. Will this make you a better investor? Probably not.
Evidence of investors appetite for the latest financial and market information is everywhere. TVs tuned to CNBC at the gym. Travelers checking stock quotes on their BlackBerrys. Cell phones delivering alerts on market ups and downs. Wall Street can be anywhere now, says hedge-fund manager Bryan Jacoboski of RBJ Partners, even a cabin in the woods. Of course, timely and democratic access to news and information contributes to smoothly functioning financial markets. But unless you make your living as a trader, an excess of news and information can be highly counter-productive. The biggest problem is that, as many studies have shown, investors tend to overreact to news, so its 24/7 availability is actually detrimental to investors long-term success. In a Harvard study conducted by psychologist Paul Andreassen, two groups of investors were given information necessary to value a stock and then asked to trade it. The only difference was that one group received frequent news reports about every little development about the company, whereas the other group received only quarterly earnings releases. The result: The latter group of investors traded far less and ended up with twice the profits of those fed frequent news. Behavioral-finance researchers attribute the tendency for investors to overreact at least partly to what they call information cascades. For example, a relatively small number of people who respond to bad news by selling can cause prices to fall, which reinforces the apparent wisdom of the early sellers and leads still others to follow the herd and sell. As all this activity is dutifully and breathlessly reported and analyzed by ubiquitous media outlets, temporary insanity can take over stocks movements as never before independent of
July 29, 2005

whether the fundamentals of the investment situation have actually changed. Irrational responses to the latest information tend to affect buyers even more than sellers. A recent study by Brad Barber of the University of California, Davis and Terrance Odean of the University of California, Berkeley concluded that individual investors disproportionately buy attention-grabbing stocks, which they defined as those heavily in the news, those experiencing high, abnormal trading volume or those having just had extreme oneday returns. Barber and Odean argue that investors behave in this way because of the difficulty they face in researching the thousands of stocks they can potentially buy. Focusing on those making news helps limit the choices. But while chasing news-makers may simplify the buying decisions, it hurts investment returns, say the authors: [For] investors most influenced by attention, the stocks they buy subsequently underperform those they sell. Another issue for investors: When it comes to decision-making, more information is not always better. The ratio of useless to significant information dis-

Looks like another case of media overload sir.


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seminated has increased significantly, says RBJ Partners Jacoboski. In a fascinating study of horse handicappers (those who set the initial odds for horse races), researchers first gave the handicappers the five pieces of information they agreed were the most important and asked them to handicap races. In the second part of the study, the same handicappers were given the same five critical pieces of information, plus 35 less important ones, and again were asked to handicap races. The result? Not only were the handicappers less accurate with more information, but, worse yet, they were twice as confident in their predictions! Of course, sometimes it pays to react immediately to news for example, Enron investors would have been well served to sell immediately once early reports of accounting irregularities surfaced. But the best long-term investment opportunities tend to be from taking advantage of the markets tendency to overreact to often-dramatic but ultimately short-term news. No one would suggest completely ignoring news about your investments, but some investors look to limit news reports impact on their daily activity. We dont want to be drawn into responding to daily news flow, says Jacoboski. His office has a Bloomberg terminal, but its not a place for his staff to frequent: We dont allow a chair in front of it, he says. The key is to keep news in context, and act only if further reflection or study indicates that the core thesis for the investment has changed. An earnings disappointment due to a suppliers manufacturing problem may say something very different than a shortfall due to pricing pressure from new competition. In almost all cases, letting the herd overreact first before taking action is probably the best bet. VII
Value Investor Insight 21

OF SOUND MIND

Why Hindsight Isnt Always 20/20


Successful investors know how important it is to learn from their mistakes. But doing so is much easier said than done.
Weve all done it: Made the same their personal views to try to prove investment mistake over and over. Even things, explains Princeton psychology the very best investors arent immune. professor and Nobel laureate Daniel Legg Masons Bill Miller, for example, in Kahneman in a recent newspaper interhis recent interview with Value Investor view. When the Soviet Union fell, the Insight (June 19, 2005) tells the story of political right said We were right. having owned apparel company Salant Squeeze the USSR with high military Corp. when it went into bankruptcy spending and the Soviet Union will colthree times. He joked: The third time, I lapse. At the same time, people on the said Three bankruptcies and were out. political left said We were lucky. We Thats one of our rules. nearly had WWIII, but thanks to An ability to learn from mistakes is Gorbachev, the Soviet Union collapsed. critical to future investment success, and This selective memory contributes to the best investors, like Bill Miller, are genwhat researchers more broadly term erally quite good at it. But learning from hindsight bias. After the fact, people mistakes can be difficult, complicated by dramatically overestimate the inevitabilideep-seated aspects of human nature. ty of what happened, so that past events One of the most basic psychological are judged as being more simple, comprebarriers to drawing useful lessons from hensible and predictable than they actualbad experiences comes from what psyly were. When researchers Martin Bolt chologists call self-attribution bias. This is the general tendency of people to attribute good outcomes to their own prescience, wisdom and skill, whereas bad outcomes are written off as due to bad luck. If your investment in Altria doubles, youre apt to see this as confirmation of your correct analysis of Altrias business opportunities and risks. But if your Altria stake is cut in half, its far more likely youll blame external factors beyond your control over-zealous regulators or half-baked juries, for example. When mistakes arent acknowledged, of course, little is learned. Further limiting opportunities for insight is that people tend to see past events as confirmation of what they already believe. The general rule is that people learn as little as Cmon, we wont get burned this time. possible from the past and use
August 29, 2005 www.valueinvestorinsight.com

and Jon Brink asked students to predict the outcome of the 1991 Senate confirmation vote on Supreme Court nominee Clarence Thomas, 58 percent predicted his approval. A week after the vote, when they asked other students to say what they would have predicted, 78% said they expected Thomas to be approved. This tendency is equally clear in investing: If all the people who now say they knew the Internet bubble was going to burst really did know, a lot of investors would be a lot richer today from shorting the obviously overvalued stocks. In fact, the bubble probably never would have formed in the first place. Seeing the past as having been more predictable than it was can pose great danger to rational investment decisionmaking. Those lulled into complacency by the perceived predictability of events run the risk of not adequately considering the wide range of future outcomes possible potentially exposing themselves to greater risks than they should. Oversimplifying past events can also lead to overconfidence and big mistakes. In numerous experiments conducted by Vernon Smith, a professor at George Mason University and also a Nobel prize winner in economics, participants were asked to trade a dividend-paying stock in which the true value was clearly laid out. A bubble would invariably form and then, eventually, burst. One would think that participants, having suffered big losses, would learn not to speculate. Yet when Smith repeated the trading exercise for a second time with the same participants, another bubble formed (though not quite as extreme). Why did this happen? Because
Value Investor Insight 19

OF SOUND MIND

the lesson the participants learned the first time wasnt the perils of speculation, but rather that one simply had to be more clever in selling at the top. But as Smith explained: The subjects are always very optimistic that theyll be able to smell the turning point and report that they're surprised by how quickly it turns and how hard it is to get out at anything like a favorable price. Sound familiar? Beyond having an awareness of the deep-seated psychological tendencies at work, how can investors maximize their ability to learn from mistakes? One tactic is to focus as much on process as on outcomes. In a probabilistic exercise such as investing, good decisions can still yield lousy outcomes, and vice versa. The best learning will likely come from a dispassionate review of how and why a given decision using the available information at the time was made. Because memory can often distort reality, the more documented the original decision process, the better. Enlisting second opinions on conclusions drawn from past experience can also be helpful. The key is to tap insight

We hate surprises
While the tendency for people to see past events as more predictable than they really were can hinder investment judgment, this hindsight bias can play a very positive psychological role. Author Malcolm Gladwell (The Tipping Point, Blink) has written extensively about the fallibility of hindsight, particularly with respect to whether the intelligence community should have seen the September 11 attacks coming and stopped them. In an interview in The New Yorker, he described the positive effects of hindsight bias: We hate surprises. We try to erase them from our memory. This is part of what keeps us sane. If, after all, we were always fully aware of the possibility of completely unpredictable events, would we be able to walk out the front door in the morning? Would we ever invest in the stock market? Would we have children? Generally speaking, people who have an accurate mental picture of why and how things happen tend to occupy mental hospitals or, at the very least, a psychiatrists office.

from diverse sources. The broader the interests, mindsets and biases of those giving input, the more likely you are to learn something useful. Not all mistakes, of course, produce profound lessons. No one is infallible and luck, good and bad, often plays a role. The goal should be to see what happened as clearly as possible, learn

what you can and move on. Excessive fear of making a mistake can be as debilitating to an investor as making the same mistake more than once. One final lesson to keep in mind, as Warren Buffett frequently reminds listeners: Remember, its better to learn from other peoples mistakes as much as possible. VII

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Value Investor Insight 20

OF SOUND MIND

What Were We Thinking?


A better understanding of the Internet bubble wont keep something similar from happening again. It may, however, help you limit the damage to your own portfolio.
I made a big mistake in not selling several of our larger holdings during The Great Bubble, wrote Warren Buffett in Berkshire Hathaways 2003 annual report. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I. Few investors came through the millennium stock-market bubble and its aftermath unscathed, leaving many to ask themselves the very what-was-I-thinking question posed by Buffett. Such introspection, of course, wont magically turn back time and allow you to sell your Cisco shares at $82. But an understanding of the underpinnings of the markets irrational rise might help you limit the next bubbles damage to your portfolio. Yale economics professor Robert Shiller, in his prescient 2000 book Irrational Exuberance, defines a speculative bubble as a situation in which temporarily high prices are sustained largely by investors enthusiasm rather than by consistent estimation of real value. Where did this enthusiasm come from in the late 1990s and into the Spring of 2000 before the bubble popped? A clear contributor was that stock investing had become a widespread cultural phenomenon, fueled by the medias reporting on the market as almost a spectator sport. The I just cant markets rise was ampliSeptember 28, 2005

line. Seven of the experimental group members were prepped in advance by Asch, while only one was an actual subject. After a few trials where everyone gave the right answer, Asch signaled for the in-the-know subjects to start giving the wrong answer. When they did, a surprising 35% of the actual subjects went along in giving the obvious wrong answer. People [have a] preference for being an accepted part of a majority over being part of the correct minority, says Mauboussin. Numerous market bubbles demonstrate this point. The herd also appears to have fallen victim to the common investor mistake of overweighting recent experience. Behavioral scientists have consistently shown that individuals are more likely to judge recent and easier-torecall events as more numerous and predictive of the future than those less recent. After four years of 20%-plus overall market returns, individual investors in a December 1999 Gallup survey of investor optimism were still predicting a 15.3% average return over the following twelve months. Optimism, based on the recent past, was rampant. I dont think anything can shake my confidence in this market, said one patron of a Cape Cod barbershop interviewed by The Wall Street Journal in March 2000. Even if we go down 30%, well just come right back, said another. imagine anything slowing this market down... Interestingly, instituwww.valueinvestorinsight.com Value Investor Insight 20

fied by the positive feedback loops among investors, writes Shiller, creating naturally occurring Ponzi processes that took the market ever higher. The role of group dynamics during the bubble went beyond just generating collective enthusiasm. Humans have a strong desire to be part of a group, says Legg Mason equity strategist Michael Mauboussin in a 2004 research paper dissecting investor decision-making. That desire makes us susceptible to fads, fashions and idea contagions. A classic research study of conforming behavior, by psychologist Solomon Asch, asked eight group members to solve a simple problem: determine which of three lines is the same length as a given base

OF SOUND MIND

tional investors were consistently less optimistic than individuals about future returns as the market roared ahead. This changed, however, after the bubble popped. A December 2000 survey of institutional investors by BusinessWeek found such investors expecting a mean S&P 500 return over the following 12 months of 19.2%. The actual return came in at minus 11.9%. Individual investors think that high past returns portend high future returns, but they are wrong. Institutional investors think that high past returns portend low future returns, but they are equally wrong, concluded investment manager Kenneth Fisher and Santa Clara University finance professor Meir Statman in a study of individual and institutional expectations around the bubble published in The Journal of Psychology and Financial Markets. Did investors think stocks were cheap as they bid up stock prices near the bubbles peak? No. Did they care? No, again. A Yale survey of investor confidence in early 2000 showed that 70% of investors

thought the market was overvalued, while 70% also believed the market would continue to go up. Studies show such a dichotomy to be common as markets peak, as investors either believe a greater fool will come along and pay more, or that they wont fall victim to overly high prices. In a study of pre-bust investors in a large telecommunications company, Yales William Goetzmann and Ravi Dhar found an overwhelming majority felt they or the financial advisors upon which they relied had an above-average ability to identify mispriced securities. The key lessons in all this? As the lawyers regularly counsel: past performance is no guarantee of future success. Thats not at all to say history is irrelevant in judging any securitys valuation, but that it should be treated as providing input rather than concrete answers. A constantly updated risk-reward judgment from today onward is what matters. Humility also matters. Overconfident investors are sloppy investors, as latestage buyers of eToys or Pets.com who

were counting on getting out before the music stopped found out the hard way. Actively and often challenge your investment assumptions, and enlist others you respect to do so also. An assumption to challenge, says longtime value manager Robert Olstein (see interview, p. 1), is the extent to which a traditional buy-and-hold strategy makes sense today. When he started in the business, Olstein says, a stock moved 25 cents for sound reasons. But since the late 1990s, he says, too many short-term investors responding to too much market information have made short-term valuation extremes more common. On the upside, this requires action: If we buy at $10 with a two-year price objective of $15 and the stock reaches $14 within two weeks, he says were not doing our job if we dont take money off the table to buy another stock with a 30% discount right away. One final bubble lesson is obvious, but bears repeating: Make your own decisions. Crowds can be ugly when they change directions. VII

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Value Investor Insight 21

OF SOUND MIND

Inspiration or Perspiration?
Successful investing is as much a creative process as it is a disciplined, analytical one even if some investors dont want to admit it.
Thomas Edisons famous quote that Genius is 1% inspiration and 99% perspiration is a sentiment shared by many when it comes to investing. As keys to success, investors tend to credit discipline, focus and analytic rigor over creativity. Investing is a simple business and every time we try to overcomplicate it we have lower returns, says one of the best money managers we know, off the record. Being creative just to be creative can waste research time, liquidity and resources. Is investing a creative process? Hardcharging money managers resist defining what they do in terms usually reserved for artists. But if one defines a creative person as does the American Heritage dictionary as one who displays productive originality, theres little doubt that successful investors and many others fit the mold. Clearly, creativity is not limited to artists, writes business historian Maury Klein in his book on the greatest entrepreneurs in history, The Change Makers. The scientist displays it in connecting ideas or observations and transforming them into insights or actions; so do inventors, philosophers, mathematicians, businessmen and athletes. Charlie Mungers use of multiple mental models to draw investing insight from the acquired wisdom in many disciplines is an example of such creativity at work. As Munger has described it: You have to realize the truth of biologist Julian Huxleys idea that, Life is just one damn relatedness after another. So you must have the models and you must see the relatedness and the effects from the relatedness. Legg Masons Bill Miller is another strong proponent of using more than just analytical firepower to drive investment success. Thats why he is fascinated by things like the adaptive learning of bees, or what the fossil record explains about how organisms evolve. As he explained in
October 28, 2005

our interview with him earlier this year, If you just do what other people do, you get the results that other people get. Fostering creativity requires effort, of course. Because the ability to discover useful patterns typically improves with the number of observations made, the first step is to devote time to diverse lines of inquiry. As equity strategist Michael Mauboussin of Legg Mason has said: There is strong evidence that the leading thinkers in many fields not just investing benefit from input diversity. Investors should allocate specific time to exploring new ideas, he says, even at the risk of wasting time on intellectual cul-desacs. Charlie Munger counsels reading everything you can: In my whole life, I have known no wise people who didnt read all the time none, zero. Keeping an open mind about new observations is key. Humans naturally organize experiences and the relationships among them as efficiently as possible, to minimize the energy used in processing, storing and recalling information. Writes applied psychologist Edward de Bono in his pioneering book on developing individual and collective creativity,

Six Thinking Hats: From the past we create standard situations. We judge into which standard situation box a new situation falls. Once we have made this judgment, our course of action is clear. Such a system works very well in a stable world [but] in a changing world the standard situations may no longer apply. We need to be thinking about what can be, not just what is. Processing novel ideas that require breaking down the standard situation boxes weve constructed isnt particularly easy or natural, which is why many ideas get dismissed out of hand shortcircuiting the process of creative thought. Creativity starts with some problem or need and moves in various ways through a series of stages, consisting of information gathering, digestion of the material, incubation, sudden inspiration, and, finally, implementation, writes Stanford Business School professor Michael Ray in his book Creativity in Business. Without plenty of ideas incubating, breakthrough thinking is much less likely. Business innovators often cite an additional requirement for creativity, which, for lack of a better description, is quiet time. Albert Einstein often mused about his getting his best ideas in the morning while shaving. In fact, researchers have found that the presence of a calm mind uncluttered by the constant processing required by daily life is far more likely to produce eureka moments of inspiration than a busy one. And what of Edisons quote about genius? To be sure, creativity isnt possible without perseverance, effort and, of course, the right attitude. Edison went through more than 9,000 experiments in his quest to create the incandescent light bulb. When derided by colleagues for what they perceived to be the foolish quest, he responded: I havent even failed once; 9,000 times Ive learned what doesnt work. VII
Value Investor Insight 22

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OF SOUND MIND

The Markets Law of Gravity


That company performance and stock prices tend to revert to long-term norms is a key reason that it can pay to be a skeptical investor.
The stock market was not on Victorian-era polymath Sir Francis Galtons agenda when he first conducted his path-breaking studies supporting what he termed reversion to the mean the tendency for extreme observations to regress over time toward long-term averages. Galton, a half-cousin of Charles Darwins, first observed mean reversion in the size of peas, while later refining the concept in studies of human height. The notion that outlier performance is exceedingly difficult to sustain, however, has been shown to be equally applicable to corporate performance and investing. In a study of average corporate returns on equity over rolling five-year periods since 1979, Sanford C. Bernstein & Co. found how hard it is for the rich to get richer. Bernstein broke its large-cap universe of companies into quintiles, from the top 20% ranked by ROE to the bottom 20%. At the beginning of any five-year period, the stars earned an average 26.3% ROE, while the laggards averaged an ROE of 1.6%. But after five years the reversion process was well in evidence: the top-quintile firms were earning an average 18.4% ROE, while those in the bottom quintile had improved their average ROE to 9.0%. Similarly, Alliance Capitals Bernstein Investment Research (no relation to Sanford C. Bernstein) studied companies in the S&P 500 from 1990 to 2003 to identify how many had sustained 25% annual earnings growth. By the fifth year only twelve companies made the cut and by year nine none had. Even increasing earnings 10% per year was difficult: only 22 companies grew at that rate after five years and just one, Walgreens, made it the entire 13 years. Thats something to keep in mind if youre buying Google today at $420 per share and 93x trailing earnings. The evidence for mean reversion is also compelling for stock prices on an individual, sector or market-cap basis. One classic long-term study by professors Werner DeBondt and Richard Thaler formed theoretical portfolios at two-year intervals based on share prices in relation to book value. In the four years prior to each portfolio being formed, the lowest price-to-book stocks underperformed the market by a whopping 26%. Yet in the

Contrarian Food for Thought


Value investors monitor stocks hitting new highs or lows for contrarian ideas new lows as potential buys, new highs as possible shorts. Morningstar helps take this concept a step further, identifying each full years top Value Creators and Value Destroyers, based on total change in market capitalization. Below are 2005s winners and losers.

The Value Destroyers


Company Pfizer IBM Verizon Dell Wal-Mart Stores DuPont Cisco Systems Comcast Tyco eBay Ticker PFE IBM VZ DELL WMT DD CSCO CMCSA TYC EBAY Market Cap (000) 12/31/04 $202,508 $164,106 $112,410 $104,689 $223,686 $57,255 $127,217 $73,878 $71,895 $77,123 Market Cap (000) 12/15/05 $167,994 $131,937 $84,636 $78,852 $205,054 $39,450 $111,439 $58,327 $57,276 $64,141 $Change (000) ($34,514) ($32,169) ($27,774) ($25,837) ($18,631) ($17,805) ($15,778) ($15,551) ($14,619) ($12,982) %Change -17.0% -19.6% -24.7% -24.7% -8.3% -31.1% -12.4% -21.0% -20.3% -16.8%

The Value Creators


Company Google Genentech ExxonMobil Apple Computer ConocoPhillips Hewlett-Packard Schlumberger Alcon Halliburton Motorola Ticker GOOG DNA XOM AAPL COP HPQ SLB ACL HAL MOT Market Cap (000) 12/31/04 $52,712 $57,141 $330,693 $24,982 $59,933 $63,327 $39,416 $24,675 $17,343 $40,679 Market Cap (000) 12/15/05 $117,989 $99,124 $370,170 $59,897 $81,547 $83,658 $59,580 $42,715 $33,796 $56,840 $Change (000) $65,277 $41,983 $39,477 $34,915 $21,614 $20,330 $20,164 $18,040 $16,453 $16,161 %Change 123.8% 73.5% 11.9% 139.8% 36.1% 32.1% 51.2% 73.1% 94.9% 39.7%

Source: Morningstar

December 30, 2005

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Value Investor Insight 20

OF SOUND MIND

four years after the portfolios were formed, the low price-to-book stocks trounced the market by 41%. The highestpriced stocks, which beat the market by 76% in the prior four years, returned 1% less than the market over the next four. All this is generally good news for value investors, who often look to buy when things dont look so great. Explains Robert Haugen in The New Finance: The Case Against the Efficient Markets: Investors tend to mistakenly project a continuation of abnormal profit levels for long periods into the future. Because of this, successful firms become overvalued. Unsuccessful [ones] become undervalued. As the process of competitive entry and exit drives performance to the mean faster than expected, investors in the formerly expensive stocks become disappointed with reported earnings and investors in the formerly cheap stocks are pleasantly surprised. Look, the people in troubled companies arent jumping off bridges, theyre trying to fix things, said Richard Pzena of Pzena Investment Management when we interviewed him earlier this year (Value Investor Insight, February 22,

2005). If theres overcapacity in the industry, they take out capacity. If costs are too high, they cut costs. If the sales effort isnt working or the products arent selling, they try to change things. Most of them succeed in making things better. The challenge for investors is that the gravitational pull on stock prices and

ONE KEY CHALLENGE: The gravitational pull on stock prices and firm performance doesnt happen in a straight line or at a typical pace.

company performance doesnt happen in a straight line or at a typical pace. Not all companies turn around and great companies can be great for a long time. A key distinguishing characteristic of superior investors, though, is their ability to determine how temporary or permanent a companys given condition is good or bad and buy or sell accordingly. Equally

important as investors such as Rich Pzena stress is to accurately define what normal performance for a company is and base ones valuation analysis on it rather than what happened last year or is expected to happen next year. So while a knee-jerk buying of market losers and selling of market winners is unlikely to be successful, using reversionto-the-mean thinking to screen for ideas can make sense. The 10 top valuedestroying stocks of 2005 identified by Morningstar (see table) trade at an average of a 13% discount to Morningstars fair-value estimates, while the average stock on the value-creating list trades at a 50% premium to fair value. Interestingly, seven of the 10 destroyers earn a widemoat rating from Morningstar, while only four of the creators have such a designation. Note with caution, however, that the top value destroyer of 2004, Pfizer, topped the same list again in 2005. Another reason for value investors to be on their toes: Value investing has dramatically outperformed growth investing for five years now. While wed like to say thats only right and just, skeptics take heed. VII

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Anythings Possible
Most investors know that investing is an exercise in probability. But knowing it and actually living by it can be two separate things.
Games of chance must be distinguished from games in which skill makes a difference, writes Peter Bernstein in Against the Gods, his historic review of risk taking. With one group the outcome is determined by fate, with the other group, choice comes into play. There are card players and racetrack bettors who are genuine professionals, but no one makes a successful profession out of shooting craps. Like playing poker and betting on horses, investing is a game of skill similarly focused on assessing the odds of uncertain future events. At the end of the day, investing is inherently a probability exercise, says Legg Mason strategist Michael Mauboussin. Most investors acknowledge this point but very few live by it. Why is it difficult for investors to think in terms of probabilities when assessing a companys future performance and stock price? It isnt human nature to view the future in terms of a wide range of possibilities, says Abingdon Capitals Bryan Jacoboski, who was featured last summer in Value Investor Insight (August 29, 2005). We naturally think in terms of what is most likely to occur and implicitly assess the probability of that scenario occurring at 100%. That may sound reckless, but its what most people do and isnt a bad way to think as long as less likely, but still plausible, scenarios dont have vastly different outcomes. In the investment world, however, they often do, so making decisions solely on the most likely outcome can cause severe damage. Anchoring on the most likely outcome is a natural attempt to reduce the complexity involved in making investment decisions, but also can reflect the dangerous overconfidence with which many investors ply their trade. Former Treasury Secretary and Goldman Sachs CoChairman Robert Rubin, who made his name on Wall Street as an arbitrage trader, warns against this excessive certainty in his book In an Uncertain World: [It] seems to me to misunderstand the very nature of reality its complexity and ambiguity and thereby provides a rather poor basis for working through decisions in a way that is likely to lead to the best results. The first basic step in incorporating probabilities into investment decisions is to explicitly consider several potential outcomes. Abingdon Capitals Jacoboski looks at each of his holdings business fundamentals under four to six distinct scenarios, calculating an intrinsic value under each scenario and applying a subjective probability to each. The final estimate of intrinsic value is the intrinsic value of each scenario weighted by its probability of occurring. A key is to capture low-probability but high-impact scenarios, primarily to see where the vulnerabilities are, he says. He decided not to short Amazon.com a couple years ago, for example, after taking into consideration what he considered to be the unlikely event that Amazons scale would start translating into the profitability gains the market was expecting. In fact, that is the scenario that began to play out, and the stock rose 180% in the following year. An added benefit to thinking in terms of probabilities is that it helps make explicit the actual risks under consideration. If given the choice between purchasing a $350 non-refundable plane ticket to attend a future event that could possibly be cancelled vs. waiting to buy a lastminute ticket for $1,200, many people would choose to wait. Nobody wants to blow $350. But in pure expected-value terms, it pays to buy the ticket now unless you believe the risk of cancellation is above 71%. Framing the question in this way may not change the decision, but can increase the chances that a more informed decision is made.

January 31, 2006

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OF SOUND MIND

In studying the common traits of those most successful at games of skill across disciplines researchers have found a clear tendency to focus more on process than individual outcomes. Poker legend Amarillo Slim has described it this way: The result of one particular game doesnt mean a damn thing, and thats why one of my mantras has always been Decisions, not results. Do the right thing enough times and the results will take care of themselves in the long run. Adds Legg Masons Mauboussin: By definition, poor decisions will periodically result in good outcomes and good decisions will lead to poor outcomes. The best in their class focus on establishing a superior process, with the understanding that outcomes will follow over time. Thats not to say that process cant be improved. Making explicit and writing down the probabilities used in making investment decisions can provide valuable learning. After all, if you judge an event to have had a 60% chance of occurring and it doesnt occur you dont know if

you were right or wrong. The only true way to know is by tracking the same or similar events to see if they, over time, happen 60% of the time. Weather forecasters and bookmakers keep track of such things to refine their ability to judge probabilities. Investors should do the same even if its with much less preci-

ON PLAYING THE ODDS: The issue is not which horse is the likely winner, but which horse offers odds that exceed their actual chances of victory.

sion to calibrate their probability-setting skills. While necessary, skillfully assessing the probabilities of various outcomes for a company is not sufficient to making a sound investment. Stock prices have future expectations already built in the trick is to find the gaps between those

expectations and your own. Perhaps the single greatest error in the investment business is a failure to distinguish between knowledge of a companys fundamentals and the expectations implied by the stock price, says Mauboussin. Driving home this point is Steven Crist, chairman of the Daily Racing Form: The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. There is no such thing as liking a horse to win a race, only an attractive discrepancy between his chances and his price. Even with a framework to assess ambiguity, the right decision in the face of great uncertainty is often just to pass. Warren Buffett refers to it as placing something in the too-hard pile. Writes Peter Bernstein: Once we act, we forfeit the option of waiting until new information comes along. As a result, not acting has value. The more uncertain the outcome, the greater may be the value of procrastination. VII

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Value Investor Insight 21

OF SOUND MIND

Sanity Check
Social psychologists devote considerable effort to trying to understand why people do self-defeating, stupid things. Investors, take note.
Its not surprising that the study of irrationality and self-destructive behavior is one of the most fertile areas of psychological study. After all, theres plenty of such behavior to go around and whole industries think tobacco, gaming, weight-loss, etc. are built either to benefit from or help ameliorate such human frailties. While much of the research into why people do stupid things, as Florida State social psychologist Roy Baumeister puts it, is not specifically focused on investing, the findings are highly relevant to investors. Ill-conceived decisions that are contrary to ones rational selfinterest should clearly be at the top of any investors list of things to avoid. Based on his own and others extensive research, Baumeister has identified five key reasons why rational, selfenlightened action breaks down: 1. Emotional Distress Emotional distress makes people far more likely to favor options with high risks and high rewards, even if these options are objectively bad choices. When research-study subjects were first asked to decide between playing one of two games the first with a 70% chance of winning $2 and the second with a 2% chance of winning $25 most chose the first, opting for the choice with the higher expected value of $1.40 vs. $0.50. Subjects who were put under stress, however, were far more likely to choose the riskier option with the much lower expected value. Baumeister attributes this to the simple fact that those under duress just dont think through the options. He confirmed this by specifically prompting certain subjects to first list the advantages and disadvantages of each option before deciding. When forced to reflect, even the stressed group of test subjects generally made the rational decision. 2. Threats to Self-Esteem When a favorable self-view is questioned or undermined by events, peoples rush to prove otherwise can result in bad decisions. Baumeister offered test subjects a chance to bet on their skill in a video game they all had learned, but subjected one subset of the group to the news that the results of an earlier test of creativity theyd taken showed they did poorly in fact, the worst the experimenter had seen. How did the bruised-ego group respond? Eager to wipe out the loss of face by winning a large bet, they made far larger bets than justified by their skill levels and ended up losing most of their money. 3. Failure of Self-Regulation The rational pursuit of self-interest often requires delayed gratification the forgoing of short-term benefits in order to achieve greater future gains. People generally self-regulate themselves to override immediate responses, but the breakdown of this self-regulating mechanism often results in self-defeating behavior. Stress is again one big cause of this mechanism breaking down, but the problem is also exacerbated when short-term

March 31, 2006

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OF SOUND MIND

gains are reliably predictable, while the longer-term costs are uncertain. Consider smoking, in which the uncertain longterm risk of developing lung cancer can be easily outweighed by the short-term and certain pleasure of lighting up. Interestingly, Baumeister found that the capacity for self-regulation operates somewhat like a muscle when constantly tested over relatively short periods it loses strength. Subjects who were hungry and were told not to eat freshlybaked chocolate chip cookies on a nearby table were far less likely to persevere in solving a variety of challenging puzzles than those who had not been similarly deprived. Such findings give strong support to the notion that sleeping on important and difficult decisions is a sensible strategy. 4. Decision Fatigue Peoples ability to make rational decisions similarly decreases as the number of decisions to be made increases. This likely explains why people love routines

and habits, which preserve the limited resources available to make decisions. Says Baumeister: People can only really make a few serious choices at a time, and then the capacity for choosing has to recover and replenish before they are fully effective again. 5. Rejection The need to be accepted by others is a central feature of human motivation, so its not surprising that rejection or the fear of rejection can result in selfdefeating behavior. In one study, subjects were brought together and spent some time getting to know each other before being put into separate rooms. They were then asked to list with whom they wanted to work on the next project in the study. In the end, everyone worked alone on the next project, but half the group was told it was because nobody chose to work with them and half were told it was because everyone chose to work with them and it was too difficult to accommodate everyones

wishes. In subsequent tests, those that were accepted generally behaved rationally, while those scorned were far more likely to be aggressive and make irrational choices. Those who thought they had been rejected even performed worse on intelligence tests than those who thought they had been accepted. What are the implications for investors? Pretty much all the elements that lead to the psychology of irrationality are likely to be present in large quantities for investors, says equity strategist James Montier of Dresdner Kleinwort Wasserstein. In particular, he cites the holding of unpopular stocks that are going down as particularly likely to trigger many of the pressures that often lead to bad decisions. Irrationality in investor decisionmaking isnt going away, of course, and the markets would be far less interesting and profitable if it did. But an awareness of what the triggers of self-defeating behavior are can go far in mitigating the damage from irrational, bad decisions. Forewarned is forearmed. VII

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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.
One of the more talked about books among investment theorists in recent years has been University of California at Berkeley professor Philip Tetlock's Expert Political Judgment: How Good Is It? How Can We Know? Based on detailed long-term research, Tetlock scrupulously explains exactly how bad experts are at making political and macroeconomic predictions. Not only are experts no better than non-experts in predicting future events, they're worse on average than even crude computer algorithms that extrapolate the past. Given that investing is all about making accurate predictions for example, about financial performance, companies' strategic choices and industry dynamics is this indictment of expertise relevant to the investment process? Is the quest for ever more specialized knowledge, at best, not really worth it and, at worst, counterproductive? Common practice and, to a certain extent, common sense would indicate otherwise. Most investment firms organize analyst functions by specialty, out of the belief that a media expert has a better chance to accurately handicap News Corp.'s business prospects than someone who knows the banking business inside and out. Expert energy consultants are doing a landoffice business counseling professional investors these days, as are firms like Gerson Lehrman Group, which serves its largely finance-industry clientele with a network of 150,000 subject-matter experts across a wide variety of industries. Lee Ainslie of Maverick Capital addressed the current state of affairs in a recent interview (VII, December 22, 2006): With the specialization of the people
March 30, 2007

we're competing against today, I think it's very difficult to have a meaningful edge without significant depth and expertise. We should know more about every one of the companies in which we invest than any other non-insider. As important as specialized knowledge is for investors, it brings with it several potential impediments to sound decision making that should be avoided. While the average person is typically overconfident in his or her ability, experts have been shown to be even more overconfident, a dangerous trait for an investor. Overconfidence not only promotes recklessness, it can also limit learning. Expertise may not translate into predictive accuracy, but it does translate into an ability to generate explanations for predictions that experts themselves find so compelling that the result is massive overconfidence, writes Tetlock. It's hard to learn much from mistakes if you don't think you're ever wrong. Cognitive studies have also shown that specialization can hinder one's ability to detect change. This is a classic can'tsee-the-forest-from-the-trees problem

and explains why industry experts in newspapers, film photography and music retailing were by and large not the first to fully understand the dramatic changes roiling their industries. Wedded to their in-depth knowledge, experts can find it difficult to think about issues in new ways. As historian Daniel Boorstin once said, The greatest obstacle to discovery is not ignorance it is the illusion of knowledge. A final danger of an over-reliance on specialized knowledge: more information doesn't always mean better decisions. One classic academic study asked M.B.A. students in an advanced financial statement analysis course to make individual-company earnings forecasts using three different sets of information: 1) baseline data, consisting of the past three quarters' net sales, share price and earnings per share; 2) the same baseline data, plus redundant or irrelevant additional information, and 3) the baseline data, plus non-redundant information that should have improved forecasting ability. The result? Forecasting errors were equally and significantly higher when additional information above the baseline was provided, whether redundant or relevant. At the same time, confidence levels in the forecasts rose significantly with any additional information. Usually two to three variables control most of the [investment] outcome, says two-time Value Investing Congress speaker Mohnish Pabrai in a recent interview with The Motley Fool. The rest is noise. If you can handicap how those key variables are approximately likely to play out, then you have a basis to do something. VII
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The Investor and Market Fluctuations


For guidance on how to prepare for and respond to market volatility, theres no better place to start than Benjamin Grahams The Intelligent Investor.
Certain investment wisdom deserves to be frequently revisited, for inspiration, information, or just as a sanity check when the investment world appears to be somewhat less than sane. At the top of that list is the eighth chapter of Benjamin Grahams The Intelligent Investor, in which the patron saint of value investing explores how market fluctuations can, and should, impact investment decisions. Warren Buffett has called it, along with chapter 20 in the same book on margin of safety, the two most important essays ever written on investing. In light of the markets recent behavior, now would appear to be an excellent time for a Graham refresher course: Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. Graham makes a distinction between trying to profit by timing and by pricing. He likens making bets on the anticipated direction of the overall market (timing) to speculative folly, providing a speculators financial results. The true opportunity presented by volatility, he writes, is simply to take advantage of the resulting price changes, to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.
September 28, 2007

A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. [W]orst thought of all, should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public, and make larger and dangerous commitments? Presented thus, the answer is a self-evident no, but even the intelligent investor is likely to need considerable willpower to keep from following the crowd. As author and journalist Jason Zweig describes in the excellent commentary

that accompanies the revised edition of Grahams book, humans are pattern-seeking animals, hard-wired to see trends even where they dont exist. Our brains automatically anticipate that rising stock prices will continue to rise and, if they do, the natural chemical dopamine is released, resulting in a feeling of euphoria. To counter this and other tests to investor willpower, Graham suggests the use of more mechanical methods for portfolio rebalancing, which today could take the form of formulaic adjustments based on asset-class exposure, industry exposure or position size. The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons mistakes of judgment. The basic advantage to which Graham refers is the individual investors freedom to freely ignore Mr. Markets whims, a luxury not always enjoyed by investment professionals dealing with cash inflows and outflows or obsessively focused on performance versus a benchmark. Jason Zweig here tweaks the media for contributing to the mental anguish caused by falling stock prices. Breathless television reporters and newspaper headlines depicting a 200-point fall in the Dow as a plunge, for example, feed investor anxiety beyond what has actually transpired. Would we consider it a plunge, Zweig points out, if the temperature
Value Investor Insight 19

Im trying to achieve total harmony of body, mind and cashflow.


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outside fell from 80 degrees to 79, the same percentage decrease as a 200-point fall in the Dow today? There are two chief morals to [the A&P] story. The first is that the stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies performance like a hawk; but he should give it a good, hard look from time to time. Graham recounts the wide swings in investor sentiment toward grocer A&P often at considerable odds with the companys actual performance, which deteriorated considerably by the early 1970s. His caution against complacency in monitoring portfolio companies given at a time

when competitive dynamics arguably changed more slowly than they do today is more relevant today than ever. It might be best for [the conservative investor] to concentrate on issues selling at a reasonably close approximation to their tangibleasset value say, at not more than one-third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the companys balance sheet, and as having a justification or support independent of the fluctuating market prices. The investor with a stock portfolio having such book values behind it can give as little attention as he pleases to the vagaries of the stock market. While he focuses on book value, Graham also highlights the importance of a satisfactory ratio of earnings to price and a sufficiently strong financial position in identifying investments that can

best weather market storms. In other words, as Thesis Capitals Stephen Roseman puts it (see p. 17): The best way to deal with the fact that market sentiment can change so quickly is to try to own absurdly cheap things. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies. This is a core message of Grahams: A stock price matters at any given time only in relation to the value of the company behind it. Staying focused on value rather price during times of market turmoil is most likely to pay financial not to mention, psychological dividends. VII

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Value Investor Insight 20

O F S O U N D M I N D : Your Money and Your Brain

Mind Over Money


The 100 billion neurons that are packed into that three-pound clump of tissue between your ears can generate an emotional tornado when you think about money, says author Jason Zweig. His new book offers advice on how to best ride out such storms.
was something I had to learn more about. The result of Zweigs 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 brains 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 reasons, the human brain constantly triggers 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 biases that get investors into trouble helping to explain, for example, why were often more likely to sell when we should be buying or why were 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 thats nurture can help counter some of the problems caused by nature, he says. Many of the practical 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. Theres an unfortunate belief that great investing is about being rational like Star Treks Mr. Spock, where you feel nothing and are just an evaluation machine, he says. I think thats wrong. Investors like Warren Buffett and Charlie Munger are very attuned to the emotions rippling through markets and Id argue that one of the things that sets them apart is that theyre inversely emotional. When they sense pain and fear in the market, they likely feel pleasure at the value being created. Theyre essentially taking the other side of the trade on other peoples 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 willpower, he says. In times of stress, willpower alone is not enough.

illing time between flights a few years ago, Jason Zweig bought an issue of Scientific American and was quickly drawn to an article describing 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 commentary for the 2003 revised edition of Ben Grahams The Intelligent Investor), he says, I knew immediately that this

The Brains Hot Button

eep in your brain, level with the top of your ears, lies a small, almond-shaped knob of tissue called the amygdala. When you confront a potential risk, this part of your reflexive brain acts as an alarm system generating hot, fast emotions like fear and anger that it shoots up to the reflective brain like warning flares. (There are actually two amygdalae, one on the left side of your brain and one on the right, just as office elevators often have one panic button on

either side of the door.) The amygdala helps focus your attention, in a flash, on anything thats new, out of place, changing fast, or just plain scary. That helps explain why we overreact to rare but vivid risks. After all, in the presence of danger, he who hesitates is lost; a fraction of a second can make the difference between life and death. Step near a snake, spot a spider, see a sharp object flying toward your face, and your amygdala will jolt you into jumping, ducking, or taking whatever evasive action should get you out of trouble in the least amount of time.

This same fear reaction is triggered by losing money or believing that you might. However, when a potential threat is financial instead of physical, reflexive fear will put you in danger more often than it will get you out of it. A moment of panic can wreak havoc on your investing strategy. Because the amygdala is so attuned to big changes, a sudden drop in the market tends to be more upsetting than a longer, slower or even a much bigger decline. On October 19, 1987, the U.S. stock market plunged 23% a deeper one-day drop than the Crash of 1929. Big, sudden, and

October 31, 2007

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O F S O U N D M I N D : Your Money and Your Brain

inexplicable, the Crash of 1987 was exactly the kind of event that sparks the amygdala into flashing fear throughout every investors brain and body. The memory was hard to erase: In 1988, U.S. investors sold $15 billion more shares in stock mutual funds than they bought, and their net purchases of stock funds did not recover to pre-crash levels until 1991. The experts were just as shell-shocked: The managers of stock funds kept at least 10% of their total assets in the safety of cash almost every month through the end of 1990, while the value of seats on the New York Stock Exchange did not regain their pre-crash level until 1994. A single drop in the stock market on one Monday in autumn disrupted the investing behavior of millions of people for at least the next three years. The philosopher William James wrote that an impression may be so exciting emotionally as almost to leave a scar upon the cerebral tissues. The amygdala seems to act like a branding iron that burns the memory of financial loss into your brain. That may help explain why a market crash, which makes stocks cheaper, also makes investors less willing to buy them for a long time to come. Fighting Your Fears When you confront risk, your reflexive brain, led by the amygdala, functions much like a gas pedal, revving up your emotions. Fortunately, your reflective brain, with the prefrontal cortex in charge, can act like a brake pedal, slowing you down until you are calm enough to make a more objective decision. The best investors make a habit of putting procedures in place, in advance, that help inhibit the hot reactions of the emotional brain. Here are some techniques that can help you keep your investing cool in the face of fear: Get it off your mind. Youll never find the presence of mind to figure out what to do about a risk gone bad unless you step back and relax. Joe Montana, the great quarterback for the San Francisco 49ers, understood this perfectly. In the 1989 Super Bowl, the 49ers trailed the Cincinnati Bengals by three points with
October 31, 2007

only three minutes left and 92 yards almost the whole length of the field to go. Offensive tackle Harris Barton felt wild with worry. But then Montana said to Barton, Hey, check it out there in the stands, standing near the exit ramp, theres John Candy. The players all turned to look at the comedian, a distraction that allowed their minds to tune out the stress and win the game in the nick of time. When you feel overwhelmed by a risk, create a John Candy moment. To break your anxiety, go for a walk, hit the gym, call a friend, play with your kids. Use your words. While vivid sights and sounds fire up the emotions in your reflexive brain, the more complex cues of language activate the prefrontal cortex and other areas of your reflective brain. By using words to counteract the stream of images the markets throw at you, you can put the hottest risks in cooler perspective. In the 1960s, Berkeley psychologist Richard Lazarus found that showing a film of a ritual circumcision triggered instant revulsion in most viewers, but that this disgust could be short-circuited by introducing the footage with an announcement that the procedure was not as painful as it looked. Viewers exposed to the verbal commentary had lower heart rates, sweated less, and reported less anxiety than those who watched the film without a soundtrack. (The commentary wasnt true, by the way but it worked.) More recently, disgusting film clips featuring burn victims being treated and close-ups of an arm being amputated have been shown to viewers by the aptly named psychologist James Gross. (Although I do not recommend watching it on a full stomach, you can view the amputation clip at http://psychology.stanford.edu/~psyphy/movs/surgery.mov.) He has found that viewers feel much less disgusted if they are given written instructions, in advance, to adopt a detached and unemotional attitude. If you view a photograph of a scary face your amygdala will flare up, setting your heart racing, your breath quickening, your palms sweating. But if you view the same photo of a scary face accompanied by words like angry or afraid, activation
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in the amygdala is stifled and your bodys alarm responses are reined in. As the prefrontal cortex goes to work trying to decide how accurately the word describes the situation, it overrides your original reflex of fear. These discoveries show that verbal information can act as a wet blanket flung over the amygdalas fiery reactions to sensory input. Thats why using words to think about an investing decision becomes so important whenever bad news hits. To be sure, formerly great investments can go to zero in no time; once Enron and WorldCom started to drop, it didnt pay to think analytically about them. But for every stock that goes into a total meltdown, there are thousands of other investments that suffer only temporary setbacks and selling too soon is often the worst thing you can do. To prevent your feelings from overwhelming the facts, use your words and ask questions like these: Other than the price, what else has changed? Are my original reasons to invest still valid? If I liked this investment enough to buy it at a much higher price, shouldnt I like it even more now that the price is lower? What other evidence do I need to evaluate in order to tell whether this is really bad news? Has this investment gone down this much before? If so, would I have 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 an investing diary. You should include what neuroscientist Antoine Bechara calls an emotional registry, tracking the ups and downs of your moods alongside the ups and downs of your money. During the markets biggest peaks and valleys, go back and read your old entries from similar periods in the past. Chances are, your own emotional record will show you that you tend to become overenthusiastic when prices (and risk) are rising, and to sink into despair when prices (and risk)
Value Investor Insight 21

O F S O U N D M I N D : Your Money and Your Brain

go down. So you need to train yourself to turn your investing emotions upside down. Many of the worlds best investors have mastered the art of treating their own feelings as reverse indicators: Excitement becomes a cue that its time to consider selling, while fear tells them that it may be time to buy. I once asked Brian Posner, a renowned fund manager at Fidelity and Legg Mason, how he sensed whether a stock would be a moneymaker. If it makes me feel like I want to throw up, he answered, I can be pretty sure its a great investment. Likewise, Christopher Davis of the Davis Funds has learned to invest when he feels scared to death. He explains, A higher perception of risk can lower the actual risk by driving prices down. We like the prices that pessimism produces. Get away from the herd. In the 1960s, psychologist Stanley Milgram carried out a series of astounding experiments. Lets imagine you are in his lab. You are offered $4 (about $27 in todays money) per hour to act as a teacher who will help guide a learner by penalizing him for wrong answers on a simple memory test. You sit in front of a machine with thirty toggle switches that are marked with escalating labels from slight shock at 15 volts, up to DANGER: SEVERE SHOCK at 375 volts, and beyond to 450 volts (marked ominously with XXX). The learner sits where you can hear but not see him. Each time the learner gets an answer wrong, the lab supervisor instructs you to flip the next switch, giving a higher shock. If you hesitate to increase the voltage, the lab supervisor politely but firmly instructs you to continue. The first few shocks are harmless. But at 75 volts, the learner grunts. At 120 volts, Milgram wrote, he complains verbally; at 150 he demands to be released from the experiment. His protests continue as the shocks escalate, growing increasingly vehement and emotional . . . At 180 volts the victim cries out, I cant stand the pain . . . At 285 volts his response can only be described as an agonized scream. What would you do if you were one of Milgrams teachers? He surveyed more than 100 people outside his lab, describOctober 31, 2007

ing the experiment and asking them at what point they thought they would stop administering the shocks. On average, they said they would quit between 120 and 135 volts. Not one predicted continuing beyond 300 volts. However, inside Milgrams lab, 100% of the teachers willingly delivered shocks of up to 135 volts, regardless of the grunts of the learner; 80% administered shocks as high as 285 volts, despite the learners agonized screams; and 62% went all the way up to the maximum (XXX) shock of 450 volts. With money at stake, fearful of bucking the authority figure in the room, people did as they were told with numbing regularity, wrote Milgram sadly. (By the way, the learner was a trained actor who was only pretending to be shocked by electric current; Milgrams machine was a harmless fake.) Milgram found two ways to shatter the chains of conformity. One is peer rebellion. Milgram paid two people to join the experiment as extra teachers and to refuse to give any shocks beyond 210 volts. Seeing these peers stop, most people were emboldened to quit, too. Milgrams other solution was disagreement between authorities. When he added a second supervisor who told the first that escalating the voltage was no longer necessary, nearly everyone stopped administering the shocks immediately. Milgrams discoveries suggest how you can resist the pull of the herd: Before entering an Internet chat room or a meeting with your colleagues, write down your views about the investment you are considering: why it is good or bad, what it is worth, and your reasons for those views. Be as specific as possible and share your conclusions with someone you respect who is not part of the group. (That way, you know someone else will keep track of whether you change your opinions to conform with the crowd.) Run the consensus of the herd past the person you respect the most who is not part of the group.
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Ask at least three questions: Do these people sound reasonable? Do their arguments seem sensible? If you were in my shoes, what else would you want to know before making this kind of decision? If you are part of an investment organization, appoint an internal sniper. Base your analysts bonus pay partly on how many times they can shoot down an idea that everyone else likes. (Rotate this role from meeting to meeting to prevent any single sniper from becoming universally disliked.) Alfred P. Sloan Jr., the legendary chairman of General Motors, once abruptly adjourned a meeting this way: Gentlemen, I take it we are all in complete agreement on the decision here. Then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about. Peer pressure can leave you with what psychologist Irving Janis called vague forebodings that you are afraid to express. Meeting with the same group over drinks in everyones favorite bar may loosen some of your inhibitions and enable you to dissent more confidently. Appoint one person as the designated thinker, whose role is to track the flow of opinions set free as other people drink. According to the Roman historian Tacitus, the ancient Germans believed that drinking wine helped them to disclose the most secret motions and purposes of their hearts, so they evaluated their important decisions twice: first when they were drunk and again when they were sober. VII
From YOUR MONEY AND YOUR BRAIN by Jason Zweig. Copyright 2007 by Jason Zweig. Reprinted by permission of Simon & Schuster, Inc.
Value Investor Insight 22

Eight Columns on Investor Irrationality (Behavioral Finance) By Whitney Tilson

T2 Partners LLC 145 E. 57th Street, Suite 1100 New York, NY 10022 Phone: (212) 386-7160 Fax: (240) 368-0299 info@T2PartnersLLC.com www.T2PartnersLLC.com

Table of Contents
1. Investors as Pecking Pigeons (6/18/04). I shared some lessons from my trip to Italy, plus two studies that provide insight into investor irrationality. 2. The Perils of Investor Overconfidence (9/20/99). In the first column I ever published, I discussed the many ways in which peoples emotions can undermine their investment decisions and performance. 3. Dont Chase Performance (10/23/02). Investors have an awful, unshakable habit of piling into the hottest investment fad at precisely the wrong time. I argued that you shouldnt let the recent stock market turbulence scare you into switching your assets into bonds or housing, which offer a false illusion of safety. 4. Dont Sell at the Bottom (11/6/02). Investors often panic and sell at precisely the wrong time. I offered some advice on how to avoid this extremely annoying -- not to mention financially painful -- phenomenon. 5. Never Too Late to Sell (3/20/01). If you own a bubble stock that may be heading toward zero, you may want to consider selling it rather than holding on in the vain hope that you might recoup your investment. Looking critically at your holdings -- particularly hopelessly depressed ones -- can be difficult, but investors who bail on bad bets before its too late may preserve both money and sanity. 6. To Sell or Not to Sell (12/5/00). Studies show that investors cling to stocks they own that have declined, even when they have lost confidence in them. With so many stocks down this year, it is especially critical now that investors think rationally about whether to buy more, hold, or sell their losing stocks. 7. Munger Goes Mental (6/4/04). Charlie Munger, the famed right-hand man of Warren Buffett, gave a brilliant speech last October at the University of California, Santa Barbara. With Mungers permission, I published a transcript for the first time and shared the highlights in this column. 8. Munger on Human Misjudgments (8/21/02). Charlie Munger gave an insightful speech on 24 Standard Causes of Human Misjudgment, which has powerful implications for investors. I summarized some key points and provided a link to the speech, so you can read for yourself.

Investors as Pecking Pigeons


Whitney Tilson shares some lessons from his trip to Italy, plus two studies that provide insight into investor irrationality. By Whitney Tilson Published on the Motley Fool web site, 6/18/04 (www.fool.com/news/commentary/2004/commentary040618wt.htm) Greetings from Molfetta, Italy! Before I get to the main topic of todays column, allow me to tell you about this coastal region on the Adriatic and why Im here. Im spending a week in this town in the southeastern part of the country vacationing with my family and teaching a seminar on value investing. This region of Italy, called Puglia, produces most of the countrys olive oil and pasta and has a fascinating, ancient history -- weve visited gorgeous castles and cathedrals that are nearly 1,000 years old. And if youre looking to get off the beaten path, this is it. We have yet to encounter other Americans. While I highly recommend Rome, Florence, and Venice, running into busloads of tourists every five minutes gets old. Our host is Francesco Azzollini, who has established a value-oriented investment fund here -- the first in Italy, he believes. He taught himself investing by reading all of the classics and sitting in on classes taught at Columbia Business School. Hes been applying those lessons with a great deal of success, compounding money at 18% since the funds inception in 2000. He invests primarily in the same situations as U.S.-based value investors: out-of-favor companies, stubs, post-bankruptcies, etc., that trade on the American stock exchanges (though, not surprisingly, he also dabbles in Europe). Its fascinating and heartening to see that the gospel of Graham, Dodd, Buffett, and Munger has reached this remote corner of Italy. Francescos success underscores two important points about value investing. First, one can become a skilled practitioner of the craft without following the typical route of getting an MBA and then apprenticing at a fund. In fact, given how poorly investing is taught at most business schools and practiced at most funds, one might be better off without these experiences! Second, the importance of having access to company managements and making site visits is way overblown. In fact, this too can work against an investors interests. (Theres an unfortunate amount of truth to the joke about how can you tell when a CEO is lying? His lips are moving.) Through the Internet, Francesco can access all of the information he needs to make informed decisions, and his remote location isolates him from the sound and fury (read: nonsense) of Wall Street. You can be sure that CNBC (Bubblevision) isnt blaring in his office, and since the U.S. market doesnt open until 3:30 in the afternoon here, he has nearly the entire day to read and do analysis. Hmmm... Maybe Ill just stay here... Investor irrationality Back to our regularly scheduled programming...

Ive long believed that investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. Equally important is the ability to overcome the natural human tendencies to be extremely irrational when it comes to money. Warren Buffett agrees, commenting that, Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. Investing for the birds With this in mind, lets examine an experiment done with pigeons that I think provides insight into the bizarre investment behavior I observed in my January column, A Scary Time for Stocks: Its mind boggling that so many investors are piling back into the same sectors that crushed them only a short time ago, like moths drawn to a flame. My lament prompted my friend Peter Kaufman, a board member of Wesco Financial (NYSE: WSC), to email me the following: Your observation made me think of classic behavioral research of the 1950s, which employed rats or pigeons to determine how thinking creatures react to certain situations. One such research project, Pigeons at a Feeding Bar, may offer some insight into this moth-like tendency of investors to return again and again to the same bad situation. In one stage of the research project, pigeons are first acclimated to a set pattern of food rewards, in which the pigeon earns his kernels by pecking a feeding bar until a unit of food is delivered (for example, the pattern might be for one kernel after every 10 strikes of the bar). Subsequent to this particular pattern being established, food delivery is terminated altogether, allowing researchers to tabulate how long a pigeon will continue to hit the feeding bar before it realizes it has become fruitless to do so. The research revealed that pigeons are, as a group, remarkably consistent in the time that elapses until they realize that a formerly productive pattern has been replaced by a new, fruitless one. Once pigeons rationally discern the true pattern, they uniformly abandon the process in a predictable and timely manner. But what happens if no true pattern of reward ever exists in the first place? For example, what happens if instead of an established pattern of rewards, the feeding bar reward sequence is purely arbitrary (i.e. a random number table is used to set reward intervals)? Under this scenario, the poor pigeons encounter a mind-spinning quandary: Although they see there are alluring rewards to be had in the system, they are unable to grasp how those rewards can be consistently earned. The amazing result: In random-number versions of this experiment, even after the food delivery has been terminated altogether, pigeons return again and again, relentlessly hitting the bar until finally they drop from physical exhaustion. What relevance do pigeon studies of the 1950s have to Wall Street behavior in 2004? Well, at the risk of overdrawing animal behavior to human behavior, investors repeatedly returning to the flame sure looks a lot like the behavior of lab pigeons in the second version of the experiment. And the reason appears to be the same: Both the investors and the pigeons are mesmerized by the tasty rewards they believe lie within the system, and both are similarly unable to divine a recognizable pattern as to how such rewards are

earned at the feeding bar. Should investors inability to grasp a recognizable pattern really surprise us? Investors have watched in bewilderment as an entire investment hierarchy has thrown out basic accounting conventions and valuation metrics that have been in effect for nearly a century; they have seen initial public offerings soar to the stratosphere for companies with no comprehensible business model, no cash flow, and sometimes, even no revenue; and they continue to see CEOs drive their companies into the ground while nevertheless receiving tens or hundreds of millions of dollars of stock options. Is it any wonder why investors are unable to identify a recognizable, dependable pattern as to how rewards are to be earned in this system? Researchers learned that pigeons, faced with alluring rewards but without recognized patterns as to how they are earned, essentially go mad, incessantly returning to hit the bar until they physically collapse. Sadly, in environments such as market bubbles, it seems this same stimulus-response mechanism can apply to human beings. Just as is the case with slot machines, lotteries and other forms of unskilled gambling, when investment returns take on the character of being arbitrary, unearned, or random, human hope springs eternal -- rendering many investors unable to resist the feeding bar. Can anything be done to stop this recurring insanity? As the lab pigeons showed us, the only real antidote for irrational investor behavior, is rationality (i.e. the ability to truly understand what is going on). In other words, the antidote for market bubbles is rational pattern recognition, recognizing that the valuations of the securities they are snapping up have no basis in future earning power or any other objective economic measure, but instead have a basis in grossly unrealistic claims, promotions, hopes, and dreams. Is there any hope that the irrational exuberance bemoaned by Alan Greenspan in December of 1996 will evolve into a saner set of investor behaviors? Im not holding my breath. Human greed and wishful thinking, time tested as they are, suggest that most human investors will never be anything but pigeons. Translating theory to practice I think my friend is exactly right, and his conclusions are supported by other studies conducted by Vernon Smith, a professor at George Mason University who shared in the 2002 Nobel Prize for economics. As described in The Wall Street Journal on April 30, in numerous experiments he conducted, participants would trade a dividend-paying stock whose value was clearly laid out for them. Invariably, a bubble would form, with the stock later crashing down to its fundamental value. One would think that the participants, having suffered horrible losses, would have learned not to speculate. Yet when they gathered for a second session, still, the stock would exceed its assigned fundamental value, though the bubble would form faster and burst sooner. How could another bubble form so quickly? Simple: The take-away lesson investors learned the first time was not dont speculate, but rather, its OK to speculate, but one must sell more quickly once the bubble starts to burst. Sound familiar?

Of course this game doesnt work either, since few people can accurately time the top and everyone tends to head for the exit at the same time. Professor Smith notes that The subjects are very optimistic that theyll be able to smell the turning point and They always report that theyre surprised by how quickly it turns and how hard it is to get out at anything like a favorable price. Thus, it is only when Professor Smith runs the session a third time that the stock trades near its fundamental value, if it trades at all. I would argue that in many sectors, we are in the midst of the second mini-bubble and that speculators will be crushed again. Investors -- and pigeons -- beware! Contributor Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.

The Perils of Investor Overconfidence


By Whitney Tilson (Tilson@Tilsonfunds.com) Published on the Motley Fool web site, 9/20/99 (http://www.fool.com/BoringPort/1999/BoringPort990920.htm) NEW YORK, NY (September 20, 1999) -- Hello, fellow Fools. Dale is away this week and he invited me to be a guest columnist today, Wednesday, and Friday in his absence. First, by way of introduction, when I began investing a few years ago, I tried to educate myself by reading everything I could find on the topic (click here for a list of my all-time favorite books on investing). Being an early user of the Internet, I soon discovered The Motley Fool, which I have enjoyed and learned from immensely. The topic Id like to discuss today is behavioral finance, which examines how peoples emotions affect their investment decisions and performance. This area has critical implications for investing; in fact, I believe it is far more important in determining investment success (or lack thereof) than an investors intellect. Warren Buffett agrees: Success in investing doesnt correlate with I.Q. once youre above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. Numerous studies have shown that human beings are extraordinarily irrational about money. There are many explanations why, but the one I tend to give the most weight to is that humans just arent wired properly. After all, homo sapiens have existed for approximately two million years, and those that survived tended to be the ones that evidenced herding behavior and fled at the first signs of danger -- characteristics that do not lend themselves well to successful investing. In contrast, modern finance theory and capital markets have existed for only 40 years or so. Placing human history on a 24-hour scale, thats less than two seconds. What have you learned in the past two seconds? People make dozens of common mistakes, including: 1) Herding behavior, driven by a desire to be part of the crowd or an assumption that the crowd is omniscient; 2) Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money; 3) Excessive aversion to loss; 4) Fear of change, resulting in an excessive bias for the status quo; 5) Fear of making an incorrect decision and feeling stupid; 6) Failing to act due to an abundance of attractive options; 7) Ignoring important data points and focusing excessively on less important ones; 8) Anchoring on irrelevant data; 9) Overestimating the likelihood of certain events based on very memorable data or experiences; 10) After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome; 11) Allowing an overabundance of short-term information to cloud long-term judgments;

12) Drawing conclusions from a limited sample size; 13) Reluctance to admit mistakes; 14) Believing that their investment success is due to their wisdom rather than a rising market; 15) Failing to accurately assess their investment time horizon; 16) A tendency to seek only information that confirms their opinions or decisions; 17) Failing to recognize the large cumulative impact of small amounts over time; 18) Forgetting the powerful tendency of regression to the mean; 19) Confusing familiarity with knowledge; 20) Overconfidence Have you ever been guilty of any of these? I doubt anyone hasnt. This is a vast topic, so for now I will focus on overconfidence. In general, an abundance of confidence is a wonderful thing. It gives us higher motivation, persistence, energy and optimism, and can allow us to accomplish things that we otherwise might not have even undertaken. Confidence also contributes a great deal to happiness. As one author writes (in an example that resonated with me, given the age of my daughters), Who wants to read their children a bedtime story whose main character is a train that says, I doubt I can, I doubt I can? But humans are not just robustly confident-they are wildly overconfident. Consider the following: - 82% of people say they are in the top 30% of safe drivers; - 86% of my Harvard Business School classmates say they are better looking than their classmates (would you expect anything less from Harvard graduates?); - 68% of lawyers in civil cases believe that their side will prevail; - Doctors consistently overestimate their ability to detect certain diseases (think about this one the next time youre wondering whether to get a second opinion); - 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed; - Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The average guesses were 27.4 days, 33.9 days, and 48.6 days, respectively. The actual average turned out to be 55.5 days. - Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement and how much the average person in the room would have. The average figures were $5 million and $2.6 million, respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1. Importantly, it turns out that the more difficult the question/task (such as predicting the future of a company or the price of a stock), the greater the degree of overconfidence. And professional investors -- so-called experts -- are generally even more prone to overconfidence than novices because they have theories and models that they tend to overweight. Perhaps more surprising than the degree of overconfidence itself is that overconfidence doesnt seem to decline over time. After all, one would think that experience would lead people to

become more realistic about their capabilities, especially in an area such as investing, where results can be calculated precisely. Part of the explanation is that people often forget failures and, even if they dont, tend to focus primarily on the future, not the past. But the main reason is that people generally remember failures very differently from successes. Successes were due to ones own wisdom and ability, while failures were due to forces beyond ones control. Thus, people believe that with a little better luck or fine-tuning, the outcome will be much better next time. You might be saying to yourself, Ah, those silly, overconfident people. Good thing Im not that way. Lets see. Quick! How do you pronounce the capital of Kentucky: Loo-ee-ville or Looiss-ville? Now, how much would you bet that you know the correct answer to the question: $5, $50, or $500? Heres another test: Give high and low estimates for the average weight of an empty Boeing 747 aircraft. Choose numbers far enough apart to be 90% certain that the true answer lies somewhere in between. Similarly, give a 90% confidence interval for the diameter of the moon. No cheating! Write down your answers and Ill come back to this in a moment. So people are overconfident. So what? If healthy confidence is good, why isnt overconfidence better? In some areas -- say, being a world-class athlete -- overconfidence in fact might be beneficial. But when it comes to financial matters, it most certainly is not. Overconfidence often leads people to: 1) Be badly prepared for the future. For example, 83% of parents with children under 18 said that they have a financial plan and 75% expressed confidence about their long-term financial well being. Yet fewer than half of these people were saving for their childrens education and fewer than 10% had financial plans that addressed basic issues such as investments, budgeting, insurance, savings, wills, etc. 2) Trade stocks excessively. In Odean and Barbers landmark study of 78,000 individual investors accounts at a large discount brokerage from 1991-1996, the average annual turnover was 80% (slightly less than the 84% average for mutual funds). The least active quintile, with average annual turnover of 1%, had 17.5% annual returns, beating the S&P, which was up 16.9% annually during this period. But the most active 20% of investors, with average turnover of more than 9% monthly, had pre-tax returns of 10% annually. The authors of the study rightly conclude that trading is hazardous to your wealth. Incidentally, I suspect that the number of hyperactive traders has increased dramatically, given the number of investors flocking to online brokerages. Odean and Barber have done another fascinating study showing that investors who switch to online trading suffer significantly lower returns. They conclude this study with another provocative quote: Trigger-happy investors are prone to shooting themselves in the foot. 3) Believe they can be above-average stock pickers, when there is little evidence to support this belief. The study cited above showed that, after trading costs (but before taxes), the average investor underperformed the market by approximately two percentage points per year. 4) Believe they can pick mutual funds that will deliver superior future performance. The markettrailing performance of the average mutual fund is proof that most people fail in this endeavor. Worse yet, investors tend to trade in and out of mutual funds at the worst possible time as they chase performance. Consider that from 1984 through 1995, the average stock mutual fund posted

a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have made nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying and holding an S&P 500 index fund. Factoring in taxes would make the differences even more dramatic. Ouch! 5) Have insufficiently diversified investment portfolios. Okay, I wont keep you in suspense any longer. The capital of Kentucky is Frankfort, not Looee-ville, an empty 747 weighs approximately 390,000 lbs., and the diameter of the moon is 2,160 miles. Most people would have lost $500 on the first question, and at least one of their two guesses would have fallen outside the 90% confidence interval they established. In large studies when people are asked 10 such questions, 4-6 answers are consistently outside their 90% confidence intervals, instead of the expected one of 10. Why? Because people tend to go through the mental process of, for example, guessing the weight of a 747 and moving up and down from this figure to arrive at high and low estimates. But unless they work for Boeing, their initial guess is likely to be wildly off the mark, so the adjustments need to be much bolder. Sticking close to an initial, uninformed estimate reeks of overconfidence. In tests like this, securities analysts and money managers are among the most overconfident. Im not surprised, given my observation that people who go into this business tend to have a very high degree of confidence. Yet ironically, it is precisely the opposite -- a great deal of humility -that is the key to investment success. --Whitney Tilson P.S. If you wish to read further on the topic of behavioral economics, I recommend the following (I have drawn on heavily on the first two in this column): - Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich. - What Have You Learned in the Past 2 Seconds?, paper by Michael Mauboussin, CS First Boston. - In May and June this year, David Gardner wrote four excellent columns in The Motley Fools Rule Breaker Portfolio: The Psychology of Investing, Whats My Anchor?, Tails-Tails-TailsTails, and The Rear-View Mirror. - Theres a great article about one of the leading scholars in the field of behavioral finance, Terrance Odean (whose studies I linked to above), in a recent issue of U.S. News & World Report: Accidental Economist - The Winners Curse, by Richard Thaller. - The Undiscovered Managers website has links to the writings of Odean and many other scholars in this area. Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.

Dont Chase Performance


Investors have an awful, unshakable habit of piling into the hottest investment fad at precisely the wrong time. Whitney Tilson argues that you shouldnt let the recent stock market turbulence scare you into switching your assets into bonds or housing, which offer a false illusion of safety. By Whitney Tilson Published on the Motley Fool web site, 10/23/02 (http://www.fool.com/news/foth/2002/foth021023.htm) If theres one thing as certain as death and taxes, its that investors will chase performance, almost always to their detriment. Consider the study from 1984 through 1995, which showed that while the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P 500), the average investor in a stock mutual fund earned only 6.3%. Put another way, over those 12 years, the average mutual fund investor would have ended up with nearly twice as much money by simply buying and holding the average mutual fund -- not to mention about 2.5 times as much by buying an S&P 500 index fund. How can this be? Simple. Like moths to a flame, investors are invariably drawn to topperforming funds. They pile into them at their peaks, ride them down, and then repeat the process again and again. For a recent example of this phenomenon, consider the tens of billions of dollars investors put into Janus mutual funds in early 2000 -- money that has all but evaporated. When it comes to mutual funds, past performance is indeed no predictor of future success. A study by the Financial Research Corp. of Boston found that from 1988 to 1998, the average performance of funds placing in the top 10% of their peer groups in one year almost invariably fell back toward the middle of the next year. In fact, the study found that, out of the 40 quarterly periods measured, only once did the average performance of the top 10% of funds place into even the top 25% in the subsequent year. (For more on this topic, I recommend a 1999 article by William Bernstein.) So what should an investor do? Invest in the worst-performing funds? Nope, studies show that they do even worse. The answer is to find an investment manager with a sound investment strategy and a proven ability to carry it out (I shared my thoughts on this topic in Traits of Successful Money Managers). The mutual funds or fund families I suggest considering are (in no particular order): Longleaf (about which Zeke Ashton recently wrote), Clipper, Oakmark, Olstein, Third Avenue, and Tweedy Browne (Id recommend the Sequoia Fund as well, but its been closed to new investors since 1982). For further information, check out The Motley Fools Mutual Fund Center and our How to Pick the Best Mutual Funds. Chasing performance is, of course, not limited to mutual funds. The same phenomenon is occurring, I believe, in the bond and housing markets today.

Bonds As investors have fled stocks over the past two and a half years, they have sought safety in other areas to such an extent that bonds have outperformed stocks over the past five, 10, and 15 years. Thats an amazing fact, given the unprecedented bull market that prevailed for most of the last two decades. Such outperformance by bonds is quite rare. According to statistics in Jeremy Siegels Stocks for the Long Run, from 1871 to 1996, stocks outperformed bonds in 72.1% of five-year periods, 82.1% of 10-year periods, and 94.4% of 20-year periods (there was no data on 15-year periods). Though recently stocks have spiked up and bond yields have risen from multi-decade lows, I think its very unlikely that bonds will continue to do better than stocks over the next five or more years. Thats not to say I think stocks will be a great investment, but with the yield on the 10-year Treasury note a mere 4.26% (as of yesterdays close), the hurdle isnt very high. The legendary Bill Gross, manager of the largest bond fund in the world, Pimco Total Return Fund, disagrees (surprise!). He thinks the fair value for the stock market is Dow 5,000, for several reasons. I agree that stocks remain overvalued, but think hes a bit too bearish on stocks, and far too bullish on bonds. Housing In addition to bonds, investors seeking safety have primarily fled to housing. While it hasnt yet reached bubble proportions nationwide, its coming close in some cities, generally on the East and West Coasts. Take a look at my hometown, New York City, N.Y. The city is still struggling to recover from 9/11, faces its worst budget crisis in decades, and is reeling from huge layoffs by Wall Street firms, yet housing prices still rose 11% in the year ended June 2002. Having recently bought an apartment there, I can attest to the craziness of the housing market. And New York is hardly alone. According to the cover story in this weeks Fortune, Since the boom began in 1995, housing prices have jumped 51%, or 32 points above inflation. The run-up has added $50,000 in wealth, on average, for every one of the nations 72 million homeowners. In many markets the gains are even more extraordinary. In Boston, home prices have risen more than 110% since 1996, to an average of $398,000. In San Francisco and San Jose, a threebedroom ranch will run you about $500,000, almost twice what it fetched seven years ago. A recent front-page story in The Wall Street Journal (subscription required) had similar data: In Miami, home prices have shot up 58% since the beginning of 1998, while incomes have risen only 16%. In New Yorks Long Island suburbs, an 81% increase in home prices compares with a 14% rise in incomes. In Boston, home prices have jumped 89%, compared with income gains of only 22%. And in some cities, including San Diego, Miami, and Washington, D.C., the run-ups have accelerated in the past year -- confounding expectations that the market would cool off before it got too far out of line. This kind of nonsense cannot and will not continue -- most obviously because mortgage interest rates are highly unlikely to fall much further (since mid-1990, the rate on a 30-year mortgage dropped from 10.5% to a recent 40-year low of 5.95%). I dont expect a collapse in housing

prices -- rather, they will likely return, at best, to the 5% growth rate of the past 30 years. Stocks are likely, I believe, to do a few percentage points per year better. Conclusion The stock market has been, for many people, a frightening place to be for the past few years, but fleeing to bonds or housing right now is the wrong move. If you can stomach the volatility and have a sound investment strategy (admittedly, two very big ifs), stocks are a better bet. Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.

Dont Sell at the Bottom


Investors often panic and sell at precisely the wrong time. Whitney Tilson offers some advice on how to avoid this extremely annoying -- not to mention financially painful -phenomenon. By Whitney Tilson Published on the Motley Fool web site, 11/6/02 (http://www.fool.com/news/foth/2002/foth021106.htm) In my last column, I wrote about investors unshakable habit of piling into the hottest investment fad at precisely the wrong time. Today, I warn about the opposite, yet equally pernicious, habit: panicking and selling at the bottom. How many times have you bought a stock or invested in a mutual fund, watched it decline, sold because you couldnt take the pain anymore, and then watched it rebound? It happens all the time, and Id wager theres not a single investor who hasnt been victimized by this extremely annoying -- not to mention financially painful -- phenomenon. With such a broad-based decline in the market (unlike last year), there have been few places to hide in 2002, as the great majority of stocks and funds have fallen significantly. If your portfolio has gotten whacked, what should you do? Dump the investments after theyve fallen, or hang on in the hope that theyll rebound? Ive found this to be the most difficult type of investment decision: distinguishing between genuinely lousy investments that will never bounce back (and thus should be sold immediately) and those that have been unfairly beaten up by the market and should therefore be held or even bought. Warren Buffett, as always, has great advice. In an interview in the latest issue of Fortune, he was asked if it bothered him that many believed you were a has-been, that you were through when Berkshire Hathaways stock -- and those of many of Buffetts holdings -- were getting pounded during the Internet bubble. Buffett replied: Never. Nothing bothers me like that. You cant do well in investments unless you think independently. And the truth is, youre neither right nor wrong because people agree with you. Youre right because your facts and your reasoning are right. In the end, thats all that counts. And there wasnt any question about the facts or reasoning being correct. In other words, to be a successful investor, you must ignore the market and the false signals that it can send out, and instead rely on your facts and your reasoning -- nothing else. This advice is undoubtedly correct, but it can be hard to apply in practice. Evaluating stocks For example, lets say you bought AOL Time Warner (NYSE: AOL) and Tyco (NYSE: TYC) a year ago at $33 and $49, respectively. Now, at $15 and change each, theyre down 52% and 69%. What should you do?

I dont have a strong opinion on either of these stocks, and thats OK, since I dont own either of them. I do, however, have an opinion (and obviously a favorable one) for every stock I own -and you should too. As I wrote in Never Too Late to Sell: You should calmly and unemotionally evaluate every one of your holdings. Are there any in which you have lost confidence, or in which you still believe, but think the valuation is too high? Then think very hard about selling. The key question that I ask myself is: If I didnt own this stock, would I buy it today? If not -- and if there are no taxable gains -then I will usually sell. As you review your portfolio, keep in mind that a stock doesnt know that you own it. Its feelings wont be hurt if you sell it, nor does it feel any obligation to rise to the price at which you bought it so that you can exit with your investment -- not to mention your dignity -- intact. Evaluating investment funds The same principles apply when evaluating investment funds. If you simply look at performance, especially over a short period in such a turbulent market, you are likely to make a bad decision. Consider what happened to three of the greatest investors of all time during the early 1970s -- the last period in which the U.S. stock market experienced a bubble and subsequent decline comparable to recent history. From 1970 to 1972, investors piled into a handful of premiere growth stocks, labeled The Nifty Fifty, which (at their peak) traded at an average P/E ratio of 42 versus the S&P 500s 19. Then the bubble burst, and in 1973 and 1974, the Dow fell 33.2% (44.4% from peak to trough). Warren Buffett (who made Berkshire Hathaway (NYSE: BRK.A) his investment vehicle after closing his partnership at the end of 1969), Charlie Munger (who had not yet formally teamed up with Buffett and was running his own partnership), and the Sequoia Funds (Nasdaq: SEQUX) Bill Ruane all experienced the worst relative and absolute investment performances of their otherwise-spectacular careers during this period. Heres the data:
Yr S&P 500 1970 3.9% 1971 14.6% 1972 18.9% 1973 -14.8% 1974 -26.6% TOTAL -11.5% Berkshire -7.1% 79.5% 14.3% -11.3% -43.7% -4.8% Munger -0.1% 20.6% 7.3% -31.9% -31.5% -39.7% Sequoia n/a 13.5% 3.7% -24.0% -15.7% -24.6%

Note: Berkshire Hathaways returns are based on year-ending share prices. The Munger Partnerships returns are net to limited partners. The Sequoia Fund was launched on July 15, 1970, and appreciated by 12.1% over the balance of the year, trailing the 20.6% return of the S&P 500 over the same period.

Imagine that you had encountered Warren Buffett at the end of 1975. Impressed with his intellect and investment approach, you would have naturally examined his track record -- and almost certainly, to your everlasting regret, not invested. Why? Because his results, as measured by the stock price of Berkshire Hathaway, were truly dreadful over a four-year period. The stock not

only declined and trailed the market during the 1973-74 downturn, but also in the 1975 rebound. Consider this data:
Yr S&P 500 1972 18.9% 1973 -14.8% 1974 -26.6% 1975 37.2% TOTAL 2.0% Berkshire 14.3% -11.3% -43.7% -5.0% -45.8%

The rest is, of course, history. From $38/share at the end of 1975, Berkshire Hathaway has risen nearly 2,000 times to yesterdays closing price of $73,900. [For more information about the track records of these investors (and many others), plus some of the wisest words ever spoken about investing, see Buffetts famous 1984 speech, The Superinvestors of Graham-and-Doddsville.] My point is not that you should ignore performance -- its that you should evaluate money managers based on two things, neither of which has anything to do with short-term investment returns. First, consider their investment approach, and second, their ability to carry out that approach successfully (assuming, of course, that the manager has the requisite integrity). Conclusion Countless studies have shown that during turbulent times like these, investors are prone to making hasty, irrational financial decisions. Dont let this happen to you! Now, more than ever, you must block out your emotions and be supremely analytical in evaluating your holdings and making investment decisions. Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.

Never Too Late to Sell


If you own a bubble stock that may be heading toward zero, Whitney Tilson says, you may want to consider selling it rather than holding on in the vain hope that you might recoup your investment. Looking critically at your holdings -- particularly hopelessly depressed ones -- can be difficult, but investors who bail on bad bets before its too late may preserve both money and sanity. By Whitney Tilson Published on the Motley Fool web site, 3/20/01 (http://www.fool.com/news/foth/2001/foth010320.htm) Its embarrassing to admit, but when I first started investing, I didnt have the foggiest notion of what I was doing. I thought I did, of course, but now I look back and thank my lucky stars that I didnt lose a lot of money, because by all rights I should have. Thank you Warren Buffett, Charlie Munger, Ben Graham, Philip Fisher and Peter Lynch, among others, for teaching me how to invest sensibly. Im going to tell you a story -- one Ive never shared with anyone because it makes me look pretty silly -- in the hopes that some people might learn from my experience. It involves my most disgraceful investment, a sham of a company called Streamlogic. (Dont bother trying to find a web site or ticker, as its long since defunct.) I heard about the stock from a friend, who got a hot tip from her brother-in-law that it was going to be acquired for $14. The stock was going nuts on this speculation, rising in a matter of days from $1 to $6. I looked up the financials, which were a joke, but greed and ignorance caused me to buy 1,000 shares anyway. You know where this storys going, dont you? I nailed the top and the stock declined relentlessly over the next few months. Every day I would look at my stock portfolio and there was Streamlogic, scornfully mocking me. It got depressing after a while, but I still didnt sell. Consumed by fatalism, I rationalized to myself that at $2 a share, it couldnt drop any further. And anyway, there was so little of my investment left that it really didnt matter, right? One day I snapped out of my funk. I remember thinking, Wait a second! $2,000 is real money! There are a lot of better things I can do with that money instead of watching it slowly evaporate. I had long since recognized that investing in Streamlogic -- at any price -- was a ghastly mistake, but I was compounding my initial folly by not taking immediate action to rectify the situation. So I sold, salvaging one-third of my original investment. (You wont be surprised to hear that the stock soon went to zero.) The reason Im telling you this story is because the emails Ive received from my readers over the past few months lead to believe that there are many, many people in similar situations today. They made bad investments in preposterous companies, know now that they made a mistake, but havent sold yet.

The truth about the Internet bubble If you got caught up in the excitement over the Internet and made some investments you regret, learn from the experience and vow never to make the same mistake again, but dont be too embarrassed. There were very powerful forces at work that lured even the most sensible people into the party. Warren Buffett wrote about this in his recent annual letter to Berkshire Hathaway shareholders: Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them. The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a companys promoters. At bottom, the business model for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen. If you own the stocks of any of the sham companies that Buffett is referring to, I suggest that you consider selling them immediately. Ah, but its not always obvious which companies are shams, with stocks that are going to zero, and which are survivors, with stocks that might be good investments at todays low prices. How can you tell the difference? There are no easy answers and reasonable people will disagree, but let me give one example of the former: Loudcloud (Nasdaq: LDCL). This companys S-1 (IPO) filing reveals miniscule revenues, enormous losses, a mediocre (at best) business model, and future prospects that depend on taking market share from larger, established companies during a period when customers are retrenching. With no reasonable likelihood of profitability anywhere on the horizon, I cant figure out how Loudcloud is going to survive, much less thrive. Whether or not Loudcloud eventually succeeds, it is clearly premature to take it public. Yes, hundreds of companies in similar situations went public over the past few years, but that was during a bubble that has now burst. In todays environment, this IPO is a travesty and both the management of Loudcloud and the underwriters, Goldman Sachs and Morgan Stanley Dean Witter, should be ashamed of themselves. Less than a week after going public, the stock is already down 20% -- well on its way to zero, where it probably belongs. To sell or not to sell My point is not that you should immediately sell any stocks you own -- whether Internet-related or not -- that have declined precipitously. Dont let yourself be frightened into selling a quality company because its stock price has fallen. In fact, you should be delighted by the opportunity to buy more of a stock you like at a lower price, all other things being equal.

Of course, all other things usually arent equal. Maybe the company has missed earnings or announced bad news. Or maybe you now realize that when you bought the stock, you were counting on a greater fool to buy it from you at a higher price -- but you ended up being the fool. My point, in the end, is that you should calmly and unemotionally evaluate every one of your holdings. Are there any in which you have lost confidence, or in which you still believe, but think the valuation is too high? Then think very hard about selling. The key question that I ask myself is: If I didnt own this stock, would I buy it today? If not -- and if there are no taxable gains -- then I will usually sell. (For more thoughts on selling, see my December column, To Sell or Not to Sell?) As you review your portfolio, keep in mind that a stock doesnt know that you own it. Its feelings wont be hurt if you sell it, nor does it feel any obligation to rise to the price at which you bought it so that you can exit with your investment -- not to mention your dignity -- intact. Conclusion You cant change the past, but you absolutely can and should take actions today that will benefit your financial future. After you cleanse your portfolio, then vow, as I did, to forevermore only own stocks in companies and industries you understand well, for which you believe the company and its management are of high quality, and that you can buy at an attractive price. -- Whitney Tilson Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of the companies mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.

To Sell or Not to Sell


Studies show that investors cling to stocks they own that have declined, even when they have lost confidence in them. With so many stocks down this year, it is especially critical now that investors think rationally about whether to buy more, hold, or sell their losing stocks. By Whitney Tilson Published on the Motley Fool web site, 12/5/00 (http://www.fool.com/news/foth/2000/foth001205.htm) Im interrupting my series on how to analyze cash flow statements and calculate free cash flow because some of the emails I received after last weeks column are troubling me. After reading the first part of my analysis of Lucents (NYSE: LU) weak cash flows, a number of readers emailed me with comments like these: I am with LU to the bitter end. I am a recently laid-off former Lucent employee and I thank you for explaining why the stock has gone to hell in a handbasket. However, I wish I would have known before what was left of my 401(k) went out the window. Will I ever get any of it back? What troubles me about these emails is that these investors, I fear, are not thinking rationally about their decision to buy more, hold, or sell their Lucent stock. It might well be a good investment at todays prices (I wont be expressing any opinion on this until I finish analyzing Lucents cash flows in my next two columns) but I think many investors are holding this stock -and others that have fallen precipitously -- for the wrong reasons. Theyre hanging on not because they firmly believe that it is among their very best investment ideas today, but because they are hoping that the stock will rebound to the price at which they bought it so they can sell without incurring a loss. This is among the most common -- and costly -- mistakes that investors make. (Terrence Odean, who has done a number of fascinating studies on investor behavior, published a paper, Are Investors Reluctant to Realize Their Losses?, which shows that investors are twice as likely to sell their winners as their losers.) Losing money on a stock -- even if only on paper -- is painful thing. (Those of you who have read my columns on American Power Conversion (Nasdaq: APCC) know that I speak from personal experience.) This pain can trigger irrational, destructive decisions, especially among less-experienced investors. Millions of people were lured into picking stocks for the first time over the past year or two by the false promise of easy riches. Until recently, they had known nothing but a euphoric bull market, but many are now sitting on losses of 50%, 80%, or more in certain stocks. Uncertainty, fear, and even panic are the widespread consequence. It is absolutely critical during times like these to be supremely rational when making investment decisions. Why investors cling to mistakes Even the most successful investors make mistakes. What generally differentiates them from the

rest of the pack is that they minimize the number of mistakes and, equally importantly, quickly recognize, acknowledge, and sell mistakes. Regarding the latter, you would think that once investors had come to realize that they had made a mistake in buying a stock, then selling would be a natural next step. Unfortunately, this is often not the case, especially when it involves selling at a loss. Why? Forty-two years ago in his timeless classic, Common Stocks and Uncommon Profits, Philip Fisher nailed the answer on the head: There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous. This sentence bears repeating: More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason. Dont fall victim to this trap! As my friend says: Dont let what you want change what is. You dont have to make it back the same way you lost it. Thinking rationally Now that we understand that it is normal to irrationally resist selling a losing stock, how can we reorient our thinking? Heres how I do it: In my mind, I assume that my entire portfolio is 100% cash. Then I ask myself, How would I invest this cash? Which stocks would I buy? What would my new built-from-scratch portfolio look like? I urge you to do the same mental exercise. Now compare your hypothetical new portfolio with your current one. Is it different? Are there any stocks in your current portfolio that you wouldnt buy today if you had 100% cash? If so, then why on earth dont you sell them immediately? One good answer is that you are sitting on a big capital gain and dont want to pay the taxes. Thats a good reason, as taxes are a real cost. (Its an especially good reason near the end of the year, when by delaying selling by less than a month, you can defer paying the taxes for an entire year.) Lets say you were lucky enough to buy Cisco (Nasdaq: CSCO) at its IPO, meaning that your cost basis is a few pennies per share. If you sold at $50, you would have to pay $10/share in taxes assuming the 20% long-term capital gains tax rate. That means you would be trading $50 of Cisco for $40 of another stock. Do you have that much confidence in another stock (or, conversely, are you quite certain that Ciscos stock will decline)? While Im a proponent of longterm investing, if youre confident that the answer to either of these questions is yes, then sell. The decision to sell should be much easier if you have a loss on a stock (assuming, as noted above, that you would not buy the stock today if you didnt own it). Think of it this way: Uncle

Sam is paying you to sell! Losing money on a stock is no fun, but a tax loss can soothe the pain a bit. Conclusion As Ive written in many previous columns, the price you pay for a stock is a critical determinant of your return. But once you own a stock, your purchase price is irrelevant to your decision whether to buy, sell, or continue holding -- other than to consider taxes. Let me be very clear: I am not advocating that you blindly sell your losing stocks. That would be falling into another trap that studies have identified: investors have a terrible habit of buying at the top and selling at the bottom. In fact, all other things being equal, you should be an even more eager buyer at a lower price, since the best time to buy is when the stock of a good company has been beaten down due to external or short-term issues. Ah, but all other things arent always equal. Companies and industries change. New information surfaces. Assumptions can prove to be inaccurate. Stocks often decline for very good reasons, and you might be correct in concluding that there are better places for your capital, even though the stock has become cheaper. The key is figuring out which stocks are mistakes and which represent opportunity. Thats not easy, but it is certainly much easier if you can overcome the natural human tendency to irrationality cling to losing stocks. -- Whitney Tilson Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, click here.

Munger Goes Mental


Charlie Munger, the famed right-hand man of Warren Buffett, gave a brilliant speech last October at the University of California, Santa Barbara. With Mungers permission, Whitney Tilson is publishing a transcript for the first time -- a Motley Fool exclusive! -and shares the highlights in this column. By Whitney Tilson Published on the Motley Fool web site, 6/4/04 (www.fool.com/news/commentary/2004/commentary040604wt.htm) Berkshire Hathaways (NYSE: BRK.A)(NYSE: BRK.B) Warren Buffett and Charlie Munger are undoubtedly the greatest investment duo ever, so I think any sensible investor should try to learn as much as possible about these two men and how they achieved their success. In the case of Buffett, its not hard -- there are many books about him, hes published lengthy annual letters for decades (you can read the last 27 of them for free on Berkshires website), and he gives speeches and makes public appearances regularly. But Munger is more private; there are only two books about him, he is a far less prolific writer, and rarely gives speeches. Thus, my heart skipped a beat when a friend gave me a recording of a speech Munger gave to the economics department at the University of California, Santa Barbara last Oct. 3. Its 85 minutes long and entitled, Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs. With that kind of title, it sounds like a real snoozer, eh? But its not. In this speech, Munger applies his famous mental models approach to critiquing how economics is taught and practiced, and I think the lessons he teaches are profound -- both for investors as well as anyone who seeks to be a better, clearer thinker. I transcribed the speech for my own benefit, but after making such an effort (it took forever, as its 21 single-spaced pages), I thought that others might be interested in Mungers wisdom, so I sent him a copy and asked if I could publish it. He asked me not to until hed had a chance to review it and make some edits. He has now done so, so Im delighted to share it with you: Click here to read it. In this column, I will share some of the highlights of the speech. Berkshires success Munger started his speech by highlighting his credentials to talk about economics -- namely the extraordinary success of Berkshire Hathaway over the years he and Buffett have been running it (Buffett ran it for a few years before Munger joined him): When Warren took over Berkshire, the market capitalization was about ten million dollars. And forty something years later, there are not many more shares outstanding now than there were then, and the market capitalization is about a hundred billion dollars, ten thousand for one. And since that has happened, year

after year, in kind of a grind-ahead fashion, with very few failures, it eventually drew some attention, indicating that maybe Warren and I knew something useful in microeconomics. Efficient market theory Buffett and Munger have always heaped scorn upon the academics who cling to the efficient market theory, unable to distinguish between an obvious truth -- that the market is mostly efficient most of the time -- and obvious nonsense -- that the market is always perfectly efficient all of the time: Berkshires whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to. I think youd have to believe in the tooth fairy to believe that you could easily outperform the market by seven-percentage points per annum just by investing in high volatility stocks. Yetmany people still believe it. But Berkshire never paid any attention to it. Multidisciplinary education and man with a hammer syndrome Over the years, Munger has always preached the importance of learning -- and then using -- all of the big disciplines, such as math, science, psychology, etc. To him, this just came naturally: For some odd reason, I had an early and extreme multidisciplinary cast of mind. I couldnt stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody elses discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen. If one doesnt embrace all multidisciplinary thinking, Munger argues, then one is likely to fall into the trap of: man with a hammer syndrome. And thats taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools. You dont have just a hammer. Youve got all the tools. And youve got to have one more trick. Youve got to use those tools checklist-style, because youll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. Problems to solve During his speech, to illustrate the types of questions his ways of thinking will help answer, Munger posed a number of problems to solve:

1. Theres an activity in America, with one-on-one contests, and a national championship. The same person won the championship on two occasions about 65 years apart. Name the activity. 2. You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price? 3. You own a small casino in Las Vegas. It has 50 standard slot machines. Identical in appearance, theyre identical in the function. They have exactly the same payout ratios. The things that cause the payouts are exactly the same. They occur in the same percentages. But theres one machine in this group of slot machines that, no matter where you put it among the 50, in fairly short order, when you go to the machines at the end of the day, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy-winning machine? For the answers to these questions, youll have to read the transcript. Second- and third-order consequences and free trade Munger gave a number of examples of how often people only look at immediate consequences of certain actions and fail to consider second- and third-order consequences. For example: Everybody in economics understands that comparative advantage is a big deal, when one considers first-order advantages in trade from the Ricardo effect. But suppose youve got a very talented ethnic group, like the Chinese, and theyre very poor and backward, and youre an advanced nation, and you create free trade with China, and it goes on for a long time. Now lets follow and second- and third-order consequences: You are more prosperous than you would have been if you hadnt traded with China in terms of average well-being in the U.S., right? Ricardo proved it. But which nation is going to be growing faster in economic terms? Its obviously China. Theyre absorbing all the modern technology of the world through this great facilitator in free trade and, like the Asian Tigers have proved, they will get ahead fast. Look at Hong Kong. Look at Taiwan. Look at early Japan. So, you start in a place where youve got a weak nation of backward peasants, a billion and a quarter of them, and in the end theyre going to be a much bigger, stronger nation than you are, maybe even having more and better atomic bombs. Well, Ricardo did not prove that thats a wonderful outcome for the former leading nation. He didnt try to determine second-order and higher-order effects. If you try and talk like this to an economics professor, and Ive done this three times, they shrink in horror and offense because they dont like this kind of talk. It really gums up this nice discipline of theirs, which is so much simpler when you ignore second- and third-order consequences.

Open-mindedness How many people do you know who actively seek out opinions contrary to their own? Munger certainly does. For example, he said: take Paul Krugman and read his essays, you will be impressed by his fluency. I cant stand his politics; Im on the other side. [Krugman constantly bashes Republicans and the Bush administration on the Op Ed page of The New York Times.] But I love this mans essays. I think Paul Krugman is one of the best essayists alive. Destroying your own best-loved ideas Munger believes that its absolutely critical not to cling to failed ideas. You must become good, he argues, at destroying your own best-loved and hardest-won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift. How important this is when it comes to investing! Not long ago, I publicly recommended a stock, yet a few weeks later, based on new information, I came to the conclusion that it was no longer a good idea. A natural tendency would have been to hold on to the stock and refuse to admit to my readers that I might have been mistaken. Making it even harder to sell was the fact that the stock had declined - why not wait until it rebounded to the price at which I had bought it, right? (This is a deadly error, as Ive discussed in previous columns.) Fortunately, I did sell, refusing to cling to failed ideas. Chutzpah Ill conclude this column with a bit of classic Munger humor: While Buffett bends over backward to appear humble, Mungers the opposite -- he jokes about his big ego. In his opening remarks, he said: As I talk about strengths and weaknesses in academic economics, one interesting fact you are entitled to know is that I never took a course in economics. And with this striking lack of credentials, you may wonder why I have the chutzpah to be up here giving this talk. The answer is I have a black belt in chutzpah. I was born with it. Contributor Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit www.tilsonfunds.com. The Motley Fool is investors writing for investors.

Munger on Human Misjudgments


Charlie Munger gave an insightful speech on 24 Standard Causes of Human Misjudgment, which has powerful implications for investors. Whitney Tilson summarizes some key points and provides a link to the speech, so you can read for yourself. By Whitney Tilson Published on the Motley Fool web site, 8/21/02 (http://www.fool.com/news/foth/2002/foth020821.htm) Behavioral finance -- which examines how peoples emotions, biases, and misjudgments affect their investment decisions -- is one of the least discussed and understood areas of investing. Yet I believe its critically important -- so important, in fact, that I covered it in my very first column (in September 1999, which seems like an investing lifetime ago, doesnt it?). Behavioral finance recently reappeared on my radar screen when I came across an 80-minute recording of a speech given by Berkshire Hathaway (NYSE: BRK.A) Vice Chairman Charlie Munger, Warren Buffetts right-hand man and a genius in his own right. Its a brilliant, powerful, and compelling tour de force. In it, Munger highlights what he calls 24 Standard Causes of Human Misjudgment, and then gives numerous examples of how these mental weaknesses can combine to create lollapalooza effects, which can be very positive -- as in the case of Alcoholics Anonymous -- or frighteningly negative, such as experiments in which average people end up brutalizing others. Id like to highlight some of Mungers most important lessons, especially as they relate to investing. Psychological denial Munger notes that sometimes reality is too painful to bear, so you just distort it until its bearable. I see this all the time among investors -- both professionals and average folks. Think of all the people who simply have no business picking stocks, such as the bull market geniuses of the late 1990s, whose portfolios have undoubtedly been obliterated in the bear market of the past two and a half years. Youd think these people wouldve recognized by now that whatever investment success they had in the late 90s was due solely to one of the most massive bubbles in the history of stock markets, and that they should get out while they still have even a little bit of money left. Im sure some are doing so, but many arent because theyd have to acknowledge some extremely painful truths (e.g., they should not, and should never have been, picking stocks; they speculated with their retirement money and frittered most of it away, and so on). Instead, Im still getting emails like this one, from people who, I suspect, are in serious psychological denial:

Why isnt anyone suggesting WorldCom as an investment possibility? Assuming WorldCom survives, and assuming they reach a third of their highest stock value prior to the decline, why not buy shares at $0.19 (as listed now) [theyre now down to $0.124] and hold them for a few years? If WorldCom manages to make it back to $10.00 a share, the profit for a small investor would be more than satisfactory. What am I missing here? It seems like another chance to get in on the ground floor. The answer is that WorldCom equity is almost certain to be worthless, and the only sane people buying the stock right now are short-sellers covering their very profitable shorts. Bias from consistency and commitment tendency Munger explains this bias with the following analogy: The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one cant get in. In other words, once people make a decision (to buy a stock, for example), then it becomes extremely unlikely that they will reverse this decision, especially if they have publicly committed to it. This is true even if overwhelming evidence emerges indicating the initial decision was disastrously wrong. Have you ever bought a stock such as Lucent, Enron, or WorldCom, seen your original investment thesis torn to shreds by subsequent developments -- such that you would never consider buying more of the stock (despite the lower price), yet you didnt sell? Ive written two columns on this common, painful mistake. Over-influence by social proof Human beings have a natural herding tendency -- to look at what everybody else is doing and do the same, however insane that behavior might be. Munger gives a classic example from corporate America: Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didnt know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think theyre all gone now, but it was a total disaster. Similar behavior led to the tech stock bubble of the late 1990s. For more on this topic, see my column The Cocktail-Party Test, in which I argue, Following the crowd and investing in what is fashionable is a recipe for disaster. Instead, look for solid companies with strong balance sheets that are either out of favor with Wall Street or, better yet, not even on Wall Streets radar screen. Other questions Munger answers Ive cited only a few examples of Mungers powerful observations and the answers he gives to a range of perplexing questions, such as:

Why are boards of directors so consistently dysfunctional and unable to rein in even the most egregious behavior by CEOs? Why was the introduction of New Coke almost one of the costliest business blunders of all time? Why didnt Salomons CEO John Gutfreund or General Counsel Donald Feuerstein immediately turn in rogue employee Paul Mozer -- a failure of judgment that cost both men their careers and nearly put Salomon out of business? How did Joe Jett lose $210 million for Kidder Peabody (and parent company GE)? How did Federal Express solve the problem of processing all of its packages overnight? Why wouldnt Sam Walton let his purchasing agents accept even the tiniest gift from a salesperson? How does Johnson & Johnson ensure that it evaluates and learns from its experience making acquisitions? How has Tupperware made billions of dollars out of a few manipulative psychological tricks? Why do bidders consistently overpay in open-outcry actions? Why is a cash register a great moral instrument? Why would it be evil not to fire an employee caught stealing? Why might raising the price of a product lead to greater sales? Why do some academicians continue to cling to the Efficient Market Theory? Why are people who grow up in terrible homes likely to marry badly? And why is it so common for a terrible first marriage to be followed by an almost-as-bad second marriage? How can real estate brokers manipulate buyers? How do lotteries and slot machines prey on human psychology? Why should we be grateful that our founding fathers were psychologically astute in setting the rules of the U.S. Constitutional Convention?

There is no space here to even begin to summarize Mungers answers to these questions, so I transcribed his speech and posted it here. I urge you to read it.

If you find his thinking and the field of behavioral economics as fascinating as I do, I suggest reading Influence, by Robert Cialdini, Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich and, for the definitive work on Munger himself, Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger, by Janet Lowe. Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.