By John Goltermann, CFA, CPA, Obermeyer Asset Management [9]
August 2012: The Perils of Overconfidence
Howard Marks, who runs Oaktree Capital (a very successful hedge fund that principally invests in distressed securities), recently pointed out that
mistakes are all that superior investing is about. In short, in order for one side of a transaction to turn out to be a major success, the other side has to have been a big mistake…Usually a buyer buys an asset because he thinks it’s worth more than the price he’s paying. But the seller sells the asset because he thinks the price he’s getting exceeds its value. It’s pretty safe to say one of them has to be wrong. Strictly speaking, that doesn’t have to be true, thanks to differences in things like tax status, timeframe and investors’ circumstances. But in general, win/win transactions are much less common than win/lose transactions. When the dust has settled after most trades, the buyer and seller are unlikely to be equally happy.
We all make mistakes. In the investment world, some mistakes arise from having imperfect information, some from not anticipating the future correctly and some from sloppy analytics. Sloppy analytics includes everything from outright mathematical errors or misinterpretations, to poor assumptions, to overfocusing on unimportant variables or underfocusing on important ones. Analytics is the most critical and controllable part of the investment process, but even if done flawlessly does not ensure a favorable outcome by any means because the views/ behaviors/incentives of other investors – and indeed, the investment environment itself – change continually in ways that can’t be anticipated.
But there is one more common mistake that is a consistent source of perplexity for active investors. Over the years, my experience has been that those who lose money more often (and in greater amounts) than they should, often do so because of overconfidence. Overconfidence can lead to the conviction that one is only buying investments that will be highly profitable and one is only selling investments that no longer have significant upside potential. This can lead to a lack of diversification and a heavy concentration of money in a single investment or asset class.
Overconfidence, however, also leads to overtrading. Trading volumes frequently increase because investors believe that they can precisely time market entry or exit points, either by themselves or with the assistance of complex trading models or charting software (there is an entire industry that capitalizes on this belief by peddling software, seminars, programs, subscriptions and other money-making schemes). So what we have at all times is a Lake Wobegon situation in investment markets, “where all the women are strong, all the men are good looking and all the children are above average.” This makes for high drama at the times when beliefs conflict with reality.
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The above chart highlights the rampant and systematic short-termism in investment markets. This trend makes it very difficult (likely impossible) to be consistently correct in establishing positions because of the fickleness of other investors – investors who often ignore the values and long-term economics and risks of the businesses in which they invest. The good news (for patient investors) is that this also means that mispricings occur. We saw high levels of trading in housing when it was near its speculative top, we saw high levels of trading in tech stocks when they were near their speculative top and now we see high levels of trading in the stock market generally.
I am not suggesting that the stock market is near a speculative top because many other factors serve to increase trading volumes through time (making trades is now almost costless, technology makes it easy, the number of tradable issues has increased and the Fed encourages speculation through loose monetary policy); but within the market itself, individual issues’ trading volume can indicate the level of speculative activity around an investment (and what may be more vulnerable to disappoint).
While speculating and trying to predict future investor behavior is fine (and there are managers who do it well), it’s always well-advised to hold investments that have economics in their favor and that are priced for potential upside (their businesses’ value is greater than the market value of their stock price plus their debt). In the process of making such investments, it is inadvisable to pay much attention to the pronouncements and prognostications of Wall Street promoters and others with a vested interest in ridding themselves of future poor investments by promoting them to an unsuspecting public. Price relative to value is everything for those with an investment horizon of more than a year.
It is surprising that many investors have to re-learn (the hard way) that the ebullience emanating from Wall Street firms on the latest and greatest trend, business model, gadget or idea is frequently wealth-destroying. We can see this in post-IPO share prices of Facebook (FB) and Groupon (GRPN), two companies with IPOs that attracted much hype and hyperbole (and that engendered so much confidence):
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Retail investors, in effect, are the group most often targeted to take up investments that the private equity firms, underwriters and their hedge fund clients don’t want. Private equity firms, which have nurtured these companies along from inception and groomed them for the day they can go public, salivate for their IPO post-lockup payday so that they can redeploy their capital in the next hot deal and pay out their partners. But rest assured, when shares are finally offered to the public, they are not offered at rock-bottom prices and the financials have been carefully finessed to put the best face on the investment. Consider the incentives: if you were the owner of a perfectly good investment that was being underpriced by markets, why sell it in the first place?! Whenever you find Wally Street cheerleaders and promoters whipping individual investors into a frenzy (especially over IPOs), put one hand over your wallet.
In the month of August, the market remained within a tight trading range. Material stocks are now priced at depressed levels while dividend stocks have become the darlings of institutional investors. Selling economically sensitive stocks and buying dividend stocks has been the trade that has been “working.” I am not saying that materials stocks cannot move lower, but rather that the good ones are likely trading well below their economic worth and prices do not reflect the potential of their long term cash-generating ability. Many (though not all) dividend payers look expensive relative to the cash-generating ability of their businesses, so those who advocate this strategy or invest this way must be prudent. I have never felt comfortable with making investments based on the characteristics of the security itself instead of the price/value relationship of the underlying asset(s) and the economics of the business that the stock or bond finances.
We put very little effort into prognosticating where “the market” itself is going. As Erik Kraus recently observed in his June newsletter, “The market currently offers a truly extraordinary opportunity! There is only one problem – We have absolutely no idea whether it is a buying or selling opportunity.” Similarly, we have no strong conviction about the market’s future direction one way or the other – but there are lots of people who do!
As with any other prognostication, it’s best to regard market calls with a healthy degree of skepticism. As Bertrand Russell said, “The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” We try to have the right kinds of doubts when evaluating investments, and seek to own those that others aren’t overly enthusiastic about but that have favorable economics and are priced with a margin of safety. We feel that this approach, in combination with an appropriate asset allocation for each client, makes an accurate forecast of the near-term direction of “the market” unimportant.