Where Most Investors Stumble

January 31, 2017

Where Most Investors Stumble

  • Are you a speculator or an investor? Speculators usually don’t survive more than one economic cycle while investors reach decent returns.
  • It’s of extreme importance to distinguish whether an asset is an investment or a speculation.
  • We’ll list 11 characteristics of successful investors, and 13 characteristics of unsuccessful investors.

Introduction

Last week, we discussed Seth Klarman’s performance and approach to investing.

Today, we’re going to dig into his book Margin of Safety – Risk-Averse Value Investing Strategies for the Thoughtful Investor. As it’s a very rare and expensive book full of extremely valuable insights, I believe our readers will find huge value in this series of articles.

Part One: Where Most Investors Stumble

In investing, most people are attracted by the prospect of quick gains and fall victim to the many fads of Wall Street. Therefore, it’s more important to know what not to do than what to do to reach long lasting satisfying returns.

The first part of Klarman’s Margin of Safety focuses on exactly that. It describes the difference between speculators and successful investors, and speculative and investment assets.

Speculators & Unsuccessful Investors

Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses.”

As an investor, you expect to profit from higher free cash flows generated from the underlying business, from an increase in the multiple others are willing to pay for the business, and from the narrowing of the gap between the share price and the underlying business value. Higher cash flows should push the stock price higher or increase dividends.

As a speculator, you expect to profit based on your beliefs on where the stock price will go, up or down. Thus, you aren’t estimating fair values or future cash flows, what you are estimating is the behavior of other market participants. Klarman describes such a strategy as the “greater-fool game” where a speculator hopes they will find someone in the future to whom they can sell the stock to at a higher price.

When the majority of market participants speculate, the market soon becomes overvalued and can stay so for longer periods of time. Gains from previous trades attract more participants, or new fools, which push market prices even higher.

What is peculiar about speculative activity is that it’s recognized as such only after considerable time has passed and much money has been lost. As Klarman wrote his book in 1991, he used the 1983 disk-drive manufacturers speculative market as an example. Going past 1991, we have had the dotcom bubble, the housing bubble, and we are now in the low interest rates bubble. It’s interesting how human behavior repeats itself and we make the same mistakes over and over again, which is the definition of stupidity, so be careful.

Is An Asset An Investment Or Speculation?

Klarman defines an investment as an asset that throws off cash flow for the benefit of the owners while speculations don’t. The value of an investment comes from the cash flows the business or asset is expected to deliver in the future, while the reasoning behind buying a speculative asset is because others have bought before. At a point in time, the speculative logic fails and losses occur. However, well thought-out investments bring value for long periods of time and have a margin of safety. Klarman suggests that for your own good, as your hard-earned savings and future financial security are at stake, you should first understand the difference between the two concepts and then choose investing.

Unfortunately, investing is a very boring activity most of the time, to quote Paul Samuelson: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

The following characteristics will show that speculators will have more fun and drama with their investments but investors will end up richer.

The Differences Between Successful & Unsuccessful Investors

Klarman attributes the following characteristics to successful investors:

  • They are unemotional, allowing the greed and fear of others to play into their hands.
  • They have confidence in their own analysis and judgement and respond to market movements with reason.
  • They demonstrate caution in frothy markets and conviction in panicky ones.
  • They see market prices and fluctuations as opportunities taking advantage of Mr. Market’s erratic behavior.
  • They know that the markets aren’t efficient and above average returns can be reached.
  • They are not afraid of paying taxes on profits and transaction costs.
  • They buy more of a security if prices fall and fundamentals remain equal.
  • They clearly distinguish stock price fluctuations from underlying business reality.
  • Value in relation to price determines their investing decisions.
  • They think the stock market is a vehicle to invest capital in and earn a decent return.
  • They allow returns to compound over time.

Unsuccessful investors have the opposite characteristics:

  • They believe the market is efficient and cannot be beaten.
  • They look to Mr. Market for guidance – sell low, i.e. when prices went already down, and buy high, i.e. when prices went already significantly up.
  • They focus on what the market is doing rather than look at what is happening with underlying fundamentals.
  • They panic when prices fall instead of buying more if a security was a good buy in the first place.
  • They think that if market prices are falling, the business must be doing badly.
  • They let emotions guide their investment decisions and respond to market fluctuations with greed and fear.
  • They take years of hard work to save but take only a few minutes to make an investment decision.
  • They think the stock market is a place to make money.
  • They seek shortcuts to investment success.
  • They constantly revise assumptions in order to justify higher prices.
  • They pour money into stocks just because bonds have low yields.
  • They seek simple investment formulas, usually by projecting the recent past into the future.
  • They project their most recent personal experiences into the future.

Klarman’s conclusion is that “financial markets offer many temptations to vulnerable investors” which makes it easy to do the wrong thing, “to speculate rather than invest.

I hope the above summary of the first chapter helps in understanding whether you are a speculator or an investor. Through history, smart investors have beaten the market, average investors have performed in line with the market, while speculators usually don’t outlast one market cycle.

In our next article, we‘ll analyze how the above concepts apply to the current market situation.

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