Mental Mistakes_whitney Tilson

T2 Partners LLC, November 2006 -0-

Common and Costly Mental Mistakes

By Whitney TilsonNovember 2006


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 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” -- Warren Buffett

What is Behavioral Finance?


Common Mental Mistakes1) Overconfidence2) Projecting the immediate past into the distant future3) Herd-like behavior (social proof), driven by a desire to be part of the crowd or an assumption that the

crowd is omniscient4) Misunderstanding randomness; seeing patterns that don’t exist5) Commitment and consistency bias6) Fear of change, resulting in a strong bias for the status quo7) “Anchoring” on irrelevant data8) Excessive aversion to loss9) Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus)

differently than other money10) Allowing emotional connections to over-ride reason11) Fear of uncertainty12) Embracing certainty (however irrelevant)13) Overestimating the likelihood of certain events based on very memorable data or experiences (vividness

bias)14) Becoming paralyzed by information overload15) Failing to act due to an abundance of attractive options16) Fear of making an incorrect decision and feeling stupid (regret aversion)17) Ignoring important data points and focusing excessively on less important ones; drawing conclusions

from a limited sample size18) Reluctance to admit mistakes19) After finding out whether or not an event occurred, overestimating the degree to which one would have

predicted the correct outcome (hindsight bias)20) Believing that one’s investment success is due to wisdom rather than a rising market, but failures are not

one’s fault21) Failing to accurately assess one’s investment time horizon22) A tendency to seek only information that confirms one’s opinions or decisions23) Failing to recognize the large cumulative impact of small amounts over time24) Forgetting the powerful tendency of regression to the mean25) Confusing familiarity with knowledge


Overconfidence1) 19% of people think they belong to the richest 1% of U.S. households2) 82% of people say they are in the top 30% of safe drivers3) 80% of students think they will finish in the top half of their class4) When asked to make a prediction at the 98% confidence level, people are right

only 60-70% of the time5) 68% of lawyers in civil cases believe that their side will prevail6) Doctors consistently overestimate their ability to detect certain diseases7) 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


Information and OverconfidenceSometimes additional information can lead to worse decisions, overconfidence and excessive trading

• Heuer study of 8 professional handicappers (set betting odds at horseraces)

– 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


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 madenearly 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


A Key Factor in Bubbles Forming: Conforming With the Crowd

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

Conforming with the crowd: the Solomon Asch experiment• 35% of the subjects conformed to the group’s judgment, even though

they knew it was wrong, because they were uncomfortable being a minority facing an overwhelming majority

• The size of the group didn’t matter• But if even one person gave the correct answer, the subject was far

more likely to also give the correct answer


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.”


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.”

http://www.amazon.com/exec/obidos/ASIN/047111927X/tilsoncapitalpar


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 horse’s chances of winning than they are immediately before laying down that bet.

The reason for the dramatic change is…our 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 one’s positions.


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. We’ve missed billions when I’ve 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 Denny’s at different prices• Anchoring on historical price (or typical price)

– Refusal to buy a stock today because it was cheaper last year orhas 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


Learning the Wrong Lessons by Misunderstanding Randomness

• Confusing making money with making a good decision– Chris Davis’s 5-bagger mistake– Munger’s example of oil executives congratulating

themselves

• Confusing losing money with making a bad decision– Calculated risks are OK– Bob Rubin’s example of politics (from In an Uncertain

World)

• Pecking pigeon experiment


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 McDonald’s food; Cantalupo’s 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)


Other Mistakes (2)• Vividness bias

– “People tend to underestimate low probability events when they haven’t 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, McDonald’s in March 2003

• Worrying about what others will think– Klarman: “As a money manager, it’s 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”


Other Mistakes (3)• Status quo bias and endowment effect

– Inheritance study– Thaler’s 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: “It’s as if someone approached you and said, ‘Let’s 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)


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)– Don’t want to sell at a loss (if stock has been falling)– If I didn’t own it, would I buy it? Or, If the stock dropped 25%,

would I enthusiastically buy more?

Not to decide is a decision


Tips to Applying Behavioral Finance• Be humble

– Avoid leverage, diversify, minimize trading

• Be patient– Don’t 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 (Pzena’s method)

– Use secret ballots– Ask “What would cause me to change my mind?”


Tips to Applying Behavioral Finance (2)

• Don’t anchor on historical information/perceptions/stock prices– Keep an open mind– Update your initial estimate of intrinsic value– Erase historical prices from your mind; don’t 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 don’t obsess– Put the initial investment thesis in writing so you can refer back to it– Sell your mistakes and move on; you don’t have to make it back the same

way you lost it– But be careful of panicking and selling at the bottom

• Don’t get fooled by randomness

• Understand and profit from regression to the mean

• Mental tricks– Pretend like you don’t own it (Steinhardt going to cash)– Sell a little bit and sleep on it (Einhorn)


Recommended Reading(in rough order of priority)

• Poor Charlie’s Almanack• Influence, Robert Cialdini• Why Smart People Make Big Money Mistakes,

Belsky and Gilovich• The Winner’s 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

http://www.investorhome.com/psych.htm

Value Investor Insight 19February 22, 2005

O F S O U N D M I N D

One of the more interesting andthought-provoking books published inrecent years was Malcolm Gladwell’sThe Tipping Point. Through vivid anec-dotes, Gladwell described the underpin-ning of “social epidemics,” from thedecline in New York City crime to theexplosive sales growth of Airwalk sneak-ers. It’s the rare book that casts a freshlook on, well, just about everything.

Gladwell’s latest book, Blink, isequally fascinating and, though notwritten specifically for investors, hasmany insights for the investmentprocess. Subtitled “The Power ofThinking Without Thinking,” Blinkexplores the psychology and science ofdecision-making, focusing largely onfirst impressions and instinct. The con-clusion: Under the right circumstances,“decisions made very quickly can beevery bit as good as decisions made cau-tiously and deliberately.”

No argument there. We’ve all learnedto listen to our instincts in making deci-sions, whether in making a hire, picking amate or picking a stock. First impressionsmatter, at the very least as a filteringmechanism. “Great decision makers aren’tthose who process the most informationor spend the most time deliberating,”

writes Gladwell, “but those who have per-fected the art of “thin-slicing” – filteringthe very few factors that matter from anoverwhelming number of variables.”

The Warren Harding Error

Most instructive to investors, however,are the book’s descriptions of where firstimpressions err. Take, for example, “TheWarren Harding Error.” Voters tookimmediately to the dashingly handsomeHarding, who “radiated common senseand dignity and all that was presidential.”This emotional connection blinded themto the fact that his policies were hollowand his record in public office undistin-guished. Harding eventually served twoyears before dying of a stroke, and mosthistorians list him as one of the worstpresidents in American history.

Behavioral finance experts cite just suchemotional connections, particularly whenthey override alternative information andinput, as a pervasive investor mistake.While Fidelity’s Peter Lynch famously madea small fortune by investing in Dunkin’Donuts stock after falling in love with itscoffee, investors who make investmentdecisions on what they like are generallydisappointed – witness Krispy Kreme, forexample.

Another classic investor error is“anchoring” too quickly on select data orinformation that turns out to be flawed.This is the mistake Coca-Cola made withits disastrous launch of New Coke. Theprimary driver of this decision was thefact that Coke consistently lost to Pepsi inhead-to-head blind taste tests. The testswere simple: subjects were asked to take asip of each soft drink and report theirpreference.

But the tests had a fatal flaw. Taking asip in a taste test is a very different expe-rience from sitting and drinking an entirecan. Consumers tend to like a sweeterproduct, which Pepsi is, initially, but formany, the sweetness becomes overpower-

ing and less appealing as more of theproduct is consumed. So Coca-Cola near-ly destroyed the world’s greatest brand byrelying too heavily on initial data thatproved to be incorrect.

Combating the ill effects of suchanchoring requires discipline on the partof investors. Rich Pzena, whose interviewis featured in this issue, uses one interest-ing technique before buying any stock:He invites the Wall Street analyst who ismost bearish on the stock to come intohis offices and make the bearish case – adirect challenge to Pzena’s most firmly-held convictions.

A final lesson from Blink: Intuitiontends to break down under duress. In1999, four New York City police officersfired 41 shots at Amadou Diallo, killinghim as he reached for his wallet. Dialloposed no threat, but the first impressionsformed by both Diallo and the officers ledto the fatal series of events over a matterof seconds. The police officers were undera great deal of stress – it was dark andthey were in a high-crime neighborhoodand likely expecting trouble – whichundoubtedly contributed to the failure oftheir intuition.

Adrenaline risk

It’s a stretch, of course, to equate theDiallo shooting with anything experiencedby investors, but the key point is thatadrenaline is not a friend to good decision-making. A dramatic move in the market ora given stock price can trigger a visceral“I’ve got to do something” reaction in eventhe most experienced investor. Numerousstudies have shown time and again, howev-er, that such visceral reactions are usuallycostly. In such cases, careful analysis, reflec-tion and patience are often virtues.

“How good people’s decisions are,”concludes Gladwell, “is a function oftraining, rules and rehearsal.” Not verysexy, but a very sound recipe for invest-ment success. VII

Investing on Instinct Should following one’s “gut” play a central role in making investment decisions? Probably not … if you really think about it.

“But I CAN be spontaneous...just give me a couple of days.”

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Value Investor Insight 19March 23, 2005


Seth Klarman has a fabulous record asan investor and market commentator. HisBaupost Group partnerships havereturned nearly 20% per year (net) since1983 vs. less than 14% for the S&P 500,and his letters to shareholders are leg-endary for their insight and wit. In thisessay from his 2004 letter, Seth exploreswhether market efficiency is at hand.

With all the money pouring into hedgefunds, you might wonder if this is whatmarket efficiency looks like. Conditions arecertainly more competitive than they havetypically been, and bargains are hard tofind. The efficient market hypothesis sug-gests that all information about a securitywill immediately be reflected in its pricing.New developments trigger prompt repric-ings. With so many hedge funds, so manypeople diligently looking to identify mis-pricings, and so much capital desperate tocrowd into even marginally mispriced situa-tions, an observer might conclude that mar-ket efficiency is now at hand.

True market efficiency would obviouslybe an enormously discouraging develop-ment. On a personal basis, a 25-year careerof successfully investing in mispriced securi-ties would be at an end. For all of us, ournet worths would cease growing ahead ofthe return on the market as a whole; worsestill, we would have to significantly ratchetup the risk we incur simply to match the

market return. Historically successfulinvestment firms would undoubtedly closetheir doors – a job once well done, but nolonger worth attempting (for no degree ofeffort would make any difference). But anyprediction of the death of fundamental-based investing is highly premature.

We offer a simple thought experiment.Imagine that every adult in America becamea securities analyst, full-time for many, part-time for the rest. Every citizen would scourthe news for fast-breaking corporate devel-opments. Some would run spreadsheets andcrunch numbers. Others would analyzecompetitive factors for various businesses,assess managerial competence, and strive toidentify the next new thing. Now, for sure,the financial markets would have becomeefficient, right? Actually, no. The reasonthat capital markets are, have always been,and will always be inefficient is not becauseof a shortage of timely information, the lackof analytical tools, or inadequate capital.The Internet will not make the market effi-cient, even though it makes far more infor-mation available, faster than ever before,right at everyone’s fingertips. Markets areinefficient because of human nature –innate, deep-rooted, permanent. Peopledon’t consciously choose to invest withemotion – they simply can’t help it.

So if the entire country became securitiesanalysts, memorized Benjamin Graham’sIntelligent Investor and regularly attendedWarren Buffett’s annual shareholder meet-ings, most people would, nevertheless, findthemselves irresistibly drawn to hot initialpublic offerings, momentum strategies andinvestment fads. Even if they somehowmanaged to be long-term value investorswith a portion of their capital, peoplewould still find it tempting to day-trade andperform technical analysis of stock charts.People would, in short, still be attracted toshort-term, get-rich-quick schemes. Peoplewould notice which of their friends andneighbors were becoming rich – and theywould quickly find out how. When others

were doing well, people would find it irk-some and begin to copy whatever wasworking at that moment. There is no salvefor the hungry investor like the immediatepositive reinforcement that comes frommaking money this very moment.

Smart people, dumb decisions

A country of security analysts would stilloverreact. They would shun stigmatizedcompanies, those experiencing financial dis-tress or accounting problems. They wouldstill liquidate money-losing positions as theywere making new lows. They would avoidless liquid securities, since those are the lastto participate in a rally and hard to get outof when things go wrong. To reduce worri-some volatility, they would overdiversify,utilize technically-based and irrational riskreduction techniques such as stop-lossorders, and avoid certain fundamentallyattractive but volatile investments. In short,even the best-trained investors would makethe same kind of mistakes that investorshave been making forever, and for the sameimmutable reason – that they cannot help it.

Hedge funds may have a more exten-sive toolkit at their disposal, in that theycan go long and short, utilize leverage, andincur greater illiquidity. They have theresources to hire the cream of every crop.But going long and short involves risks,and leverage can be deadly. Not all hedgefund managers will turn out to be skilledcraftsmen; the use of some of these toolswill inevitably exacerbate rather than mit-igate problems. Really smart people canmake really dumb investment decisions –witness the Nobel Laureates at Long-TermCapital Management. Hedge funds are bigbusiness, and virtually every investmentbusiness, whether the stodgiest of old lineinvestment firms or the savviest hedgefund, faces short-term pressure to perform.In short, we believe market efficiency is afine academic theory that is unlikely everto bear meaningful resemblance to the realworld of investing. VII

Deficient Markets Hypothesis Would securities mispricings – and the ability to profit from them – disappear if everyone became a securities analyst?

“None of that steady income and securitycrap! I just want to make a big fat killing and check out”



Value Investor Insight 19April 27, 2005


As investor mistakes go, sins of omis-sion would appear to be relatively benign.After all, foregoing an opportunity to buywhat turned out to be a ten-bagger willnever show up in anybody’s performancereport. But ask investors those miscues thatdrive them most crazy, and the answermore often than not is the missed opportu-nity. “The main mistakes we’ve made,”lamented Warren Buffett at BerkshireHathaway’s 2004 annual meeting, “havebeen 1) When we didn’t invest at all, evenwhen we understood [something] wascheap; and 2) When we started in on aninvestment and didn’t maximize it.”

Why investors fail to act, against their

better judgment, is often the result of inter-nal psychology rather than poor analysis.Consider “anchoring” for example. “Valueinvestors are just genetically wired to buyas the price is going down,” says FairholmeCapital Management founder BruceBerkowitz. “They get anchored on the lastprice they paid. The stock goes up, youstop buying.” Buffett admitted as much atthe 2004 meeting: “When I bought some-thing at X and it went up to X and 1/8th, Isometimes stopped buying, perhaps hopingit would come back down. We’ve missedbillions when I’ve gotten anchored.”

Another reason investors fail to act is byoverweighting recent or vivid data, even if

it’s unimportant to the investment thesis.One New York hedge-fund managermissed a dramatic rise in shares of Claire’sStores when he decided not to buy afterbeing unimpressed after meeting one of thecompany Chairman’s daughters in late2001. He explains: “I’d done all of theanalysis and was ready to take a big posi-tion, but the meeting shook my confidence.It was inexcusable because even if thedaughter was a less-than-stellar manager, itwas irrelevant because she wasn’t runningthe company – her father was. Even if shewas – as she is now, by the way – the stockwas cheap enough and the business goodenough that the stock would have donegreat.”

“Regret aversion” can also play a pow-erful role in investor inaction. “Most peo-ple want to avoid the pain of regret and theresponsibility for negative outcomes,”write Gary Belsky and Thomas Gilovich intheir outstanding 1999 book, Why SmartPeople Make Big Money Mistakes. “Andto the extent that decisions to act – deci-sions to change the status quo – impart ahigher level of responsibility than decisionsto do nothing, people are naturally averseto sticking their necks out and setting them-selves up for feelings of regret.”

The irony is that such regret aversion, inaddition to possibly causing lucrativeopportunities to be missed, doesn’t even doa good job of averting regret. As Belsky andGilovich explain: “Research indicates thatpeople experience more regret over theirmistakes of action in the short term, whileregrets of inaction are the ones that aremore painful in the long run.” This con-firms the insight of Mark Twain, who oncesaid, “Twenty years from now you will bemore disappointed by the things you didn’tdo than by the ones you did do.”

Fear of regret can also play a big role ininvestors failing to sell a stock that hasdeclined. Of course, sometimes when astock falls it’s a great opportunity toincrease the investment at an even more

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?


“I didn’t actually catch anything, but I do feel I gained some valuable experience.”


Value Investor Insight 20April 27, 2005


attractive price, but even in cases wheninvestors have made an obvious mistakeand, logically, should sell immediately,behavioral research shows that they willoften hang on, thereby suffering evengreater losses. Why? Because by selling,they have permanently locked in the lossand then have to confront the pain andregret of having made a bad investment,including the potential embarrassment ofdisclosing the loss to family, investors, etc.

The argument that losers in your portfo-lio will outperform in the future doesn’tgenerally hold up to close scrutiny. Afteranalyzing the trading records of 10,000 dis-

count-brokerage accounts, TerranceOdean, now of the University ofCalifornia, Berkeley, concluded that“Investors who sell winners and hold losersbecause they expect the losers to outper-form the winners in the future are, on aver-age, mistaken.” Odean found that soldwinners – those that had increased in pricebefore being sold – beat a market indexover the next two years after sale by 6.5%.Interestingly, the losing investments thatwere sold also beat the market index overthe two-year period – so be careful to notsell 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 asneutral a position as possible. Ignore allsunk costs. Don’t overvalue your currentpositions – pretend that you don’t ownthem and ask, “If I didn’t own this stocktoday, would I buy it?” If the answer is no,you should think hard about selling. And,finally, don’t compound past mistakes forfear of embarrassment.

In the end, the best advice is to learnfrom mistakes and move on. “If every shotyou hit in golf was a hole-in-one, you’d loseinterest,” Warren Buffett has said. “Yougotta hit a few in the woods.” VII


My Most Memorable WhiffMissing a wonderful opportunity to buy or sell, of course, isnot always the result of some grand flaw in an investor’s psy-che. It’s also often simply the result of errant judgment – of anindustry, a company or a management. Three highly-success-ful value investors – and Berkshire Hathaway roundtable-dis-cussion participants – share with us their most memorablegaffes of omission, and the valuable lessons learned:

Matthew Sauer, Oak Value Capital Management

I can cite a whole industry I underestimated, the gamingindustry. I remember looking at all the data in 1990-91 whenthe Mississippi gambling riverboats were coming on line, andbeing convinced that there was too much supply for thedemand.

There are rare industries, like gaming, where no matter howmuch supply comes on the market it gets soaked up. I keptthinking something will happen to drive [gaming] shares downand provide a buying opportunity – I’m still waiting.

Bruce Berkowitz, Fairholme Capital Management

We had a very large position in Household Financial and wedid very well with it – really understood the industry, the peo-ple, 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 Iknew the company and the dynamics well enough that I’d beable to see any fundamental changes. The bottom line was Icouldn’t, and I didn’t, and the company had a funding issue.The stock went down and the CEO bailed, selling out andtaking a golden parachute that made him as much money as

if the company was hitting new highs, leaving everybody elseholding the bag.

This taught me a couple things. In a highly leveraged situa-tion, no matter how close you think you are, if you’re not deal-ing with exactly the right people it’s going to bite you,because you’re not going to know fast enough if somethinggoes wrong. And, now when I hear anybody say they loveever-increasing smooth earnings, I don’t want to have any-thing to do with it.

Thomas Russo, Gardner Russo & Gardner

At the peak of the Internet bubble, [check manufacturer]Deluxe Corp. shares had collapsed because everybody knewthere would never be anything but electronic bill pay goingforward. I didn’t quite buy it, because I held out stronglyagainst the view that technology would transform everything. Ithought it was a rich area to pursue, since common fear oftenleads to excessive pessimism.

I went to an investor presentation by the company in St. Paul,Minnesota in which they described, in fact, that the Internetwas going to flatter, not tarnish the check business. So I waspretty excited. Then the CEO launched into a big discussionabout how he was going to convert his core franchise to anew platform he called Internet gift sales, and that they weregoing to lose $50 million a year on it. I went away and didn’tbuy the stock, disgusted with that idea.

What I learned from this, however, was that really dumb ideaslike this one actually have a habit of meeting an early death. Infact, it turned out to be such a dumb idea that it died quitequickly, leaving the business to flourish under its core dynam-ics, unburdened by ill-considered strategic moves. That was abig lesson.

F R O M T H E T R E N C H E S


Value Investor Insight 19May 22, 2005


There’s no question that confidence inone’s investing abilities is a prerequisite tosuccessful investing. To commit your ownand others’ hard-earned capital requiresconviction, and conviction requires confi-dence. But as with fine scotch or pepperonipizza, too much of a good thing can causeproblems.

Social scientists have confirmed time andagain that people generally overestimatetheir abilities and knowledge. More than80% of drivers think they’re among thesafest 30% of those driving. More than85% of the Harvard Business School class of1994 say they are better looking than theiraverage classmate. When asked at confer-ences to write down how much money theythought they would have at retirement vs.the amount the average person in the roomwould have, money managers and businessexecutives consistently judge that they’llhave about twice the average – also animpossibility, of course.

Healthy self-confidence is generally posi-tive, as it can lead to great achievement andcertainly contributes to a happier life. Butwhen it comes to managing money, a consis-tent dose of humility is an invaluable asset.The market can be unforgiving when over-

confidence results in too much trading, slop-py analysis, lack of follow-through andexcessive risk-taking.

Brad Barber and Terrance Odean of theUniversity of California, Davis, in extensivestudies of individual trading behavior, foundthat investors generally overestimate boththe precision of their knowledge about asecurity’s value, as well as the probabilitytheir assessment is more accurate than theassessments of others. The result, they say, ismore active trading – “I’ve got to act on theadvantage I have” – but not better perform-ance. In fact, “those who trade the mostrealize, by far, the worst performance,”Barber and Odean conclude.

Overconfidence can also lead to analyti-cal short-cuts. A recent study by Lin Peng ofBaruch College and Wei Xiong of PrincetonUniversity found that overconfident, time-pressed investors put too much weight onmarket- or sector-level information and notenough on firm-specific data. The authorsargue that this was a key contributor to theInternet-stock bubble, as investors ignoredcompany specifics and made judgmentsalmost solely on the industry as a whole –much to their eventual chagrin.

Complacency about existing holdings is

another risk. It’s natural, of course, tobecome more certain about any given idea’ssoundness as the investment thesis plays out.But if this certainty results in less-diligentongoing analysis and monitoring of yourholdings, you can be left unprepared whencircumstances change. “I’ve learned not tofall in love with either the idea or my seem-ing brilliance,” says MLF Investments’ MattFeshbach (see interview, page 1). “I’ve donethat in a few instances at great cost.”

The best guards against investor hubris?Benjamin Graham’s discipline of investingwith a significant “margin of safety” is agreat start. The consequences of overesti-mating a company and your ability to ana-lyze it are greatly diminished when you’repaying a lot less for it than your analysisshows it’s worth.

Second opinions are also critical, so testyour thinking out on as many informed anddispassionate listeners as possible. In addi-tion to the obvious benefits of hearing alter-native viewpoints or questions you didn’tthink of, the simple act of articulating anidea is a powerful check on the thorough-ness of your analysis.

Make sure to have a disciplined investingapproach and stick with it. Many greatinvestors have a written checklist they gothrough in analyzing ideas: Is this within mycircle of competence? Is this a good busi-ness? Do I give management high marks? Isthe stock really cheap? If you’re already in astock, don’t waver in your approach as theprice moves up or down. “I try to keep aneutral attitude and stay rational whetherthe stock is going up or down,” advises MattFeshbach. “I’m constantly assessing risks inthe business model … [and] whether it’s[right now] an opportunity or a mistake.”

Above all, counsels Amit Wadhwaney ofThird Avenue Management (see interview,page 1), stay within yourself: “Just avoidwhat you can’t totally get your mindaround,” he says. “It’s just not worth it.There will be plenty of other things to investin – keep the cash for then.” VII

Confidence GameIt’s far better to remind yourself to avoid the pitfalls of investor overconfidencethan to have the market do it for you.


“When I said none of us were infallible, I didn’t mean you sir.”


Value Investor Insight 20June 19, 2005


“I think I’ve been in the top five per-cent of my age cohort almost all myadult life in understanding the power ofincentives,” says Berkshire Hathaway’sCharlie Munger in the recently pub-lished Poor Charlie’s Almanack, “andyet I’ve always underestimated thatpower.”

The power of self-interest in businessand economics is, of course, well estab-lished. "It is not from the benevolence ofthe butcher, the brewer, or the baker thatwe expect our dinner,” wrote AdamSmith in The Wealth of Nations, “butfrom their regard to their own interest.”Michael Douglas, as corporate raiderGordon Gekko in the movie Wall Street,opined somewhat more coarsely: “Greedis good. Greed works. Greed clarifies,cuts through and captures the essence ofthe evolutionary spirit. It's all aboutbucks. The rest is conversation."

As established as the concept is thatincentives motivate behavior, investorsare frequently blind to the excesses thatcan develop. How else to explain thedeafening silence from investors as com-panies awarded ever more extravagant

perks and stock-option packages tomanagers and employees during the1990s? How else to explain the wide-spread basing of investment decisions onthe opinions of ever more compromisedWall Street analysts during the Internetboom? More recently, how else toexplain the explosive growth of interest-only, little-or-no-money-down mortgageloans pushed by mortgage lenders to buyresidential real estate at ever-inflatedprices? When prices are rising, sensitivi-ty to conflicts of interest falls – withoften unfortunate results.

Successful investors tend to be well-attuned to the power, and biases, of self-interested behavior. In his interview inthis issue (see p. 1), Legg Mason’s BillMiller recounts how early in his career apotential client rejected one of his invest-ment ideas because Miller couldn’texplain why the stock would outperformthe S&P 500 over the following ninemonths. The prospective clientexplained: “There’s a lot of performancepressure in this business, and performingthree to five years down the road doesn’tcut it. You won’t be in business then.Clients expect you to perform rightnow.” To profit from this bias to per-form in the short-term that persiststoday, Miller focuses his attention onbets that are expected to fully play outmore than a year hence. “The market isless efficient beyond the next 12months,” he says.

This is not to say that money-man-agers’ fixation on short-term perform-ance is irrational or not in their self-interest. In fact, funds with the greatestnet new asset growth at any given timetend to be those with top 12-monthrecords. But this only reinforces the mis-pricing that can result from a short-termbias, creating other opportunities to findvalue.

For example, investors with shortertime horizons are more likely to react to

bad news by selling than are long-terminvestors. Resulting less-than-rationalprice declines can provide buying oppor-tunities – as Warren Buffett counsels,“be greedy when others are fearful.”

Equally important for investors is aclear understanding of the incentives ofmanagers in their portfolio companies.“It’s almost impossible to understate theimportance of having the right incentivesin business,” says Mark Sellers of SellersCapital LLC (see interview, p.1). “Thewrong incentives can cripple a busi-ness.” Though not always readily avail-able, the more knowledgeable investorsare about the incentives of those runningthe companies in which they own astake, the more informed the investmentdecision they make. What percentage oftop management’s total compensation issalary vs. bonus vs. equity? What is therelative focus on short-term vs. long-term in determining pay? How closelytied is incentive compensation to metricsover which managers truly have control?What accounting policies and controlsare in place to promote and monitor spe-cific corporate behaviors?

While change is slow in coming, pro-gressive companies are instituting incen-tives that better align with the long-termcreation of shareholder wealth.Berkshire Hathaway avoids all incen-tives based on short-term targets.Restricted-stock programs at Microsoftand Amazon.com limit the threats ofmisbehavior fostered by wildly lucrativestock-option plans. White MountainsInsurance awards stock options withstrike prices that continue to increase aset percentage every year. Morningstarpays bonuses based on divisional returnson capital in excess of the cost of capital.

No system can do away with theinevitable excesses that occur from advi-sors, investors and managers acting intheir self-interest. Forewarned, however,is forearmed. VII

Whose bread I eat, his song I singA heightened sensitivity to the biases inherent in pursuing self-interest – one’s own and others’ – is a valuable trait of successful investors.


“This is no time to be thinkingabout ourselves, Matthews.

So, I’ll see you at the meeting on Monday?”


Value Investor Insight 21July 29, 2005


Evidence of investors’ appetite forthe latest financial and market informa-tion is everywhere. TVs tuned to CNBCat the gym. Travelers checking stockquotes on their BlackBerrys. Cellphones delivering alerts on market upsand downs. “Wall Street can be any-where now,” says hedge-fund managerBryan Jacoboski of RBJ Partners, “evena cabin in the woods.”

Of course, timely and democraticaccess to news and information con-tributes to smoothly functioning finan-cial markets. But unless you make yourliving as a trader, an excess of news andinformation can be highly counter-pro-ductive.

The biggest problem is that, as manystudies have shown, investors tend tooverreact to news, so its 24/7 availabili-ty is actually detrimental to investors’long-term success. In a Harvard studyconducted by psychologist PaulAndreassen, two groups of investorswere given information necessary tovalue a stock and then asked to trade it.The only difference was that one groupreceived frequent news reports aboutevery little development about the com-pany, whereas the other group receivedonly quarterly earnings releases. Theresult: The latter group of investorstraded far less and ended up with twicethe profits of those fed frequent news.

Behavioral-finance researchers attrib-ute the tendency for investors to overre-act at least partly to what they call“information cascades.” For example, arelatively small number of people whorespond to bad news by selling cancause prices to fall, which reinforces theapparent wisdom of the early sellers andleads still others to follow the herd andsell. As all this activity is dutifully andbreathlessly reported and “analyzed” byubiquitous media outlets, temporaryinsanity can take over stocks’ move-ments as never before – independent of

whether the fundamentals of the invest-ment situation have actually changed.

Irrational responses to the latestinformation tend to affect buyers evenmore than sellers. A recent study byBrad Barber of the University ofCalifornia, Davis and Terrance Odeanof the University of California, Berkeleyconcluded that individual investors dis-proportionately buy “attention-grab-bing” stocks, which they defined asthose heavily in the news, those experi-encing high, abnormal trading volumeor those having just had extreme one-day returns. Barber and Odean arguethat investors behave in this waybecause of the difficulty they face inresearching the thousands of stocks theycan potentially buy. Focusing on thosemaking news helps limit the choices.

But while chasing news-makers maysimplify the buying decisions, it hurtsinvestment returns, say the authors:“[For] investors most influenced byattention, the stocks they buy subse-quently underperform those they sell.”

Another issue for investors: When itcomes to decision-making, more infor-mation is not always better. “The ratioof useless to significant information dis-

seminated has increased significantly,”says RBJ Partners’ Jacoboski. In a fasci-nating study of horse handicappers(those who set the initial odds for horseraces), researchers first gave the handi-cappers the five pieces of informationthey agreed were the most importantand asked them to handicap races. Inthe second part of the study, the samehandicappers were given the same fivecritical pieces of information, plus 35less important ones, and again wereasked to handicap races. The result?Not only were the handicappers lessaccurate with more information, but,worse yet, they were twice as confidentin their predictions!

Of course, sometimes it pays to reactimmediately to news – for example,Enron investors would have been wellserved to sell immediately once earlyreports of accounting irregularities sur-faced. But the best long-term investmentopportunities tend to be from takingadvantage of the market’s tendency tooverreact to often-dramatic but ulti-mately short-term news.

No one would suggest completelyignoring news about your investments,but some investors look to limit newsreports’ impact on their daily activity.“We don’t want to be drawn intoresponding to daily news flow,” saysJacoboski. His office has a Bloombergterminal, but it’s not a place for his staffto frequent: “We don’t allow a chair infront of it,” he says.

The key is to keep news in context,and act only if further reflection orstudy indicates that the core thesis forthe investment has changed. An earn-ings disappointment due to a supplier’smanufacturing problem may say some-thing very different than a shortfall dueto pricing pressure from new competi-tion. In almost all cases, letting the herdoverreact first before taking action isprobably the best bet. VII

You’re OverreactingThe Internet, TV and various nifty new portable devices put the latest company and marketinformation at your fingertips 24/7. Will this make you a better investor? Probably not.


“Looks like another case of media overload sir.”


Value Investor Insight 19August 29, 2005


We’ve all done it: Made the sameinvestment mistake over and over. Eventhe very best investors aren’t immune.Legg Mason’s Bill Miller, for example, inhis recent interview with Value InvestorInsight (June 19, 2005) tells the story ofhaving owned apparel company SalantCorp. when it went into bankruptcy …three times. He joked: “The third time, Isaid ‘Three bankruptcies and we’re out.’That’s one of our rules.”

An ability to learn from mistakes iscritical to future investment success, andthe best investors, like Bill Miller, are gen-erally quite good at it. But learning frommistakes can be difficult, complicated bydeep-seated aspects of human nature.

One of the most basic psychologicalbarriers to drawing useful lessons frombad experiences comes from what psy-chologists call “self-attribu-tion bias.” This is the generaltendency of people to attrib-ute good outcomes to theirown prescience, wisdom andskill, whereas bad outcomesare written off as due to badluck. If your investment inAltria doubles, you’re apt tosee this as confirmation ofyour correct analysis ofAltria’s business opportunitiesand risks. But if your Altriastake is cut in half, it’s farmore likely you’ll blame exter-nal factors beyond your con-trol – over-zealous regulatorsor half-baked juries, for exam-ple. When mistakes aren’tacknowledged, of course, littleis learned.

Further limiting opportuni-ties for insight is that peopletend to see past events as con-firmation of what they alreadybelieve. “The general rule isthat people learn as little aspossible from the past and use

their personal views to try to provethings,” explains Princeton psychologyprofessor and Nobel laureate DanielKahneman in a recent newspaper inter-view. “When the Soviet Union fell, thepolitical right said ‘We were right.Squeeze the USSR with high militaryspending and the Soviet Union will col-lapse.’ At the same time, people on thepolitical left said ‘We were lucky. Wenearly had WWIII, but thanks toGorbachev, the Soviet Union collapsed.’”

This selective memory contributes towhat researchers more broadly term“hindsight bias.” After the fact, peopledramatically overestimate the inevitabili-ty of what happened, so that past eventsare judged as being more simple, compre-hensible and predictable than they actual-ly were. When researchers Martin Bolt

and Jon Brink asked students to predictthe outcome of the 1991 Senate confirma-tion vote on Supreme Court nomineeClarence Thomas, 58 percent predictedhis approval. A week after the vote, whenthey asked other students to say whatthey would have predicted, 78% said theyexpected Thomas to be approved. Thistendency is equally clear in investing: Ifall the people who now say they knew theInternet bubble was going to burst reallydid know, a lot of investors would be a lotricher today from shorting the “obvious-ly” overvalued stocks. In fact, the bubbleprobably never would have formed in thefirst place.

Seeing the past as having been morepredictable than it was can pose greatdanger to rational investment decision-making. Those lulled into complacency

by the perceived predictability ofevents run the risk of not ade-quately considering the widerange of future outcomes possi-ble – potentially exposing them-selves to greater risks than theyshould.

Oversimplifying past eventscan also lead to overconfidence –and big mistakes. In numerousexperiments conducted byVernon Smith, a professor atGeorge Mason University andalso a Nobel prize winner in eco-nomics, participants were askedto trade a dividend-paying stockin which the true value wasclearly laid out. A bubble wouldinvariably form and then, even-tually, burst. One would thinkthat participants, having suf-fered big losses, would learn notto speculate. Yet when Smithrepeated the trading exercise fora second time with the same par-ticipants, another bubble formed(though not quite as extreme).Why did this happen? Because

Why Hindsight Isn’t Always 20/20Successful investors know how important it is to learn from their mistakes. But doing so is much easier said than done.


“C’mon, we won’t get burned this time.”


Value Investor Insight 20August 29, 2005


the lesson the participants learned thefirst time wasn’t the perils of speculation,but rather that one simply had to bemore clever in selling at the top. But asSmith explained: “The subjects arealways very optimistic that they’ll be ableto smell the turning point and report thatthey're surprised by how quickly it turnsand how hard it is to get out at anythinglike a favorable price.” Sound familiar?

Beyond having an awareness of thedeep-seated psychological tendencies atwork, how can investors maximize theirability to learn from mistakes? One tacticis to focus as much on process as on out-comes. In a probabilistic exercise such asinvesting, good decisions can still yieldlousy outcomes, and vice versa. The bestlearning will likely come from a dispas-sionate review of how and why a givendecision – using the available informa-tion at the time – was made. Becausememory can often distort reality, themore documented the original decisionprocess, the better.

Enlisting second opinions on conclu-sions drawn from past experience canalso be helpful. The key is to tap insight

from diverse sources. The broader theinterests, mindsets and biases of thosegiving input, the more likely you are tolearn something useful.

Not all mistakes, of course, produceprofound lessons. No one is infallibleand luck, good and bad, often plays arole. The goal should be to see whathappened as clearly as possible, learn

what you can and move on. Excessivefear of making a mistake can be as debil-itating to an investor as making the samemistake more than once.

One final lesson to keep in mind, asWarren Buffett frequently reminds lis-teners: “Remember, it’s better to learnfrom other people’s mistakes as much aspossible.” VII


“We hate surprises”

While the tendency for people to seepast events as more predictable thanthey really were can hinder investmentjudgment, this hindsight bias can play avery positive psychological role. AuthorMalcolm Gladwell (The Tipping Point,Blink) has written extensively about thefallibility of hindsight, particularly withrespect to whether the intelligence com-munity should have seen the September11 attacks coming and stopped them. Inan interview in The New Yorker, hedescribed the positive effects of hind-

sight bias: “We hate surprises. We try toerase them from our memory. This is partof what keeps us sane. If, after all, wewere always fully aware of the possibili-ty of completely unpredictable events,would we be able to walk out the frontdoor in the morning? Would we everinvest in the stock market? Would wehave children? Generally speaking, peo-ple who have an accurate mental pictureof why and how things happen tend tooccupy mental hospitals – or, at the veryleast, a psychiatrist’s office.”

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Value Investor Insight 20September 28, 2005


“I made a big mistake in not sellingseveral of our larger holdings during TheGreat Bubble,” wrote Warren Buffett inBerkshire Hathaway’s 2003 annualreport. “If these stocks are fully pricednow, you may wonder what I was think-ing four years ago when their intrinsicvalue was lower and their prices far high-er. So do I.”

Few investors came through the mil-lennium stock-market bubble and itsaftermath unscathed, leaving many to askthemselves the very what-was-I-thinkingquestion posed by Buffett. Such intro-spection, of course, won’t magically turnback time and allow you to sell yourCisco shares at $82. But an understand-ing of the underpinnings of the market’sirrational rise mighthelp you limit the nextbubble’s damage toyour portfolio.

Yale economics pro-fessor Robert Shiller, inhis prescient 2000 bookIrrational Exuberance,defines a speculativebubble as “a situationin which temporarilyhigh prices are sus-tained largely byinvestors’ enthusiasmrather than by consis-tent estimation of realvalue.” Where did thisenthusiasm come fromin the late 1990s andinto the Spring of 2000before the bubblepopped? A clear con-tributor was that stockinvesting had become awidespread culturalphenomenon, fueled bythe media’s reportingon the market as almosta spectator sport. Themarket’s rise was ampli-

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 thebubble went beyond just generating col-lective enthusiasm. “Humans have astrong desire to be part of a group,” saysLegg Mason equity strategist MichaelMauboussin in a 2004 research paper dis-secting investor decision-making. “Thatdesire makes us susceptible to fads, fash-ions and idea contagions.”

A classic research study of conformingbehavior, by psychologist Solomon Asch,asked eight group members to solve asimple problem: determine which of threelines is the same length as a given base

line. Seven of the experimental groupmembers were prepped in advance byAsch, while only one was an actual sub-ject. After a few trials where everyonegave the right answer, Asch signaled forthe in-the-know subjects to start givingthe wrong answer. When they did, a sur-prising 35% of the actual subjects wentalong in giving the obvious wronganswer. “People [have a] preference forbeing an accepted part of a majority overbeing part of the correct minority,” saysMauboussin. “Numerous market bubblesdemonstrate this point.”

The “herd” also appears to have fallenvictim to the common investor mistake ofoverweighting recent experience.Behavioral scientists have consistently

shown that individualsare more likely to judgerecent and easier-to-recall events as morenumerous and predictiveof the future than thoseless recent. After fouryears of 20%-plus over-all market returns, indi-vidual investors in aDecember 1999 Gallupsurvey of investor opti-mism were still predict-ing a 15.3% averagereturn over the follow-ing twelve months.Optimism, based on therecent past, was ram-pant. “I don’t think any-thing can shake my con-fidence in this market,”said one patron of aCape Cod barbershopinterviewed by The WallStreet Journal in March2000. “Even if we godown 30%, we’ll justcome right back,” saidanother.

Interestingly, institu-

What Were We Thinking?A better understanding of the Internet bubble won’t keep something similar from happeningagain. It may, however, help you limit the damage to your own portfolio.


“I just can’t imagine anything slowing this market down...”


Value Investor Insight 21September 28, 2005


tional investors were consistently lessoptimistic than individuals about futurereturns as the market roared ahead. Thischanged, however, after the bubblepopped.

A December 2000 survey of institu-tional investors by BusinessWeek foundsuch investors expecting a mean S&P 500return over the following 12 months of19.2%. The actual return came in atminus 11.9%. “Individual investors thinkthat high past returns portend high futurereturns, but they are wrong. Institutionalinvestors think that high past returns por-tend low future returns, but they areequally wrong,” concluded investmentmanager Kenneth Fisher and Santa ClaraUniversity finance professor MeirStatman in a study of individual and insti-tutional expectations around the bubblepublished in The Journal of Psychologyand Financial Markets.

Did investors think stocks were cheapas they bid up stock prices near the bub-ble’s peak? No. Did they care? No, again.A Yale survey of investor confidence inearly 2000 showed that 70% of investors

thought the market was overvalued,while 70% also believed the marketwould continue to go up. Studies showsuch a dichotomy to be common as mar-kets peak, as investors either believe a“greater fool” will come along and paymore, or that they won’t fall victim tooverly high prices. In a study of pre-bustinvestors in a large telecommunicationscompany, Yale’s William Goetzmann andRavi Dhar found an “overwhelmingmajority” felt they – or the financial advi-sors upon which they relied – had anabove-average ability to identify mis-priced securities.

The key lessons in all this? As thelawyers regularly counsel: past perform-ance is no guarantee of future success.That’s not at all to say history is irrelevantin judging any security’s valuation, butthat it should be treated as providinginput rather than concrete answers. Aconstantly updated risk-reward judgment– from today onward – is what matters.

Humility also matters. Overconfidentinvestors are sloppy investors, as late-stage buyers of eToys or Pets.com who

were counting on getting out before themusic stopped found out the hard way.Actively and often challenge your invest-ment assumptions, and enlist others yourespect to do so also.

An assumption to challenge, says long-time value manager Robert Olstein (seeinterview, p. 1), is the extent to which atraditional buy-and-hold strategy makessense today. When he started in the busi-ness, Olstein says, “a stock moved 25cents for sound reasons.” But since thelate 1990s, he says, too many short-terminvestors responding to too much marketinformation have made short-term valua-tion extremes more common. On theupside, this requires action: “If we buy at$10 with a two-year price objective of$15 and the stock reaches $14 within twoweeks,” he says “we’re not doing our jobif we don’t take money off the table tobuy another stock with a 30% discountright away.”

One final “bubble” lesson is obvious,but bears repeating: Make your own deci-sions. Crowds can be ugly when theychange directions. VII


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Value Investor Insight 22October 28, 2005


Thomas Edison’s famous quote that“Genius is 1% inspiration and 99% per-spiration” is a sentiment shared by manywhen it comes to investing. As keys tosuccess, investors tend to credit discipline,focus and analytic rigor over creativity.“Investing is a simple business and everytime we try to overcomplicate it we havelower returns,” says one of the bestmoney managers we know, off the record.“Being creative just to be creative canwaste research time, liquidity andresources.”

Is investing a creative process? Hard-charging money managers resist definingwhat they do in terms usually reserved forartists. But if one defines a creative person– as does the American Heritage diction-ary – as “one who displays productiveoriginality,” there’s little doubt that suc-cessful investors and many others fit themold. “Clearly, creativity is not limited toartists,” writes business historian MauryKlein in his book on the greatest entrepre-neurs in history, The Change Makers.“The scientist displays it in connectingideas or observations and transformingthem into insights or actions; so do inven-tors, philosophers, mathematicians, busi-nessmen and athletes.”

Charlie Munger’s use of “multiplemental models” to draw investing insightfrom the acquired wisdom in many disci-plines is an example of such creativity atwork. As Munger has described it: “Youhave to realize the truth of biologistJulian Huxley’s idea that, ‘Life is just onedamn relatedness after another.’ So youmust have the models and you must seethe relatedness and the effects from therelatedness.”

Legg Mason’s Bill Miller is anotherstrong proponent of using more than justanalytical firepower to drive investmentsuccess. That’s why he is fascinated bythings like the adaptive learning of bees,or what the fossil record explains abouthow organisms evolve. As he explained in

our interview with him earlier this year,“If you just do what other people do, youget the results that other people get.”

Fostering creativity requires effort, ofcourse. Because the ability to discoveruseful patterns typically improves withthe number of observations made, thefirst step is to devote time to diverse linesof inquiry. As equity strategist MichaelMauboussin of Legg Mason has said:“There is strong evidence that the leadingthinkers in many fields – not just invest-ing – benefit from input diversity.”Investors should allocate specific time toexploring new ideas, he says, “even at therisk of wasting time on intellectual cul-de-sacs.” Charlie Munger counsels readingeverything you can: “In my whole life, Ihave known no wise people who didn’tread all the time – none, zero.”

Keeping an open mind about newobservations is key. Humans naturallyorganize experiences and the relation-ships among them as efficiently as possi-ble, to minimize the energy used in pro-cessing, storing and recalling informa-tion. Writes applied psychologist Edwardde Bono in his pioneering book on devel-oping individual and collective creativity,

Six Thinking Hats: “From the past wecreate standard situations. We judge intowhich ‘standard situation box’ a new sit-uation falls. Once we have made thisjudgment, our course of action is clear.Such a system works very well in a stableworld [but] in a changing world the stan-dard situations may no longer apply. Weneed to be thinking about ‘what can be,’not just ‘what is.’”

Processing novel ideas that requirebreaking down the “standard situationboxes” we’ve constructed isn’t particular-ly easy or natural, which is why manyideas get dismissed out of hand – short-circuiting the process of creative thought.“Creativity starts with some problem orneed and moves in various ways througha series of stages, consisting of informa-tion gathering, digestion of the material,incubation, sudden inspiration, and,finally, implementation,” writes StanfordBusiness School professor Michael Ray inhis book Creativity in Business. Withoutplenty of ideas “incubating,” break-through thinking is much less likely.

Business innovators often cite an addi-tional requirement for creativity, which,for lack of a better description, is “quiettime.” Albert Einstein often mused abouthis getting his best ideas in the morningwhile shaving. In fact, researchers havefound that the presence of a calm mind –uncluttered by the constant processingrequired by daily life – is far more likelyto produce “eureka” moments of inspira-tion than a busy one.

And what of Edison’s quote aboutgenius? To be sure, creativity isn’t possi-ble without perseverance, effort and, ofcourse, the right attitude. Edison wentthrough more than 9,000 experiments inhis quest to create the incandescent lightbulb. When derided by colleagues forwhat they perceived to be the foolishquest, he responded: “I haven’t evenfailed once; 9,000 times I’ve learned whatdoesn’t work.” VII

Inspiration or Perspiration?Successful investing is as much a creative process as it is a disciplined, analytical one – even if some investors don’t want to admit it.



The stock market was not onVictorian-era polymath Sir FrancisGalton’s agenda when he first conductedhis path-breaking studies supportingwhat he termed “reversion to the mean”– the tendency for extreme observationsto regress over time toward long-termaverages. Galton, a half-cousin of CharlesDarwin’s, first observed mean reversionin the size of peas, while later refining theconcept in studies of human height.

The notion that “outlier” performanceis exceedingly difficult to sustain, however,has been shown to be equally applicable tocorporate performance and investing. In astudy of average corporate returns onequity over rolling five-year periods since1979, Sanford C. Bernstein & Co. foundhow hard it is for the rich to get richer.Bernstein broke its large-cap universe ofcompanies into quintiles, from the top20% 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 reversionprocess was well in evidence: the top-quin-tile firms were earning an average 18.4%ROE, while those in the bottom quintilehad improved their average ROE to 9.0%.

Similarly, Alliance Capital’s BernsteinInvestment Research (no relation toSanford C. Bernstein) studied companiesin the S&P 500 from 1990 to 2003 toidentify how many had sustained 25%annual earnings growth. By the fifth yearonly twelve companies made the cut andby year nine none had. Even increasingearnings 10% per year was difficult: only22 companies grew at that rate after fiveyears and just one, Walgreens, made it theentire 13 years. That’s something to keepin mind if you’re buying Google today at$420 per share and 93x trailing earnings.

The evidence for mean reversion is alsocompelling for stock prices – on an indi-vidual, sector or market-cap basis. One

classic long-term study by professorsWerner DeBondt and Richard Thalerformed theoretical portfolios at two-yearintervals based on share prices in relation

to book value. In the four years prior toeach portfolio being formed, the lowestprice-to-book stocks underperformed themarket by a whopping 26%. Yet in the

Value Investor Insight 20December 30, 2005


The Market’s Law of GravityThat 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.


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

The Value Destroyers

Company TickerMarket Cap (000)

12/31/04Market Cap (000)

12/15/05$Change

(000) %Change

Pfizer PFE $202,508 $167,994 ($34,514) -17.0%

IBM IBM $164,106 $131,937 ($32,169) -19.6%

Verizon VZ $112,410 $84,636 ($27,774) -24.7%

Dell DELL $104,689 $78,852 ($25,837) -24.7%

Wal-Mart Stores WMT $223,686 $205,054 ($18,631) -8.3%

DuPont DD $57,255 $39,450 ($17,805) -31.1%

Cisco Systems CSCO $127,217 $111,439 ($15,778) -12.4%

Comcast CMCSA $73,878 $58,327 ($15,551) -21.0%

Tyco TYC $71,895 $57,276 ($14,619) -20.3%

eBay EBAY $77,123 $64,141 ($12,982) -16.8%

The Value Creators

Company TickerMarket Cap (000)

12/31/04Market Cap (000)

12/15/05$Change

(000)%Change

Google GOOG $52,712 $117,989 $65,277 123.8%

Genentech DNA $57,141 $99,124 $41,983 73.5%

ExxonMobil XOM $330,693 $370,170 $39,477 11.9%

Apple Computer AAPL $24,982 $59,897 $34,915 139.8%

ConocoPhillips COP $59,933 $81,547 $21,614 36.1%

Hewlett-Packard HPQ $63,327 $83,658 $20,330 32.1%

Schlumberger SLB $39,416 $59,580 $20,164 51.2%

Alcon ACL $24,675 $42,715 $18,040 73.1%

Halliburton HAL $17,343 $33,796 $16,453 94.9%

Motorola MOT $40,679 $56,840 $16,161 39.7%

Source: Morningstar


four years after the portfolios wereformed, the low price-to-book stockstrounced the market by 41%. The highest-priced stocks, which beat the market by76% in the prior four years, returned 1%less than the market over the next four.

All this is generally good news for valueinvestors, who often look to buy whenthings don’t look so great. Explains RobertHaugen in The New Finance: The CaseAgainst the Efficient Markets: “Investorstend to mistakenly project a continuationof abnormal profit levels for long periodsinto the future. Because of this, successfulfirms become overvalued. Unsuccessful[ones] become undervalued. As the processof competitive entry and exit drives per-formance to the mean faster than expect-ed, investors in the formerly expensivestocks become disappointed with reportedearnings and investors in the formerlycheap stocks are pleasantly surprised.”

“Look, the people in troubled compa-nies aren’t jumping off bridges, they’retrying to fix things,” said Richard Pzenaof Pzena Investment Management whenwe interviewed him earlier this year(Value Investor Insight, February 22,

2005). “If there’s overcapacity in theindustry, they take out capacity. If costsare too high, they cut costs. If the saleseffort isn’t working or the products aren’tselling, they try to change things. Most ofthem succeed in making things better.”

The challenge for investors is that thegravitational pull on stock prices and

company performance doesn’t happen ina straight line or at a “typical” pace. Notall companies turn around and great com-panies can be great for a long time. A keydistinguishing characteristic of superiorinvestors, though, is their ability to deter-mine how temporary or permanent acompany’s given condition is – good orbad – and buy or sell accordingly. Equally

important – as investors such as RichPzena stress – is to accurately define what“normal” performance for a company isand base one’s valuation analysis on itrather than what happened last year or isexpected to happen next year.

So while a knee-jerk buying of marketlosers and selling of market winners isunlikely to be successful, using reversion-to-the-mean thinking to screen for ideascan make sense. The 10 top value-destroying stocks of 2005 identified byMorningstar (see table) trade at an aver-age of a 13% discount to Morningstar’sfair-value estimates, while the averagestock on the value-creating list trades at a50% premium to fair value. Interestingly,seven of the 10 destroyers earn a “wide-moat” rating from Morningstar, whileonly four of the creators have such a des-ignation. 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 beon their toes: Value investing has dramati-cally outperformed growth investing forfive years now. While we’d like to say that’sonly right and just, skeptics take heed. VII

Value Investor Insight 21December 30, 2005



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ONE KEY CHALLENGE:

The gravitational pull on stock

prices and firm performance

doesn’t happen in a straight

line or at a “typical” pace.








“Games of chance must be distin-guished from games in which skill makesa difference,” writes Peter Bernstein inAgainst the Gods, his historic review ofrisk taking. “With one group the outcomeis determined by fate, with the othergroup, choice comes into play. There arecard players and racetrack bettors whoare genuine professionals, but no onemakes a successful profession out ofshooting craps.”

Like playing poker and betting onhorses, investing is a game of skill similar-ly focused on assessing the odds of uncer-tain future events. “At the end of the day,investing is inherently a probability exer-cise,” says Legg Mason strategist MichaelMauboussin. “Most investors acknowl-edge this point but very few live by it.”

Why is it difficult for investors to thinkin terms of probabilities when assessing acompany’s future performance and stockprice? “It isn’t human nature to view thefuture in terms of a wide range of possi-bilities,” says Abingdon Capital’s BryanJacoboski, who was featured last summerin Value Investor Insight (August 29,2005). “We naturally think in terms ofwhat is most likely to occur and implicit-ly assess the probability of that scenariooccurring at 100%. That may soundreckless, but it’s what most people do andisn’t a bad way to think as long as lesslikely, but still plausible, scenarios don’thave vastly different outcomes. In theinvestment world, however, they oftendo, so making decisions solely on themost likely outcome can cause severedamage.”

Anchoring on the most likely outcomeis a natural attempt to reduce the com-plexity involved in making investmentdecisions, but also can reflect the danger-ous overconfidence with which manyinvestors ply their trade. Former TreasurySecretary and Goldman Sachs Co-Chairman Robert Rubin, who made his

name on Wall Street as an arbitrage trad-er, warns against this “excessive certain-ty” in his book In an Uncertain World:“[It] seems to me to misunderstand thevery nature of reality – its complexity andambiguity – and thereby provides a ratherpoor basis for working through decisionsin a way that is likely to lead to the bestresults.”

The first basic step in incorporatingprobabilities into investment decisions isto explicitly consider several potentialoutcomes. Abingdon Capital’s Jacoboskilooks at each of his holding’s businessfundamentals under four to six distinctscenarios, calculating an intrinsic valueunder each scenario and applying a sub-jective probability to each. The final esti-mate of intrinsic value is the intrinsicvalue of each scenario weighted by itsprobability of occurring. “A key is to cap-ture low-probability but high-impact sce-narios, primarily to see where the vulner-abilities are,” he says. He decided not to

short Amazon.com a couple years ago,for example, after taking into considera-tion what he considered to be the unlike-ly event that Amazon’s scale would starttranslating into the profitability gains themarket was expecting. In fact, that is thescenario that began to play out, and thestock rose 180% in the following year.

An added benefit to thinking in termsof probabilities is that it helps makeexplicit the actual risks under considera-tion. If given the choice between purchas-ing a $350 non-refundable plane ticket toattend a future event that could possiblybe cancelled vs. waiting to buy a last-minute ticket for $1,200, many peoplewould choose to wait. Nobody wants toblow $350. But in pure expected-valueterms, it pays to buy the ticket now unlessyou believe the risk of cancellation isabove 71%. Framing the question in thisway may not change the decision, but canincrease the chances that a more informeddecision is made.

Value Investor Insight 20January 31, 2006


Anything’s PossibleMost investors know that investing is an exercise in probability. But knowing it and actually living by it can be two separate things.



In studying the common traits ofthose most successful at games of skill –across disciplines – researchers havefound a clear tendency to focus more onprocess than individual outcomes. Pokerlegend Amarillo Slim has described itthis way: “The result of one particulargame doesn’t mean a damn thing, andthat’s why one of my mantras has alwaysbeen ‘Decisions, not results.’ Do theright thing enough times and the resultswill take care of themselves in the longrun.” Adds Legg Mason’s Mauboussin:“By definition, poor decisions will peri-odically result in good outcomes andgood decisions will lead to poor out-comes. The best in their class focus onestablishing a superior process, with theunderstanding that outcomes will followover time.”

That’s not to say that process can’t beimproved. Making explicit – and writingdown – the probabilities used in makinginvestment decisions can provide valuablelearning. After all, if you judge an eventto have had a 60% chance of occurring –and it doesn’t occur – you don’t know if

you were right or wrong. The only trueway to know is by tracking the same orsimilar events to see if they, over time,happen 60% of the time. Weather fore-casters and bookmakers keep track ofsuch things to refine their ability to judgeprobabilities. Investors should do thesame – even if it’s with much less preci-

sion – to calibrate their probability-set-ting skills.

While necessary, skillfully assessing theprobabilities of various outcomes for acompany is not sufficient to making asound investment. Stock prices havefuture expectations already built in – thetrick is to find the gaps between those

expectations and your own. “Perhaps the single greatest error in

the investment business is a failure to dis-tinguish between knowledge of a compa-ny’s fundamentals and the expectationsimplied by the stock price,” saysMauboussin. Driving home this point isSteven Crist, chairman of the DailyRacing Form: “The issue is not whichhorse in the race is the most likely winner,but which horse or horses are offeringodds that exceed their actual chances ofvictory. There is no such thing as “liking”a horse to win a race, only an attractivediscrepancy between his chances and hisprice.”

Even with a framework to assess ambi-guity, the right decision in the face ofgreat uncertainty is often just to pass.Warren Buffett refers to it as placingsomething in the “too-hard pile.” WritesPeter Bernstein: “Once we act, we forfeitthe option of waiting until new informa-tion comes along. As a result, not actinghas value. The more uncertain the out-come, the greater may be the value ofprocrastination.” VII

Value Investor Insight 21January 31, 2006



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.

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It’s not surprising that the study ofirrationality and self-destructive behav-ior is one of the most fertile areas of psy-chological study. After all, there’s plentyof such behavior to go around andwhole industries – think tobacco, gam-ing, weight-loss, etc. – are built either tobenefit from or help ameliorate suchhuman frailties.

While much of the research into “whypeople do stupid things,” as FloridaState social psychologist Roy Baumeisterputs it, is not specifically focused oninvesting, the findings are highly rele-vant to investors. Ill-conceived decisionsthat are contrary to one’s rational self-interest should clearly be at the top ofany investor’s list of things to avoid.

Based on his own and others’ exten-sive research, Baumeister has identifiedfive key reasons why rational, self-enlightened action breaks down:

1. Emotional Distress

Emotional distress makes people farmore likely to favor options with highrisks and high rewards, even if theseoptions are objectively bad choices.When research-study subjects were firstasked to decide between playing one oftwo games – the first with a 70% chanceof winning $2 and the second with a 2%chance of winning $25 – most chose thefirst, opting for the choice with the high-er expected value of $1.40 vs. $0.50.

Subjects who were put under stress,however, were far more likely to choosethe riskier option with the much lowerexpected value. Baumeister attributesthis to the simple fact that those underduress just don’t think through theoptions. He confirmed this by specifical-ly prompting certain subjects to first listthe advantages and disadvantages ofeach option before deciding. Whenforced to reflect, even the stressed group

of test subjects generally made therational decision.

2. Threats to Self-Esteem

When a favorable self-view is ques-tioned or undermined by events, people’srush to prove otherwise can result in baddecisions. Baumeister offered test sub-jects a chance to bet on their skill in avideo game they all had learned, but sub-jected one subset of the group to thenews that the results of an earlier test ofcreativity they’d taken showed they didpoorly – in fact, the worst the experi-menter had seen.

How did the bruised-ego grouprespond? Eager to wipe out the loss of

face by winning a large bet, they madefar larger bets than justified by their skilllevels – and ended up losing most oftheir money.

3. Failure of Self-Regulation

The rational pursuit of self-interestoften requires delayed gratification – theforgoing of short-term benefits in orderto achieve greater future gains. Peoplegenerally self-regulate themselves tooverride immediate responses, but thebreakdown of this self-regulating mecha-nism often results in self-defeating behav-ior. Stress is again one big cause of thismechanism breaking down, but the prob-lem is also exacerbated when short-term



Sanity CheckSocial psychologists devote considerable effort to trying to understand why people do self-defeating, stupid things. Investors, take note.



gains are reliably predictable, while thelonger-term costs are uncertain. Considersmoking, in which the uncertain long-term risk of developing lung cancer canbe easily outweighed by the short-termand certain pleasure of lighting up.

Interestingly, Baumeister found thatthe capacity for self-regulation operatessomewhat like a muscle – when con-stantly tested over relatively short peri-ods it loses strength. Subjects who werehungry and were told not to eat freshly-baked chocolate chip cookies on a near-by table were far less likely to perseverein solving a variety of challenging puz-zles than those who had not been simi-larly deprived. Such findings give strongsupport to the notion that “sleeping on”important and difficult decisions is asensible strategy.

4. Decision Fatigue

People’s ability to make rational deci-sions similarly decreases as the numberof decisions to be made increases. Thislikely explains why people love routines

and habits, which preserve the limited“resources” available to make decisions.Says Baumeister: “People can only reallymake a few serious choices at a time,and then the capacity for choosing has torecover and replenish before they arefully effective again.”

5. Rejection

The need to be accepted by others is acentral feature of human motivation, soit’s not surprising that rejection – or thefear of rejection – can result in self-defeating behavior.

In one study, subjects were broughttogether and spent some time getting toknow each other before being put intoseparate rooms. They were then asked tolist with whom they wanted to work onthe next project in the study. In the end,everyone worked alone on the next proj-ect, but half the group was told it wasbecause nobody chose to work with themand half were told it was because every-one chose to work with them and it wastoo difficult to accommodate everyone’s

wishes. In subsequent tests, those thatwere “accepted” generally behavedrationally, while those “scorned” werefar more likely to be aggressive and makeirrational choices. Those who thoughtthey had been rejected even performedworse on intelligence tests than thosewho thought they had been accepted.

What are the implications forinvestors? “Pretty much all the elementsthat lead to the psychology of irrational-ity are likely to be present in large quan-tities for investors,” says equity strate-gist James Montier of DresdnerKleinwort Wasserstein. In particular, hecites the holding of unpopular stocksthat are going down as particularly like-ly to trigger many of the pressures thatoften lead to bad decisions.

Irrationality in investor decision-making isn’t going away, of course, andthe markets would be far less interesting– and profitable – if it did. But an aware-ness of what the triggers of self-defeatingbehavior are can go far in mitigating thedamage from irrational, bad decisions.Forewarned is forearmed. VII




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One of the more talked about booksamong investment theorists in recentyears has been University of California atBerkeley professor Philip Tetlock's ExpertPolitical Judgment: How Good Is It?How Can We Know? Based on detailedlong-term research, Tetlock scrupulouslyexplains exactly how bad experts are atmaking political and macroeconomic pre-dictions. Not only are experts no betterthan non-experts in predicting futureevents, they're worse on average thaneven crude computer algorithms thatextrapolate the past.

Given that investing is all about mak-ing accurate predictions – for example,about financial performance, companies'strategic choices and industry dynamics –is this indictment of expertise relevant tothe investment process? Is the quest forever more specialized knowledge, at best,not really worth it and, at worst, coun-terproductive?

Common practice – and, to a certainextent, common sense – would indicateotherwise. Most investment firms organ-ize analyst functions by specialty, out ofthe belief that a media expert has a betterchance to accurately handicapNews Corp.'s businessprospects than someone whoknows the banking businessinside and out. Expert energyconsultants are doing a land-office business counseling pro-fessional investors these days,as are firms like GersonLehrman Group, which servesits largely finance-industryclientele with a network of“150,000 subject-matterexperts” across a wide varietyof industries. Lee Ainslie ofMaverick Capital addressedthe current state of affairs in arecent interview (VII,December 22, 2006): “Withthe specialization of the people

we're competing against today, I think it'svery difficult to have a meaningful edgewithout significant depth and expertise.We should know more about every one ofthe companies in which we invest thanany other non-insider.”

As important as specialized knowledgeis for investors, it brings with it severalpotential impediments to sound decisionmaking that should be avoided. While theaverage person is typically overconfidentin his or her ability, experts have beenshown to be even more overconfident, adangerous trait for an investor.Overconfidence not only promotes reck-lessness, it can also limit learning.“Expertise may not translate into predic-tive accuracy, but it does translate into anability to generate explanations for pre-dictions that experts themselves find socompelling that the result is massive over-confidence,” writes Tetlock. It's hard tolearn much from mistakes if you don'tthink you're ever wrong.

Cognitive studies have also shownthat specialization can hinder one's abili-ty to detect change. This is a classic can't-see-the-forest-from-the-trees problem

and explains why industry experts innewspapers, film photography and musicretailing were by and large not the first tofully understand the dramatic changesroiling their industries. Wedded to theirin-depth knowledge, experts can find itdifficult to think about issues in newways. As historian Daniel Boorstin oncesaid, “The greatest obstacle to discoveryis not ignorance – it is the illusion ofknowledge.”

A final danger of an over-reliance onspecialized knowledge: more informa-tion doesn't always mean better deci-sions. One classic academic study askedM.B.A. students in an advanced finan-cial statement analysis course to makeindividual-company earnings forecastsusing three different sets of information:1) “baseline” data, consisting of the pastthree quarters' net sales, share price andearnings per share; 2) the same baselinedata, plus redundant or irrelevant addi-tional information, and 3) the baselinedata, plus non-redundant informationthat should have improved forecastingability.

The result? Forecasting errors wereequally and significantly high-er when additional informa-tion above the baseline wasprovided, whether redundantor relevant. At the same time,confidence levels in the fore-casts rose significantly withany additional information.

“Usually two to three vari-ables control most of the[investment] outcome,” saystwo-time Value InvestingCongress speaker MohnishPabrai in a recent interviewwith The Motley Fool. “Therest is noise. If you can hand-icap how those key variablesare approximately likely toplay out, then you have abasis to do something.” VII



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.



Certain investment wisdom deservesto be frequently revisited, for inspira-tion, information, or just as a sanitycheck when the investment worldappears to be somewhat less than sane.At the top of that list is the eighth chap-ter of Benjamin Graham’s The IntelligentInvestor, in which the patron saint ofvalue investing explores how marketfluctuations can, and should, impactinvestment decisions. Warren Buffett hascalled it, along with chapter 20 in thesame book on margin of safety, “the twomost important essays ever written oninvesting.” In light of the market’s recentbehavior, now would appear to be anexcellent time for a Graham refreshercourse:

“Since common stocks, even ofinvestment grade, are subject torecurrent and wide fluctua-tions in their prices, the intel-ligent investor should beinterested in the possibilitiesof profiting from these pen-dulum swings. He shouldalways remember that marketquotations are there for hisconvenience, either to betaken advantage of or to beignored.”

Graham makes a distinctionbetween trying to profit by “tim-ing” and by “pricing.” He likensmaking bets on the anticipateddirection of the overall market(“timing”) to speculative folly,providing “a speculator’s finan-cial results.” The true opportuni-ty presented by volatility, hewrites, is simply to take advan-tage of the resulting pricechanges, “to buy stocks whenthey are quoted below their fairvalue and to sell them when theyrise above such value.”

“A substantial rise in the market isat once a legitimate reason for satis-faction and a cause for prudent con-cern, but it may also bring a strongtemptation toward imprudentaction. [W]orst thought of all,should you now give way to thebull-market atmosphere, becomeinfected with the enthusiasm, theoverconfidence and the greed of thegreat public, and make larger anddangerous commitments? Presentedthus, the answer is a self-evident‘no’, but even the intelligentinvestor is likely to need consider-able willpower to keep from follow-ing the crowd.”

As author and journalist Jason Zweigdescribes in the excellent commentary

that accompanies the revised edition ofGraham’s book, humans are pattern-seek-ing animals, hard-wired to see trends evenwhere they don’t exist. Our brains auto-matically anticipate that rising stockprices will continue to rise and, if they do,the natural chemical dopamine isreleased, resulting in a feeling of eupho-ria. To counter this and other tests toinvestor willpower, Graham suggests theuse of more mechanical methods for port-folio rebalancing, which today could takethe form of formulaic adjustments basedon asset-class exposure, industry expo-sure or position size.

“The investor who permits himselfto be stampeded or unduly worriedby unjustified market declines in hisholdings is perversely transforminghis basic advantage into a basic dis-

advantage. That man would bebetter off if his stocks had nomarket quotation at all, for hewould then be spared the men-tal anguish caused him by otherpersons’ mistakes of judgment.”

The “basic advantage” to whichGraham refers is the individualinvestor’s freedom to freely ignoreMr. Market’s whims, a luxury notalways enjoyed by investment pro-fessionals dealing with cashinflows and outflows or obsessive-ly focused on performance versus abenchmark.

Jason Zweig here tweaks themedia for contributing to the“mental anguish” caused by fallingstock prices. Breathless televisionreporters and newspaper headlinesdepicting a 200-point fall in theDow as a “plunge,” for example,feed investor anxiety beyond whathas actually transpired. Would we

consider it a plunge, Zweigpoints out, if the temperature

“The Investor and Market Fluctuations”For guidance on how to prepare for – and respond to – market volatility, there’s no better placeto start than Benjamin Graham’s The Intelligent Investor.

“I’m trying to achieve total harmony of

body, mind and cashflow.”

Value Investor Insight 19September 28, 2007 www.valueinvestorinsight.com


Value Investor Insight 20September 28, 2007 www.valueinvestorinsight.com

outside fell from 80 degrees to 79, thesame percentage decrease as a 200-pointfall in the Dow today?

“There are two chief morals to [theA&P] story. The first is that thestock market often goes far wrong,and sometimes an alert and coura-geous investor can take advantageof its patent errors. The other is thatmost businesses change in characterand quality over the years, some-times for the better, perhaps moreoften for the worse. The investorneed not watch his companies’ per-formance like a hawk; but heshould give it a good, hard lookfrom time to time.”

Graham recounts the wide swings ininvestor sentiment toward grocer A&P –often at considerable odds with the com-pany’s actual performance, which deterio-rated considerably by the early 1970s. Hiscaution against complacency in monitor-ing portfolio companies – given at a time

when competitive dynamics arguablychanged more slowly than they do today –is more relevant today than ever.

“It might be best for [the conserva-tive investor] to concentrate onissues selling at a reasonably closeapproximation to their tangible-asset value – say, at not more thanone-third above that figure.Purchases made at such levels, orlower, may with logic be regardedas related to the company’s balancesheet, and as having a justificationor support independent of the fluc-tuating market prices. The investorwith a stock portfolio having suchbook values behind it … can give aslittle attention as he pleases to thevagaries 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 posi-tion” in identifying investments that can

best weather market storms. In otherwords, as Thesis Capital’s StephenRoseman puts it (see p. 17): “The bestway to deal with the fact that market sen-timent can change so quickly is to try toown absurdly cheap things.”

“Basically, price fluctuations haveonly one significant meaning for thetrue investor. They provide himwith an opportunity to buy wiselywhen prices fall sharply and to sellwisely when they advance a greatdeal. At other times he will do bet-ter if he forgets about the stockmarket and pays attention to hisdividend returns and to the operat-ing results of his companies.”

This is a core message of Graham’s: Astock price matters at any given time onlyin relation to the value of the companybehind it. Staying focused on value ratherprice during times of market turmoil ismost likely to pay financial – not to men-tion, psychological – dividends. VII

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

Value Investor Insight 20October 31, 2007 www.valueinvestorinsight.com

The Brain’s Hot Button

Deep in your brain, level with thetop of your ears, lies a small,almond-shaped knob of tissue

called the amygdala. When you confront apotential risk, this part of your reflexivebrain acts as an alarm system – generatinghot, fast emotions like fear and anger thatit shoots up to the reflective brain likewarning flares. (There are actually twoamygdalae, one on the left side of yourbrain and one on the right, just as officeelevators often have one panic button on

either side of the door.)The amygdala helps focus your atten-

tion, in a flash, on anything that’s new, outof place, changing fast, or just plain scary.That helps explain why we overreact torare but vivid risks. After all, in the pres-ence of danger, he who hesitates is lost; afraction of a second can make the differ-ence between life and death. Step near asnake, spot a spider, see a sharp object fly-ing toward your face, and your amygdalawill jolt you into jumping, ducking, or tak-ing whatever evasive action should get youout of trouble in the least amount of time.

This same fear reaction is triggered bylosing money – or believing that youmight. However, when a potential threat isfinancial instead of physical, reflexive fearwill put you in danger more often than itwill get you out of it. A moment of paniccan wreak havoc on your investing strate-gy. Because the amygdala is so attuned tobig changes, a sudden drop in the markettends to be more upsetting than a longer,slower – or even a much bigger – decline.On October 19, 1987, the U.S. stock mar-ket plunged 23% – a deeper one-day dropthan the Crash of 1929. Big, sudden, and

Mind Over Money“The 100 billion neurons that are packed into that three-pound clump of tissue between your earscan generate an emotional tornado when you think about money,” says author Jason Zweig. Hisnew book offers advice on how to best ride out such storms.

Killing time between flights a few

years ago, Jason Zweig bought an

issue of Scientific American and

was quickly drawn to an article describ-

ing 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 com-

mentary for the 2003 revised edition of

Ben Graham’s The Intelligent Investor),

he says, “I knew immediately that this

was something I had to learn more

about.”

The result of Zweig’s 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 brain’s 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 rea-

sons, the human brain constantly trig-

gers 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 bias-

es that get investors into trouble – help-

ing to explain, for example, why we’re

often more likely to sell when we should

be buying or why we’re 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 – that’s nurture – can help

counter some of the problems caused

by nature,” he says. “Many of the practi-

cal 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. “There’s an unfortunate

belief that great investing is about being

rational like Star Trek’s Mr. Spock, where

you feel nothing and are just an evalua-

tion machine,” he says. “I think that’s

wrong. Investors like Warren Buffett and

Charlie Munger are very attuned to the

emotions rippling through markets and

I’d argue that one of the things that sets

them apart is that they’re ‘inversely’ emo-

tional. When they sense pain and fear in

the market, they likely feel pleasure at the

value being created. They’re essentially

taking the other side of the trade on

other people’s 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 willpow-

er,” he says. “In times of stress, willpow-

er alone is not enough.”



inexplicable, the Crash of 1987 was exact-ly the kind of event that sparks the amyg-dala into flashing fear throughout everyinvestor’s brain and body. The memorywas hard to erase: In 1988, U.S. investorssold $15 billion more shares in stockmutual funds than they bought, and theirnet purchases of stock funds did notrecover to pre-crash levels until 1991. The“experts” were just as shell-shocked: Themanagers of stock funds kept at least 10%of their total assets in the safety of cashalmost every month through the end of1990, while the value of seats on the NewYork Stock Exchange did not regain theirpre-crash level until 1994. A single drop inthe stock market on one Monday inautumn disrupted the investing behaviorof millions of people for at least the nextthree years.

The philosopher William James wrotethat “an impression may be so excitingemotionally as almost to leave a scar uponthe cerebral tissues.” The amygdala seemsto act like a branding iron that burns thememory of financial loss into your brain.That may help explain why a marketcrash, which makes stocks cheaper, alsomakes investors less willing to buy themfor a long time to come.

Fighting Your Fears

When you confront risk, your reflexivebrain, led by the amygdala, functionsmuch like a gas pedal, revving up youremotions. Fortunately, your reflectivebrain, with the prefrontal cortex in charge,can act like a brake pedal, slowing youdown until you are calm enough to make amore objective decision. The best investorsmake a habit of putting procedures inplace, in advance, that help inhibit the hotreactions of the emotional brain. Here aresome techniques that can help you keepyour investing cool in the face of fear:

Get it off your mind. You’ll never findthe presence of mind to figure out what todo about a risk gone bad unless you stepback and relax. Joe Montana, the greatquarterback for the San Francisco 49ers,understood this perfectly. In the 1989Super Bowl, the 49ers trailed theCincinnati Bengals by three points with

only three minutes left and 92 yards –almost the whole length of the field – togo. Offensive tackle Harris Barton felt“wild” with worry. But then Montanasaid to Barton, “Hey, check it out – therein the stands, standing near the exit ramp,there’s John Candy.” The players allturned to look at the comedian, a distrac-tion that allowed their minds to tune outthe stress and win the game in the nick oftime. When you feel overwhelmed by arisk, create a John Candy moment. Tobreak your anxiety, go for a walk, hit thegym, call a friend, play with your kids.

Use your words. While vivid sights andsounds fire up the emotions in your reflex-ive brain, the more complex cues of lan-guage activate the prefrontal cortex andother areas of your reflective brain. Byusing words to counteract the stream ofimages the markets throw at you, you canput the hottest risks in cooler perspective.

In the 1960s, Berkeley psychologistRichard Lazarus found that showing afilm of a ritual circumcision triggeredinstant revulsion in most viewers, but thatthis disgust could be “short-circuited” byintroducing the footage with anannouncement that the procedure was notas painful as it looked. Viewers exposed tothe verbal commentary had lower heartrates, sweated less, and reported less anx-iety than those who watched the filmwithout a soundtrack. (The commentarywasn’t true, by the way – but it worked.)

More recently, disgusting film clips –featuring burn victims being treated andclose-ups of an arm being amputated –have been shown to viewers by the aptlynamed psychologist James Gross.(Although I do not recommend watchingit on a full stomach, you can view theamputation clip at http://psychology.stan-ford.edu/~psyphy/movs/surgery.mov.) Hehas found that viewers feel much less dis-gusted if they are given written instruc-tions, in advance, to adopt a “detachedand unemotional” attitude.

If you view a photograph of a scaryface your amygdala will flare up, settingyour heart racing, your breath quickening,your palms sweating. But if you view thesame photo of a scary face accompaniedby words like angry or afraid, activation

in the amygdala is stifled and your body’salarm responses are reined in. As the pre-frontal cortex goes to work trying todecide how accurately the word describesthe situation, it overrides your originalreflex of fear.

These discoveries show that verbalinformation can act as a wet blanket flungover the amygdala’s fiery reactions to sen-sory input. That’s why using words tothink about an investing decision becomesso important whenever bad news hits. Tobe sure, formerly great investments can goto zero in no time; once Enron andWorldCom started to drop, it didn’t payto think analytically about them. But forevery stock that goes into a total melt-down, there are thousands of other invest-ments that suffer only temporary setbacks– and selling too soon is often the worstthing you can do. To prevent your feelingsfrom overwhelming the facts, use yourwords and ask questions like these:

�Other than the price, what elsehas changed?

�Are my original reasons to investstill valid?

�If I liked this investment enoughto buy it at a much higher price,shouldn’t I like it even more nowthat the price is lower?

�What other evidence do I need toevaluate in order to tell whetherthis is really bad news?

�Has this investment gone downthis much before? If so, would Ihave 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 aninvesting diary. You should include whatneuroscientist Antoine Bechara calls an“emotional registry,” tracking the upsand downs of your moods alongside theups and downs of your money. Duringthe market’s biggest peaks and valleys, goback and read your old entries from sim-ilar periods in the past. Chances are, yourown emotional record will show you thatyou tend to become overenthusiasticwhen prices (and risk) are rising, and tosink into despair when prices (and risk)

go down. So you need to train yourself toturn your investing emotions upsidedown. Many of the world’s best investorshave mastered the art of treating theirown feelings as reverse indicators:Excitement becomes a cue that it’s time toconsider selling, while fear tells them thatit may be time to buy. I once asked BrianPosner, a renowned fund manager atFidelity and Legg Mason, how he sensedwhether a stock would be a moneymaker.“If it makes me feel like I want to throwup,” he answered, “I can be pretty sureit’s a great investment.” Likewise,Christopher Davis of the Davis Funds haslearned to invest when he feels “scared todeath.” He explains, “A higher percep-tion of risk can lower the actual risk bydriving prices down. We like the pricesthat pessimism produces.”

Get away from the herd. In the 1960s,psychologist Stanley Milgram carried outa series of astounding experiments. Let’simagine you are in his lab. You are offered$4 (about $27 in today’s money) per hourto act as a “teacher” who will help guidea “learner” by penalizing him for wronganswers on a simple memory test. You sitin front of a machine with thirty toggleswitches that are marked with escalatinglabels from “slight shock” at 15 volts, upto “DANGER: SEVERE SHOCK” at 375volts, and beyond to 450 volts (markedominously with “XXX”). The learner sitswhere you can hear but not see him. Eachtime the learner gets an answer wrong, thelab supervisor instructs you to flip thenext switch, giving a higher shock. If youhesitate to increase the voltage, the labsupervisor politely but firmly instructsyou to continue. The first few shocks areharmless. But at 75 volts, the learnergrunts. “At 120 volts,” Milgram wrote,“he complains verbally; at 150 hedemands to be released from the experi-ment. His protests continue as the shocksescalate, growing increasingly vehementand emotional . . . At 180 volts the victimcries out, ‘I can’t stand the pain’ . . . At285 volts his response can only bedescribed as an agonized scream.”

What would you do if you were one ofMilgram’s “teachers”? He surveyed morethan 100 people outside his lab, describ-

ing the experiment and asking them atwhat point they thought they would stopadministering the shocks. On average,they said they would quit between 120and 135 volts. Not one predicted continu-ing beyond 300 volts.

However, inside Milgram’s lab, 100%of the “teachers” willingly deliveredshocks of up to 135 volts, regardless of thegrunts of the learner; 80% administeredshocks as high as 285 volts, despite thelearner’s agonized screams; and 62% wentall the way up to the maximum (“XXX”)shock of 450 volts. With money at stake,fearful of bucking the authority figure inthe room, people did as they were told“with numbing regularity,” wroteMilgram sadly. (By the way, the “learner”was a trained actor who was only pretend-ing to be shocked by electric current;Milgram’s machine was a harmless fake.)

Milgram found two ways to shatter thechains of conformity. One is “peer rebel-lion.” Milgram paid two people to jointhe experiment as extra “teachers” – andto refuse to give any shocks beyond 210volts. Seeing these peers stop, most peoplewere emboldened to quit, too. Milgram’sother solution was “disagreementbetween authorities.” When he added asecond supervisor who told the first thatescalating the voltage was no longer nec-essary, nearly everyone stopped adminis-tering the shocks immediately.

Milgram’s discoveries suggest how youcan resist the pull of the herd:

�Before entering an Internet chatroom or a meeting with your col-leagues, write down your viewsabout the investment you are con-sidering: why it is good or bad,what it is worth, and your reasonsfor those views. Be as specific aspossible – and share your conclu-sions with someone you respectwho is not part of the group.(That way, you know someoneelse will keep track of whetheryou change your opinions to con-form with the crowd.)

�Run the consensus of the herdpast the person you respect themost who is not part of the group.

Ask at least three questions: Dothese people sound reasonable?Do their arguments seem sensi-ble? If you were in my shoes,what else would you want toknow before making this kind ofdecision?

�If you are part of an investmentorganization, appoint an internalsniper. Base your analysts’ bonuspay partly on how many timesthey can shoot down an idea thateveryone else likes. (Rotate thisrole from meeting to meeting toprevent any single sniper frombecoming universally disliked.)

�Alfred P. Sloan Jr., the legendarychairman of General Motors,once abruptly adjourned a meet-ing this way: “Gentlemen, I takeit we are all in complete agree-ment on the decision here. Then Ipropose we postpone further dis-cussion of this matter until ournext meeting to give ourselvestime to develop disagreement andperhaps gain some understandingof what the decision is all about.”Peer pressure can leave you withwhat psychologist Irving Janiscalled “vague forebodings” thatyou are afraid to express. Meetingwith the same group over drinksin everyone’s favorite bar mayloosen some of your inhibitionsand enable you to dissent moreconfidently. Appoint one personas the “designated thinker,”whose role is to track the flow ofopinions set free as other peopledrink. According to the Romanhistorian Tacitus, the ancientGermans believed that drinkingwine helped them “to disclose themost secret motions and purposesof their hearts,” so they evaluatedtheir important decisions twice:first when they were drunk andagain when they were sober.

From YOUR MONEY AND YOURBRAIN by Jason Zweig. Copyright ©2007 by Jason Zweig. Reprinted bypermission of Simon & Schuster, Inc.

VII



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 [email protected] 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 people’s emotions can undermine their investment decisions and performance.

3. Don’t 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 shouldn’t let the recent stock market turbulence scare you into switching your assets into bonds or housing, which offer a false illusion of safety.

4. Don’t 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 it’s 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 Munger’s 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 today’s column, allow me to tell you about this coastal region on the Adriatic and why I’m here. I’m 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 country’s olive oil and pasta and has a fascinating, ancient history -- we’ve visited gorgeous castles and cathedrals that are nearly 1,000 years old. And if you’re 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. He’s been applying those lessons with a great deal of success, compounding money at 18% since the fund’s 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). It’s fascinating and heartening to see that the gospel of Graham, Dodd, Buffett, and Munger has reached this remote corner of Italy. Francesco’s 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 investor’s interests. (There’s 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) isn’t blaring in his office, and since the U.S. market doesn’t open until 3:30 in the afternoon here, he has nearly the entire day to read and do analysis. Hmmm... Maybe I’ll just stay here... Investor irrationality Back to our regularly scheduled programming...

I’ve 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, let’s 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: “It’s 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? I’m 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 “don’t speculate,” but rather, “it’s OK to speculate, but one must sell more quickly once the bubble starts to burst.” Sound familiar?

Of course this game doesn’t 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 they’ll be able to smell the turning point” and “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.” 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 ([email protected]) 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 I’d like to discuss today is behavioral finance, which examines how people’s 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 investor’s intellect. Warren Buffett agrees: “Success in investing doesn’t correlate with I.Q. once you’re 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 aren’t “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, that’s 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 hasn’t. 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 you’re 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 doesn’t 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 don’t, 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 one’s own wisdom and ability, while failures were due to forces beyond one’s 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 I’m not that way.” Let’s see. Quick! How do you pronounce the capital of Kentucky: “Loo-ee-ville” or “Loo-iss-ville”? Now, how much would you bet that you know the correct answer to the question: $5, $50, or $500? Here’s 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 I’ll come back to this in a moment. So people are overconfident. So what? If healthy confidence is good, why isn’t 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 children’s 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 Barber’s 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 market-trailing 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 won’t keep you in suspense any longer. The capital of Kentucky is Frankfort, not “Loo-ee-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. I’m 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 Fool’s Rule Breaker Portfolio: The Psychology of Investing, What’s My Anchor?, Tails-Tails-Tails-Tails, and The Rear-View Mirror. - There’s 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 Winner’s 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 [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.

Don’t 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 shouldn’t 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 there’s one thing as certain as death and taxes, it’s 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 top-performing 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 (I’d recommend the Sequoia Fund as well, but it’s been closed to new investors since 1982). For further information, check out The Motley Fool’s 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. That’s 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 Siegel’s 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 it’s very unlikely that bonds will continue to do better than stocks over the next five or more years. That’s 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 yesterday’s close), the hurdle isn’t 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 he’s 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 hasn’t yet reached bubble proportions nationwide, it’s 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 week’s 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 nation’s 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 three-bedroom 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 York’s 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 don’t 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 [email protected]. The Motley Fool is investors writing for investors.

Don’t 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 couldn’t take the pain anymore, and then watched it rebound? It happens all the time, and I’d wager there’s not a single investor who hasn’t 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 they’ve fallen, or hang on in the hope that they’ll rebound? I’ve 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 Hathaway’s stock -- and those of many of Buffett’s holdings -- were getting pounded during the Internet bubble. Buffett replied: “Never. Nothing bothers me like that. You can’t do well in investments unless you think independently. And the truth is, you’re neither right nor wrong because people agree with you. You’re right because your facts and your reasoning are right. In the end, that’s all that counts. And there wasn’t 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, let’s 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, they’re down 52% and 69%. What should you do?

I don’t have a strong opinion on either of these stocks, and that’s OK, since I don’t 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 didn’t 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 doesn’t know that you own it. Its feelings won’t 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 500’s 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 Fund’s (Nasdaq: SEQUX) Bill Ruane all experienced the worst relative and absolute investment performances of their otherwise-spectacular careers during this period. Here’s the data: Yr S&P 500 Berkshire Munger Sequoia 1970 3.9% -7.1% -0.1% n/a 1971 14.6% 79.5% 20.6% 13.5% 1972 18.9% 14.3% 7.3% 3.7% 1973 -14.8% -11.3% -31.9% -24.0% 1974 -26.6% -43.7% -31.5% -15.7% TOTAL -11.5% -4.8% -39.7% -24.6% Note: Berkshire Hathaway’s returns are based on year-ending share prices. The Munger Partnership’s 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 Berkshire 1972 18.9% 14.3% 1973 -14.8% -11.3% 1974 -26.6% -43.7% 1975 37.2% -5.0% TOTAL 2.0% -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 yesterday’s 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 Buffett’s famous 1984 speech, The Superinvestors of Graham-and-Doddsville.] My point is not that you should ignore performance -- it’s 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. Don’t 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 [email protected]. 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 it’s 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) It’s embarrassing to admit, but when I first started investing, I didn’t 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 didn’t 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. I’m going to tell you a story -- one I’ve 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. (Don’t bother trying to find a web site or ticker, as it’s 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 story’s going, don’t 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 didn’t sell. Consumed by fatalism, I rationalized to myself that at $2 a share, it couldn’t drop any further. And anyway, there was so little of my investment left that it really didn’t 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 won’t be surprised to hear that the stock soon went to zero.) The reason I’m telling you this story is because the emails I’ve 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 haven’t 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 don’t 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 company’s 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 it’s 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 today’s 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 company’s 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 can’t 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 today’s 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. Don’t 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 aren’t 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 didn’t 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 doesn’t know that you own it. Its feelings won’t 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 can’t 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 [email protected]. 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) I’m interrupting my series on how to analyze cash flow statements and calculate free cash flow because some of the emails I received after last week’s column are troubling me. After reading the first part of my analysis of Lucent’s (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 today’s prices (I won’t be expressing any opinion on this until I finish analyzing Lucent’s 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. They’re 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.” Don’t fall victim to this trap! As my friend says: “Don’t let what you want change what is. You don’t 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? Here’s 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 wouldn’t buy today if you had 100% cash? If so, then why on earth don’t you sell them immediately? One good answer is that you are sitting on a big capital gain and don’t want to pay the taxes. That’s a good reason, as taxes are a real cost. (It’s 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.) Let’s 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 Cisco’s stock will decline)? While I’m a proponent of long-term investing, if you’re 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 didn’t 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 I’ve 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 aren’t 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. That’s 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 [email protected]. 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 Munger’s 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 Hathaway’s (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, it’s not hard -- there are many books about him, he’s published lengthy annual letters for decades (you can read the last 27 of them for free on Berkshire’s 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. It’s 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 it’s 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 it’s 21 single-spaced pages), I thought that others might be interested in Munger’s wisdom, so I sent him a copy and asked if I could publish it. He asked me not to until he’d had a chance to review it and make some edits. He has now done so, so I’m delighted to share it with you: Click here to read it. In this column, I will share some of the highlights of the speech. Berkshire’s 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:

Berkshire’s 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 you’d 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. Yet…many 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 couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s 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 doesn’t embrace all multidisciplinary thinking, Munger argues, then one is likely to fall into the trap of:

“man with a hammer syndrome.” And that’s 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 don’t have just a hammer. You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style, because you’ll 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. There’s 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, they’re 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 there’s 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, you’ll 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 you’ve got a very talented ethnic group, like the Chinese, and they’re very poor and backward, and you’re an advanced nation, and you create free trade with China, and it goes on for a long time. Now let’s follow and second- and third-order consequences: You are more prosperous than you would have been if you hadn’t 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? It’s obviously China. They’re 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 you’ve got a weak nation of backward peasants, a billion and a quarter of them, and in the end they’re 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 that’s a wonderful outcome for the former leading nation. He didn’t try to determine second-order and higher-order effects. If you try and talk like this to an economics professor, and I’ve done this three times, they shrink in horror and offense because they don’t 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 can’t stand his politics; I’m 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 man’s essays. I think Paul Krugman is one of the best essayists alive.

Destroying your own best-loved ideas Munger believes that it’s 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 I’ve discussed in previous columns.) Fortunately, I did sell, refusing to “cling to failed ideas.” Chutzpah I’ll conclude this column with a bit of classic Munger humor: While Buffett bends over backward to appear humble, Munger’s 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 people’s emotions, biases, and misjudgments affect their investment decisions -- is one of the least discussed and understood areas of investing. Yet I believe it’s 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, doesn’t 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 Buffett’s right-hand man and a genius in his own right. It’s 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. I’d like to highlight some of Munger’s 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 it’s 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. You’d think these people would’ve 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. I’m sure some are doing so, but many aren’t because they’d 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, I’m still getting emails like this one, from people who, I suspect, are in serious psychological denial:

Why isn’t 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) [they’re 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 can’t 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 didn’t sell? I’ve 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 didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re 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 Street’s radar screen.” Other questions Munger answers I’ve cited only a few examples of Munger’s 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 didn’t Salomon’s 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 wouldn’t 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 Munger’s 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 [email protected]. 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.

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