Though there are many extremely successful value investors, few money managers and individual investors choose to follow the value investing strategy. They don’t follow it because it doesn’t work all the time. That is, investment returns are not positive every day, every quarter, and every year. Because it is a long-term strategy, investors do not have the discipline to stick with it even though, over long periods of time, it works wonderfully. Instead, they keep searching for other strategies that work all time, or at least appear to work all the time.
Today, Wall Street is dominated with tech-savvy investors, who, instead of putting in the effort to analyze individual companies based on their valuations, the quality of their management, and the strength of their competitors, use complex formulas and super-fast computers to take advantage of various market inefficiencies. Because these inefficiencies tend to be small, many times these investors use a significant amount of leverage to magnify their investment results. The positive aspect of their strategy is that it seems to work most of the time (which is why it gained popularity). However, during the times that it doesn’t work, even if it is only less than one percent of the time, it completely collapses. It is equivalent to playing Russian roulette with a 100-bullet revolver with only one bullet loaded. Every time you pull the trigger and it doesn’t kill you, you make lots of money. However, the one time that you are unlucky and get the bullet, you are dead. With these kinds of odds, would you want to play this game? I wouldn’t, but this is exactly how some of the “brightest” minds on Wall Street manage money. In his book, The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Scott Patterson of the Wall Street Journal argues that a swashbuckling breed of mathematicians and computer scientists nearly destroyed Wall Street and are behind the financial meltdown.
But what is absolutely amazing is that these types of investors fail to learn from others who made similar mistakes such as Long-Term Capital Management, which was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Meriwether recruited two Nobel Prize winners in economics, Myron S. Scholes and Robert C. Merton, and a former Harvard University economics professor and retired vice-chairman of the Federal Reserve Board of Governors, David W. Mullins, Jr. The fund used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading. The idea was to find very small inefficiencies in the market and capitalize on them. Because these inefficiencies were so small, high leverage was used to increase returns. When everything was going well, the fund generated returns of 40% per year after fees. But after the Russian government defaulted on its government bonds, the fund collapsed and nearly took the entire U.S. economy down with it. In the end, the Fed had to bail them out.
Will value investing finally become more popular among investors? I don’t think so, and I hope that it doesn’t because, if the majority used it, it wouldn’t work so wonderfully. There will always be new investors who think that calculus, physics, astrology, and maybe biology will give them the answers to their quest for high and stable investment returns with zero or little risk.
Filed under: How to Think About Investing
Well, goes to show you that Ben Grahams comments (paraphrasing) “an investors worst enemy is likely to himself” is always going to be true. People in general find it hard to always be patient (myself included). But that, along with a modicum of intelligence, can make you a successful long-term investor.
With regards to Hester’s comments on the small business owner. Most folks who own their own business regard control as the most important factor, in my experience. I advise and meet with small business owners all year in my practice. They see a lot of the crap that goes on on Wall Street and feel they are playing with a loaded deck. I can say I agree with that thought process sometimes. Most of these folks do not have the inclination to do the homework that it takes to lower your risk and make quality investments. My point is that while value investing certainly works, the element of control of the flow of money (ie management of the business) is the bigger fear/concern for the small business owner.
Anyway, I suggest folks read “Value Investing” by Montier for a great discussion of behavioral economics/investing and how it relates to being a successful investor.
Casey Mattson
http://www.jmpcpas.com
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Hi there Mariusz,
Human nature is the basic safeguard of what we do, and I believe it keeps our numbers small. The thing that really convinced me was how wrong my so called investing was going on the back of some lightweight reading from some of the “popular” investment authors out there.
When I realised the “this has to work” model just would not and could not work for me based on what effectively wall street does with more sophisticated models, and as you say gets it wrong, I decided to try and work out how to make it work.
The first port of call was to look at who does this the best and that led me to Warren Buffet. I didn’t read any of the many books that dissect his current or past methodology as I thought a more meaningful route was to find out how he had acquired his training. From there my next port of call was the Intelligent Investor, where I realised how little I actually knew. Then it was on to Warren Buffets Letters, followed finally by broader and deeper reading.
What we try to do is simple, yet doing it well is actually quite hard, as we have to watch hard earned pennies lose perhaps 50% of their market value before they rebound. All the time we have to resist the urge to capitulate, to the gathering tide of our losses, whilst having enough faith in our analysis to increase our investment in a given equity. We also have to accept that we make mistakes for time to time and although it hurts, again it has to be done in order to get the capital working again.
I have some very close friends, who have high academic attainment, but they simply don’t get it. I give them example after example, and they just don’t get it. They always come back to trying to spot trends in the markets or try to tell me that the market has a “sentiment” on a given day hour or minute.
As for trying to read through the mists of the technical indicators, what people who use these things don’t seem to realise is that for every time they trade and gain someone else trades and looses, and that the system is closed; the economy isn’t infinitely extensible based on mass optimism.
For every thousand or so sharp traders I hope there will always be one or two value investors, allocating capital when things get crazy either across the board or in just a few cases. I don’t think there’ll be more it requires too much effort and the right temperament and those combined qualities are hard to come by. Don’t let’s be too hard on the sharp traders; we do after all need them to provide a moderately liquid market.
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It’s really amazing, isn’t it? Why do so many people refuse to use a rational investment strategy? Someone should do a psychological study!
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