Buffettology:TheDangersofWarrenBuffettBias

Wednesday,Oct132010bytimarr

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It'saracingcertaintythatmorepeoplehavelostmoneyfollowingthewisdomoftheSageofOmahathanfollowingtipsfromany

numberofothersocalledgurus.Ofcourse,it'sperfectlycorrectthatvirtuallyeverypearlofwisdomdrippingfromthelipsofthe

Chairman of Berkshire Hathaway is worth a thousand utterances from the plethora of mass market media mavens
masqueradingaspsychicpredictorsoftheunforeseeable.UnfortunatelytherearetwosidestoeveryequationandBuffett,hard
thoughhetries,canonlybeononeofthem.
ThesimplicityofBuffett'sapproachandhisfolksiewisdombelieatoughmindedandintenselyfocusedindividualwhosecareer
hasbeenmarkedbyasinglemindeddeterminationtomakemoney.Mostpeopledon'tseethis,though,whattheyseearethe
incrediblegainsthatcanbemadebyactivelytradinganddrawtheobvious,butmad,conclusionthatwhat'sgoodenoughfor
the one person capable of defying the logic of markets is good enough for them. Following Warren Buffett without Warren
Buffett'stemperamentisaonewaytickettothepoorhouse.
ClarityandConsistency
It'simpossibletoreadBuffett'sletterstoBerkshireshareholdersoranythingelsehewriteswithoutbeingstruckbytheclarity
of thought and expression that he brings to a world mainly characterised by confusion and inconsistency. If you read most
commentatorsoveralongenoughperiodoftimeyouusuallyfindthattheiropinionshaveshiftedmarkedlywithoutanypublicpronunciations,presumablyonthegroundsthat
theyfiguremostpeoplewon'tnotice.
Mainlytheydon't,althoughmainlybecausetheydon'tcare.
Buffett'swonderfulabilitytocommunicatecomplexideas,toexplainhowtheambiguityanduncertaintyofmarketscanbemanagedandhowtoseethedeadwoodfromthe
livingtreesisashiningexampleofhowit'spossibletotalkintelligentlyaboutfinancialmatterstopeoplewillingtoexpendabitofefforttounderstand."Effortaftermeaning"it's
called,originatingwithacharactercalledFrederickBartlettwhobelievedthatmemoryisanactivething,somethingyoucreateoutofyourowneffortstorecall:hisWarofthe
Ghostsexperimentisastorystillworthretelling.
Unfortunatelywhatthisalsomeansisthatwhatisrecalledisnotalwayswhatthewriterwouldliketoberememberedoftenthemessageislostwhilewhatremainsisafaint
reflectionofwhatwasintended.Blamingthewriterforthisislikeshootingthepianoplayer:we'redoingthebestwecan.Still,themessagestakenfromhiswritingswilloftennot
bewhatBuffettintended.
ConcentrationofActivity
AcoupleofthemesseemtoarisequiteregularlyindiscussionsaroundBuffett:theabilitytogenerateabnormalreturnsthroughactiveinvestingandthefocusonahighly
concentratedportfolio"putallyoureggsinonebasketandthenwatchitlikeahawk".Yetthesearepossiblytwooftheworstmessagesyoucantakeawayfromthegreatman.
Activeinvestingisaworsethanzerosumgamemostpeoplewilllosemoneyeveniftheychoosetoinvestinmutualfundsthroughovertradingandimprobablybadmarket
timing.WilliamSharpeshowedthisyearsagoinTheArithmaticofActiveManagementinwhichhepointedout:

"Itmustbethecasethat...aftercosts,thereturnontheactivelymanageddollarwillbelessthanthereturnonthepassivelymanagementdollar".

Themainproblemis,asusual,psychological.WithoutgoinganywherenearananalysisofMr.Buffett'spsycheit'squiteclearthathe'sanunusualpersonfewpeoplesought
outBenGrahamasdidBuffett,nogentileotherthanBuffettsucceededingettingGrahamtoemployhim,nooneelsethendecidedtobranchoutontheirownwiththeirown
uniqueapproachthelistgoesonandon.It'ssimplyimpossibletohavemadeasmuchmoneyasBuffetthasdonebyluck,whateverthetheoristsmaysay,andthatmeans
thathemustbemuchmorecapableofmanaginghisownbiasesthanthevastmajorityofus.
GoFigure,Yourself
ThecorollarytothisisthattryingtoinvestlikeWarrenBuffettwithouthavinghismentalityisaonewaytickettopenury.Learningtheoutwardsignsandinvestmentstrategiesis
onethingbuthavinghispsychologicalstrengthisentirelyanother.You'dhavethoughtthatafterthebestpartofsixtyyearsthatcommentatorswouldhavethesensetoavoid
betting against him but, once again when the going got tough people decided that taking a swing at him was a sensible approach. Of course it is, if you reckon today's
commentaryistomorrow'selectronicgarbage.
Inthedepth'softhe20072008crisisBuffettpennedthispieceforTheNewYorkTimes,anditcontainsmoresensiblecommentontheopportunityfromahistoricalperspective
thanvirtuallyeveryotherpieceofscribblagewrittenduringthatperiod:
"Overthelongterm,thestockmarketnewswillbegood.Inthe20thcentury,theUnitedStatesenduredtwoworldwarsandothertraumaticandexpensivemilitaryconflictsthe
Depressionadozenorsorecessionsandfinancialpanicsoilshocksafluepidemicandtheresignationofadisgracedpresident.YettheDowrosefrom66to11,497.
Youmightthinkitwouldhavebeenimpossibleforaninvestortolosemoneyduringacenturymarkedbysuchanextraordinarygain.Butsomeinvestorsdid.Thehaplessones
boughtstocksonlywhentheyfeltcomfortindoingsoandthenproceededtosellwhentheheadlinesmadethemqueasy."Itprovokedsomestrongresponses,manyofwhich

pointedoutthatitwaseasytoadvisepeopletobuystockswhenyouweren'tpersonallyhavingtoworryaboutthenextpaycheckandwhetheryouweregoingtohaveajobnext
month.Italsohelpedhavingafewbillionsloshingaroundinthecheckingaccount,ofcourse.
Thepoint,though,isthathavingtherightpsychologyisonlypartoftheoverallpackage.Understandinghistoryhelps,asdoesmakingsureyouhaveenoughcasharoundto
takeadvantageoftheseoccasionalbutoddlyfrequentmarketcollapses.ToactonBuffett'sadvicegenerallyyou'vegottothinklikehimallthetime,andendingupinearly
2008gearedtothegillswouldn'thavebeenconducivetofollowinghislead.
Diworsification
Diversificationisanotherproblem,partlycausedbyBuffettandCharlieMungerwhohaverepeatedlypointedoutthatyoucan'tmakeexcessivereturnsifyoubuythemarket.
They'rerightbecausetomakereallyabnormalreturnsyouneedtohaveaconcentratedportfolioofstocks.Unfortunatelyyoualsohavetobuytherightstocksand,aswe've
seeninDiworsificationIsGoodForYou,that'snotgoingtohappenbyluck.Ontopofwhich,quiteoften,you'llhavetosittightthroughsomehorrendouslosses.Ifyou'vechosen
correctlythesewillbetemporarybutifyouhaven'tthenit'sahardwaytolearnthatyou'renotWarrenBuffett.
BerkshireHathaway,ofcourse,ishugelydiversifiedthesedayssoishardlyatestbedforthisapproach.Still,diversificationiscriticalformostinvestorsandfiguringouthowto
beproperlydiversifiedwithoutbuyingthemarket,andcreatingyourownexpensiveindextracker,isoneofthemainchallengesforactiveinvestors.Notleastbecausepeople
insistonrepeatingthemyththatyoucangetdecentportfoliodiversificationwithasfewasfifteenstocks.
InvestinYourself
Otherlessonsarejustasimportantbutdon'tseemtohavequitethesamepowertobreachpeople'sthoughtbarriers.Perhapsthemostimportantistoonlyinvestinthingsyou
understand,asocalled"circleofcompetence".Now,Idon'tknowaboutanyoneelse,butlimitingmyselftothehandfulofthingsIhaveadecentappreciationofwouldleadtoa
portfoliowithafocusonsmallITstocks,babywearretailersandbuggerallelse:concentratedtobesure,butoptimal?
Buffett'sthoughtsoncirclesofcompetencecanbefoundinBerkshire's1996AnnualLettertoShareholders,andwellworthreadingtheyare:
"Letmeaddafewthoughtsaboutyourowninvestments.Mostinvestors,bothinstitutionalandindividual,willfindthatthebestwaytoowncommonstocksisthroughanindex
fundthatchargesminimalfees.Thosefollowingthispatharesuretobeatthenetresults(afterfeesandexpenses)deliveredbythegreatmajorityofinvestmentprofessionals.
Shouldyouchoose,however,toconstructyourownportfolio,thereareafewthoughtsworthremembering.Intelligentinvestingisnotcomplex,thoughthatisfarfromsayingthat
itiseasy.Whataninvestorneedsistheabilitytocorrectlyevaluateselectedbusinesses.Notethatword"selected":Youdon'thavetobeanexpertoneverycompany,oreven
many.Youonlyhavetobeabletoevaluatecompanieswithinyourcircleofcompetence.Thesizeofthatcircleisnotveryimportantknowingitsboundaries,however,isvital.
Toinvestsuccessfully,youneednotunderstandbeta,efficientmarkets,modernportfoliotheory,optionpricingoremergingmarkets.Youmay,infact,bebetteroffknowing
nothingofthese.That,ofcourse,isnottheprevailingviewatmostbusinessschools,whosefinancecurriculumtendstobedominatedbysuchsubjects.Inourview,though,
investmentstudentsneedonlytwowelltaughtcoursesHowtoValueaBusiness,andHowtoThinkAboutMarketPrices."Ofcourse,thepointisthatinvestorsneedtomakea
realefforttounderstandbusinessesbeforetheyinvestinthemaboveandbeyondthepurereadingofthebalancesheetalthoughoftenthat'dbeagoodstart.Thistypeof
analysistakestimeandalotofeffortandthesearethingsthatthevastmajorityofprivateinvestorssimplydon'thave,sotheytakeshortcutsandusuallyendupholdinga
bunchofstockswhichdothingsthattheyonlyfaintlyunderstand,ifthat.
Understandingabusinessistheproperwaytoderiskingitasaninvestmentandisacriticalstepifyou'regoingtoholdthekindofundiversifiedportfoliothatyouneedtomake
trulygreatreturns.Formostofusthisisvery,verydifficultalthoughonesuspectsthatbothBuffettandMungerwouldshrugatthiscaveat:expectingittobeeasytomakelots
ofmoneythroughinvestingisacategorymistake,ifitweretruenoonewouldneedtoworkforaliving.
WarrenBuffettBias
TheideathatWarrenBuffettBiasdrivesmanyinvestorsintofoolishlyinvestingdirectlyinundiversifiedportfoliosofstockswithouthavingtheproperpsychologicalshieldingor
themarginofsafetythatcomesfromtrulyunderstandingthecompaniesinquestionisnodoubtexactlytheoppositeofwhatthemanhimselfwouldwish.Yetit'slikelythatthisis
exactlywhat'shappening.
We can't stop the nave masses from following their suicidal instincts, even when pointed in the right direction, but we can learn the proper lessons ourselves. Invest with
humility, be patient when markets crash and never let your psychological biases outweigh your investment skill. Let's face it, none of us are going to be Warren Buffett.
Fortunatelywedon'tneedtobeand,ifnothingelse,we'vegothiswritingstoperuseandamuseonthelongwinternightswhenotherwisewe'dbeworryingaboutportfolio
valuationsandthinkingabouttrading.

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sasan

10thSep'12

1of2

FromEVERYthingI'veread,diversificationstartstoloseitsbenefitsrapidlyafter10stocks?
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dangersimpson

10thSep'12

2of2

I'mabigfanofdiversification.
Althoughthemathematicaltheoryshowsthatalimitednumberofstocksgivesmostofthebenefitofdiversificationyouhavetounderstandwhatthesestudiesarereally
measuringandwhyrealitycanbequitedifferent:
Thestudiesdefineriskasvolatilityanddiversificationasreducingvolatility.HoweverIsee3typesofriskwithincompanies,market,industryandcompanyspecific.By
using volatility it is market risk that all the academic studies on diversification focus on, they don't assess the impact of lack of diversification within industries or
companies.
I diversify because I am not omniscient no matter how much I research there will always be things that I do not know about a company or are fundamentally un
knowable.ThinkoftheeffectoftheMacondowellonBP'ssharepriceoroneofthecompaniesthathassufferedduetoemployeefraud.Ifthesehappenedtobeabig
proportionofyourportfolioyouwouldsuffersignificantlossesnomatterhowcloselyyouwatchedthem.Icaremoreaboutavoidingabigunexpectedlossthanhigh
volatility.
Thereforeitmakesalotofsensetolimitthesizeofanyonecompanywithinyourportfoliobelievingthatyoucanknowacompanywellenoughtoeliminatecompany
specificriskmustcountasextremeoverconfidence.
Ifyoureallywanttolimitvolatilityinthesamewayitmakessensetolimityourholdinginanyoneindustryandideallyholdundervaluedcompaniesinindustriesthatare
differentlycorrelatedwithmajoreconomicorcommodityvariablese.g.itisbettertoholdanundervaluedoilproducerandundervaluedoilconsumerthan2equally
undervaluedoilproducers.
[ThisisalsooneofthereasonsI'mabigfanofCineworld(LON:CINE)it'srevenuestreamofshowingfilmsisnegativelycorrelatedwiththeeconomyanditsrevenue
streamofshowingadvertsispositivelycorrelatedmakingthebusinessitselfdiversified.Thesteadinessofit'scashflowallowsittogearitselfupquitehighlywithout
addingmuchrisktothebusinessandinvestthatcapitalefficientlywithamarginalROCEofc30%withoutresorttoshareholders.]
FinallyintermsofmarketriskHaugenetalshowthatfarfromrisk=reward,ariskyportfoliounderperformsanunriskyonesoyoushouldholdundervaluedlowbetaor
uncorrelatedstocks.Diversificationreallyisoneoftheonlytrulyfreelunchesoutthere.
Therearealsocoupleofadditionalreasonswhydiversificationisprobablyagoodideafromthestockopediavalueinvestingebook:
1.Duetothepsychologicalbiasestimarrwritesaboutmostpeopleholdstocksthatareprettycorrelatedsodon'thavetruediversification.
2.Thereisariskofunderperformingthemarketbynotholdingtherightsstocks.Themarkethasa'longtail'andportfoliosthatfailtoholdsomeofthefewbigwinnerswill
underperform.
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