I was reading through fund letters from The Baupost Group, managed by value investor Seth Klarman.
Here is something very interesting that I came across in his year-end 1996 shareholder letter. Klarman wrote…
We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers.
This statement contains a big truth that I, as an investor, ignored all these years.
So I bought a stock because I thought my analysis was right. I thought my calculation of the stock’s intrinsic value was right. I thought my decision to buy the stock was right even when I always wondered what could be the reason someone else was selling the same stock.
All in all, my arrogance – of being right – made me buy several stocks over these years. While I’m satisfied with my long term returns, I consider my performance more a result of luck than my own aptitude of picking up the right stocks.
“Why do you say so?” you may ask.
Well, the reason is that in considering myself the most right (and thus the most arrogant) investor in the world, I often failed to ask the most important question that an investor must ask himself before buying or selling a stock.
“What if I’m wrong?”
Yes, that’s the question I often failed to ask while investing in a stock.
What is it if not ‘arrogance’ on my part?
As Klarman also wrote along with his above note on arrogance…
We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.
This is an interesting concept, and one that I, like most investors, did not fully consider when purchasing a stock (though I’ve now learnt my lessons).
You see, when you’re buying a stock, somebody is simultaneously selling it. In the same way, when you’re selling a stock, someone somewhere is buying it.
While many people understand that concept, the implications of that action should lead one to ask two important questions:
- If I am buying, someone else is selling. How likely is it that I know something that this other person does not know?
- If I am selling, someone else is buying. How likely is it that I know something that this other person does not know?
While these two simple question should be a part of one’s analysis to begin with, these often get swept aside when emotions (“I must buy/sell this stock now before it’s too late”) and biases (such as confirmation bias, or the tendency of people to favour information that confirms their beliefs or hypotheses) get involved.
But as I’ve experienced myself of late, stopping to ask this question can avoid serious errors of judgment on your part.
The risk is not in our stocks, but in ourselves
This is what Jason Zweig wrote in his commentary for Chapter 20 of Benjamin Graham’s The Intelligent Investor…
Risk exists in another dimension: inside you. If you overestimate how well you really understand an investment, or overstate your ability to ride out a temporary plunge in prices, it doesn’t matter what you own or how the market does.
Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are. If you want to know what risk really is, go to the nearest bathroom and step up to the mirror.
That’s risk, gazing back at you from the glass.
Be prepared for the future
As an investor, you should always remember, in the words of the psychologist Paul Slovic, that ‘risk in investing‘ is brewed from an equal dose of two ingredients:
- Probabilities, and
Before you invest, always ensure that you have realistically assessed your probability of being right – by not being too arrogant – and how you will react to the consequences of being wrong – by thinking through it with humility.
After all, the only indisputable truth that the past teaches us is that the future will always surprise us – always!
In the same way, as financial history proves time and again, the stock markets will most brutally surprise the very people who are most certain/arrogant that their views about the future are right.
Staying humble with your analysis and forecasting powers will keep you from risking too much in a view of the future that may well turn out to be wrong.
So, by all means you should lower your expectations – but take care not to depress your spirit. For the intelligent investor, hope always springs eternal, because it should.
I’ve learned these important lessons by being the world’s most arrogant investor in the past. Now, I’m practicing to be among the most humble!
What about you? Are you an arrogant or a humble investor? Let me know your views in the Comments section below.