When Columbus set off in 1492, a considerable number of people still believed (despite scientific calculations going as far back as the Greeks) that he would sail off the edge of a flat world. As a child hearing this story, I was incredulous that people could have ignored something as obvious as the shape of the Earth. Yet here we are more than 500 years later and despite overwhelming evidence to the contrary, there are still people who believe that the moon landing was staged, that the Holocaust didn’t happen and that Elvis is alive.
People can and do live their entire lives believing almost anything. When indisputable facts run into firmly held beliefs—the beliefs will win almost all the time. This is the world we inhabit.
The world of long-term investing is a fortunate exception: In long-term investing it doesn’t matter what you believe, what everybody else believes, how much money you have, how influential your financial advisor is or what the headlines say—and most definitely it doesn’t matter what the pundits say. All that matters are the facts. The facts are an investor’s compass, his guide for navigating safely through the investment wilderness.
Of course, if investing were that simple, I wouldn’t be sitting at my laptop writing this column. The world throws up one challenge after another: bad information, social pressure, conventional wisdom and the ubiquitous daily noise that distracts all but the clearest-thinking investors from the simple facts staring them in the face.
Consider the challenges of social conformity. On one hand, without it we couldn’t have a civil society; imagine a world where individuals didn’t follow traffic laws or other laws or any rules of behavior we take for granted. Life as we know it could not exist. Yet social conformity in an investment setting is an impediment to clear thinking and good decision-making.
Solomon Asch’s classic experiment from the 1950s illustrates the dark side of social conformity. A group of students seated in a classroom were asked to participate in a “vision test.” In reality, all but one of the students were confederates of Asch. The students were given a number of different tests, each of which involved two cards, one with a single line and the other with three lines of differing lengths. The “subjects” were asked to identify which line on the second card matched the single line on the first and then to give their answer aloud. All the confederates answered before the actual subject—and all gave the same answer.
Asch wanted to see when the confederates gave obviously incorrect answers, whether the pressure to conform would affect the responses of the actual subjects. What he discovered was that the subjects were influenced to provide incorrect answers nearly a third of the time, and over the course of the experiment 75% of the subjects gave at least one incorrect answer. In control groups, without the pressure to conform, incorrect responses dropped to less than 3%.
There have been many behavioral studies since Asch. All of them demonstrate how difficult it is to stand apart from the crowd, even if you know you’re right. “Misery loves company” means that our poor choices don’t feel so bad when everyone else is making them. However, in investing, doing what all your friends are doing guarantees mediocre long-term results.
Consider the following investment fact: In order for even the best value manager to produce above-average long-term returns, his fund must underperform the overall market, sometimes for extended periods of time. Yet it is next to impossible for most investors to live with underperformance, because the conventional wisdom on Wall Street is that underperforming the market is bad. This assumption and the social pressure that follows from it can lead even sophisticated investors to make terrible decisions.
Jeremy Grantham (co-founder of GMO) writes about his experience with underperformance: In the late 1990s at the height of the Internet bubble, when GMO was not participating in the speculative fever, it lost 60% of its assets as the firm’s supposedly sophisticated institutional clients pulled their money out to chase the market. GMO, of course, was more concerned about overvaluation than underperformance, and its remaining clients were the grateful beneficiaries of that sensible policy.
In 1984 Warren Buffett wrote an article for the Columbia Business School magazine titled “The Superinvestors of Graham-and-Doddsville,” which highlighted the records of seven value managers. The managers in Buffett’s article had outperformed the market annually by 750 to 1,600 basis points, for periods ranging from 13 to 28 years. As a point of reference, if a fund manager today outperforms the overall market by just 100 basis points a year for 10 years, that manager will be in the top 2% of all fund managers. Despite their truly incredible performance, six of these seven Superinvestors had underperformed the market regularly, sometimes many years in a row.
It crosses my mind to wonder who wouldn’t be willing to accept short-term underperformance to get those kinds of long-term returns—especially with an investment strategy so focused on risk aversion. Well, the results are in—not too many investors are so willing. Next time someone starts talking investing with you, see how many of these names produce even a hint of recognition: Charles Munger, Rich Guerin, Stan Perlmeter, Bill Ruane, Tweedy/Browne or Walter Schloss. Schloss retired in 2006, after having exceeded the market’s annualized return by some 500 basis points—for 49 years.
If you think that I’m bemoaning the anonymity of these superstars, think again. It’s about the best news an investor could ever hope for: (1) a proven investment philosophy that can be explained in a few simple sentences; (2) some 70 years of demonstrable attractive performance; (3) reams of academic research supporting its thesis; (4) brilliant and successful fund managers available today to invest with; and (5) a virtual guarantee that it will never become too popular.
In a world where almost nothing can be predicted with any accuracy, investor behavior is one of the rare exceptions. You can take it to the bank that investors will continue to be driven by impatience, social conformity, conventional wisdom, fear, greed and a confusion of volatility with risk. By standing apart and being driven solely by the facts, the value investor can take advantage of the opportunities caused by those behaviors—and be in the optimal position to create and preserve wealth.
Value doesn’t just apply to investing. We make value judgments regularly in our everyday life: where we live, how we spend money, how we spend time, what we eat, what we wear and what we say. All our decisions are calculations of value, balancing the potential benefit with the estimated cost. Value investing is just the application of the principles underlying our sensible everyday behavior to the specialized activity of investing. It’s really that simple.
Asch demonstrated how difficult it is for an individual to make a correct choice when that choice is unpopular. That is why even sophisticated investors can be driven to make such poor decisions.
The value of value investing is its simple but powerful common sense foundation—which is what keeps our behavior firmly anchored in reality. Despite our feelings, the market’s actions and especially the actions of our friends, we can be confident that our judgment is sound, our choices logical and our actions appropriate.