3 Myths of the Investment World
- By Rupert Hargreaves
The investment world is full of myths, so separating separating fact from fiction is vital if you want to succeed over the long term as an investor.
Charlie Munger (Trades, Portfolio), vice chairman of Berkshire Hathaway (BRK-A)(BRK-B) and Warren Buffett ( Trades , Portfolio )'s right-hand man, has spoken about these investment misconceptions at length before. As a result, it would be a good idea to look back at some of his advice on these topics because there is always something to learn from this great investor and thinker.
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First, Munger has repeatedly warned investors that there are many people out there who will try to sell you the best story. These stories should be ignored:
"People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There's always been a market for people who pretend to know the future. Listening to today's forecasters is just as crazy as when the king hired the guy to look at the sheep guts."
Trying to tell the future is impossible, and forecasting is just as unpredictable. Some surveys have shown that, on average, forecasters are incorrect more often than they are correct. As a result, this is something every investor should consider before believing what Wall Street analysts say.
As Munger alluded to in the quote above, there has always been, and always will be, someone willing to try and predict the future. More often than not, they will tell you what you want to hear. It is best to ignore these prognosticators, as they may push you into making decisions that you might be comfortable with based on nothing more than rumor and speculation.
Munger's warning about forecasting ties in quite nicely to his next piece of advice, which is to be aware of optimists:
"The Greek orator was clearly right about an excess of optimism being the normal human condition, even when pain or the threat of pain is absent. Witness happy people buying lottery tickets or believing that credit-furnishing, delivery-making grocery stores were going to displace a great many superefficient cash-and-carry supermarkets."
People generally tend to be optimistic because it is challenging to be the opposite. Research shows that psychologically, people feel losses more than they feel gains, so it is easier to be an optimist than it is to be a pessimist. This is particularly true of Wall Street analysts, who generally have a bullish outlook on the market and the stocks they cover. It is unusual to see a sell rating on blue-chip companies, or indeed any companies come to think of it.
Analysts' optimism is undoubtedly to blame. Being too optimistic will cloud your judgment and prevent you from asking tough questions. Rather than taking the optimist's view of "how much I can make," every investment should be viewed through the lens of "how much can I lose?"
The next investment myth refers to beta and portfolio risk:
"Beta and modern portfolio theory and the like-- none of it makes any sense to me. We're trying to buy businesses with sustainable competitive advantages at a low, or even a fair, price. How can professors spread this [nonsense that a stock's volatility is a measure of risk]?"
Once again, this miconception ties into the two above. Everyone wants to be a forecaster, and everyone wants to try to predict the future. Academics believe beta can help you do just that as it will, in theory, allow you to build a portfolio around a set range of volatility. This idea also plays nicely into optimism myth in that supporters of beta are hopeful it will help them reduce losses. This is just not true.
Munger believes these three myths dominate investors' minds. While people have always had a craving for forecasts, more often than not, their predictions are incorrect. In addition, humans tend to be optimistic and, therefore, projections rarely consider the downside. Finally, investors must come to grips with the fact that equity risk cannot be condensed down into one neat formula.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
Klarman: Find Your Edge and Stick to It
Charlie Munger on Envy and Jealousy
Buffett on Diversification: There Are Not That Many Wonderful Companies Out There
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This article first appeared on GuruFocus.
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