May 31, 2019
On a recent vacation, a book titled "The Great Degeneration: How Institutions Decay and Economies Die" caught my eye. Drawn in by the unrelenting pessimism of the title, I was tempted to buy it, knowing it might contribute to the landslide-prone stack that builds on my night table. But my wife intervened. "You don't need to buy that book," she said. "I can sum it up for you in two words: laziness and greed." I thought about that over the next day or so, a little jealous that she had composed history's shortest Cliffs Note with no effort. But every case I envisioned fit into that box, and they certainly did so in the financial industry.
"To my way of thinking, the reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The Internet will not make the market efficient, even though it makes far more information available at everyone’s fingertips, faster than ever before. Markets are inefficient because of human nature — innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions — they simply cannot help it."
He continues:
"There is no salve for the hungry investor like the immediate positive reinforcement that comes from making money instantaneously. A country of security analysts would still overreact. They would shun stigmatized companies, those experiencing financial distress, or those experiencing accounting problems. They would still liquidate money-losing positions as they were making new lows. They would avoid less liquid securities, since those are the last to participate in a rally and hard to get out of when things go wrong. In short, a country full of well-trained investors would make the same kind of mistakes that investors have been making forever, and for the same immutable reason — that they cannot help it."
In other words, the presence of human emotion will override human logic, even when the logic is well-crafted. It doesn't matter if an investor can figure out where a great investment lies, the mere fact of humanity will cause his or her actions to be non-optimal at times. This is what Klarman tries to use to his advantage, transferring that inefficiency from other investors' emotions to his coffers.
Beyond the debate over stock picking, this implies that all investing risks fall into the same albatross. Dalbar, a research firm that studies investor behavior, reported:
In 2018 the average investor underperformed the S&P 500 in both good times and bad... Judging by the cash flows we saw, investors sensed danger in the markets and decreased their exposure but not nearly enough to prevent serious losses. Unfortunately, the problem was compounded by being out of the market during the recovery months. As a result, equity investors gained no alpha, and in fact trailed the S&P by 504 basis points [5.04%].
That is a huge opportunity cost in one year, and much of it is due to emotion.
Dan Cunningham
"Alpha," cited above, is a measure of return of investment performance against a benchmark, such as an index.
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