Bias to recent events

Humans have a habit of overweighing recent experiences, this is particularly true of investment results. Jason Zweig’s recent article in the WSJ suggests that US investors expect to make a whopping 17.3% over the next 12 months.

I’m sure we can all recall a recent conversation with someone expressing over-confidence around their investment ability. This is typical during bull markets and vice versa following a market correction.

“After seeing a movie that dramatizes nuclear war, they worried more about nuclear war; indeed, they felt that it was more likely to happen. The sheer volatility of people’s judgement of the odds — their sense of the odds could be changed by two hours in a movie theatre — told you something about the reliability of the mechanism that judged those odds.” Michael Lewis

Being over-confident at any time is dangerous especially when it is founded on recent success. Given the cyclicality of investment markets, is it not more logical that a winning streak brings us closer to a period of weaker returns?

Focus on what we can control

A share price is simply the result of a vote. A short-term forecast is tantamount to guessing the opinions, moods and unique circumstances of thousands of other people. Investors (especially new ones) struggle to recognize the immense margin of error in short-term forecasts.

So if we have little (no) control over short-term results, why place any specific expectations on them? “Expectations outside of reasoned choice leave you fragile, rigid, and reactive” Alex J Hughes in the Daily Stoic.

Jeff Bezos is well-aware of the psychological impact of investment returns. He advises his staff to ignore short-term movements in Amazon stock… “When the stock is up 30% in a month, don’t feel 30% smarter. Because when the stock is down 30% in a month, it’s not going to feel so good to feel 30% dumber.”

By removing expectations we are better able to focus on repeating the types of decisions which we are confident will deliver us our objective, that is, to max out returns while avoiding any permanent capital losses.

I know this statement is on repeat but it’s important. We measure our effectiveness over a 3–5 year period and we are grateful that you (our investors) provide us the slack to do so. Your patience is our competitive advantage.

Now is the time for caution — not over-confidence

It is true that we would love this streak to continue. Strong returns provide a utopic sensation that is addictive. Have you ever noticed that you check your share prices more often when your portfolio is up?

We humans have a tendency to be over-confident anyway. Charlie Munger quotes Demosthenes “what a man wishes, that also will he believe”. There is a force that drives people to believe the stock market, casinos or lotteries is a source of quick riches. Being aware of our inclination to be over-confident is helpful — especially today.

Strong returns are a trap. Because they feel so good, we get a false sense of security which can blind us. It is well understood that investors are far more risk averse following a large correction. It’s important we recognise the opposing effect of a bull market. Now, more than ever, we need to be cautious.

Despite the short lived (COVID) correction, we have enjoyed a 12 year bull market. Given we are clearly at the market’s historical extremes, it seems reasonable to us that we are nearing the end of this fabulous run (at the very least we are closer to the end than the beginning).

Despite this we are witnessing an unprecedented bias to risky investing. This optimism is being fuelled by low interest rates and an expectation the good times will just keep on rolling. News flash — they won’t.

A colleague suggested he would gladly borrow at 8% to invest. They suggested that generating a return of +15% is ‘easy’. Humans have a habit of confusing returns achieved in the short-term, with long-term incompetence.

“Only when the tide goes out do you discover who’s been swimming naked” — Warren Buffett

We have all had a great time over the past decade being rewarded handsomely for almost any financial decision we make. Instead of extrapolation, let us do more consolidation.

On a ride last weekend I didn’t pack my spare tyre. My saddle bag had broken and it was inconvenient to hold the spare on me. I hadn’t had a puncture in a year so I was feeling lucky. Needless to say, I got a puncture and my lacklustre approach to an obvious risk cut my ride short.

Warren Buffett’s success was not determined by any single result, rather his ability to protect and compound over decades. It’s relatively easy to make money in the good times but extremely difficult to do it across multiple cycles.

This period of easy returns has attracted all kinds of people to the investing game. The proportion of the population owning shares is the greatest it has ever been — a typical feature of any late stage bull market. What is also typical is that when the tide eventually turns, there will be less investors.

The question I regularly ask myself is whether we will be one of those washed away, or, one of the few left standing? Our priority is to protect and grow. One objective doesn’t survive without the other.

I’m confident that the principles set out in these letters will achieve that for us.

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Acknowledgements: Shane Parrish, Charlie Munger, Alex Hughes, Jeff Bezos, Michael Lewis.