Diversification is slow and boring, concentration is fun and exciting. But if fun and exciting is what you seek, the stock market can be a very expensive place to find it.
Notes
1. Warren Buffett, 1994 Berkshire Hathaway annual letter, March 7, 1995.
2. Hendrick Bessembinder, “Do Stocks Outperform Treasury Bills?,” Journal of Financial Economics, November 22, 2017.
3. Ibid.
4. Thomas Heath, “An Epic Winning Streak on Wall Street – Then One Ugly Loss,” Washington Post, August 12, 2017.
5. Ibid.
6. Ruane, Cunniff & Goldfarb, “Sequoia Fund,” www.sequoiafund.com, December 2017.
7. Warren Buffett, “The Superinvestors of Graham‐and‐Doddsville,” Hermes (New York: Columbia Business School, 1984).
8. Ruane, Cunniff & Goldfarb, 2016 Sequoia Fund annual report, December 31, 2016.
9. Author's calculation.
10. Author's calculation. Note that the first S&P 500 index fund was not created until 1976, so such an investment would have been impossible until that year.
11. Author's calculations using data from Bloomberg.
12. Ruane, Cunniff & Goldfarb, 2010 Sequoia Fund annual report, December 31, 2010.
13. Ibid.
14. Steven Goldberg, “What I Learned from Sequoia Fund's Tragic Love Affair with Valeant,” Kiplinger, April 29, 2016.
15. Ibid.
16. Ibid.
17. StreetInsider.com, “Imprimis Pharma (IMMY) Announces Lower‐Cost Option to Valeant's (VRX) Lead Poisoning Treatment,” October 17, 2016.
18. Quoted in Bob Bryan, “Warren Buffett and Charlie Munger Just Destroyed Valeant at Berkshire's Annual Meeting,” Business Insider, April 30, 2016.
19. Citron Research, “Valeant: Could This Be the Pharmaceutical Enron?,” October 21, 2015.
20. Ruane, Cunniff & Goldfarb, Letter to Shareholders, October 28, 2015.
21. James B. Stewart, “Huge Valeant Stake Exposes Rift at Sequoia Fund,” New York Times, November 12, 2015.
22. Heath, “An Epic Winning Streak.”
23. Lucinda Shen, “Valeant's Second Largest Investor Just Dumped the Rest of Its Stock,” Fortune, July 13, 2017.
CHAPTER 12
John Maynard Keynes
The Most Addictive Game
How could economics not be behavioral? If it isn't behavioral, what the hell is it?
—Charlie Munger
The cost of raising a child today is $233,610.1 This is a 41% increase over the past 15 years, or 2.3% a year.2
From gasoline to food to education and raising children, prices tend to rise over time. Staying ahead of inflation is why millions of Americans invest. But what about the one‐tenth of one percenters who have more money than they can spend in 4,000 lifetimes? Why do they still invest? I'm not talking about wealthy people who invest for future generations, but billionaires who spend the entirety of their sixth and seventh decades trying to beat the S&P 500.
A 60‐year‐old with a billion dollars can spend more than $90,000 a day until their 90th birthday. So if the purpose of investing is to defer current consumption for future benefit, there has to be another reason why these people spend so much time trying to beat the market when they've already won. The reason why some billionaires are still consumed by the market is because these people are driven to climb mountains, and putting all the market's pieces together is the Everest of intellectual challenges. In a 1987 documentary, Trader, Paul Tudor Jones says:
During my second semester senior year in college he said I've always liked backgammon, chess, those type of games, and he said if you think those are fun, if you really enjoy that type of stimulation, then I'll show you a game that is the most exciting and most challenging of all.3
Jones continued to explain that once he reached a particular mark, he would stop and retire. He didn't specify what that number was, but it's now 30 years later, he's been a billionaire for a long time, and he's still running his fund.
Every minute of every day, markets are putting out clues, little crumbs of information for would‐be market detectives. This is the most addictive game on the planet because it's a game that never ends. The pieces are always zigging and zagging and by the time you think you've got things figured out, new rules are implemented. Where are interest rates today and where are they going tomorrow? How has the economy performed over the past 12 months and what will the next 12 look like? How are markets behaving? And not just stocks, but what about currencies and commodities and real estate and bonds? This is the macro game, and it has destroyed many more fortunes than it's created.
Even if we had tomorrow's news today, we couldn't know how markets would react because the laws of physics do not govern them. There is no E = MC2. If you drop an eight‐sided ball, there's no way to predict which way it would bounce. The same idea holds true in finance – Serotonin plus adrenaline plus different time horizons times a few million participants equals literally nobody knows.
Let's pretend that we knew with complete certainty that Apple's earnings will grow by 8% a year for the next decade. Would this give you the confidence to buy its stock? It shouldn't, and here's why. How fast is the overall market growing and how fast are investors expecting Apple to grow? Even if we have clairvoyance on the most important driver of long‐term returns, earnings, it wouldn't be enough to ensure success. The missing ingredient, which cannot be modeled by all the PhDs in the world, is investor's moods and expectations. Investing with perfect information is difficult – investing with imperfect information and cognitive biases has made mincemeat out of millions of investors.
When you're betting on sports or horses, you can't know who's going to win, but at least you know the odds. If you have a feeling that the Golden State Warriors are going to win the finals next year, you're not alone. The Warriors are the favorites to win the championship and the market, or the betting odds in this case, reflect the current optimism. If you bet $100 on the Warriors winning the finals in 2018 and they do, you'd receive only $60.61. On the other hand, if you bet on the New York Knicks, a long shot, a $100 wager would payout $50,000!4 Steven Crist, a famous handicapper, explains this idea perfectly, “Even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds.”5
The parallels between betting on the horses or the Warriors and betting on stocks or commodities are obvious, but there is one major difference: With investing, the odds are determined by investor's expectations, and they're not published on any website. They're not quantifiable because they're subject to our manic highs and depressive lows. You can have all the information in the world, but humans set prices, and decisions are rarely made with perfect information.
Few people understood the disconnect between what the market should do and what it actually does better than one of the most infamous names in all of finance, John Maynard Keynes. He once said that:
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs…each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors… We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.6
Investors can learn a lot from Keynes, who learned that trying to beat the market by anticipating what average opinion expects the average opinion to be is a game that's not worth playing.
Chapter 12 of Keynes's The General Theory of Employment, Interest and Money is one of the most influential things ever written in finance. Jack Bogle wrote, “That chapter, laced with investment wisdom, made a major impact on my 1951 senior thesis…Keynes the investor, not the economist, has been the inspiration for my central investment philosophy.”7 Warren Buffett said, “If you understand chapters 8 and 20 of The In
telligent Investor and chapter 12 of The General Theory, you don't need to read anything else and you can turn off your TV.”8 George Soros wrote, “I fancied myself as some kind of god or an economic reformer like Keynes.”9 Finally, the intellectual giant Peter Bernstein credits Keynes with defining risk “as it has come to be understood today.”10 What was it about Keynes that made these financial giants speak with such reverence?
Keynes wrote several international best‐selling books, revolutionized institutional asset management, and practically built the global monetary system as we know it. He designed England's financing of World War II, and he was hugely influential in designing the Bretton Woods agreement, which established the postwar global monetary system. When Keynes died, the obituary in The Times read, “To find an economist of comparable influence, one would have to go back to Adam Smith.”11 Keynes was so far ahead of his time that when John Kenneth Galbraith reviewed his seminal work, The General Theory of Employment, Interest and Money, he wrote, “The economists of established reputation had not taken to Keynes. Faced with the choice of changing one's mind versus proving that there is no need to do so, almost everyone opts for the latter.”12
Keynes received his education at King's College, Cambridge, and began his professional career in 1906 as a civil servant in the revenue, statistics and commerce department of England's India office. A few years later, he began lecturing at Cambridge University.
After World War I, the global monetary system was left in tatters. Keynes was the Treasury's representative at the peace conference in Versailles, but he vehemently disagreed with how the Allies wanted to be compensated for war damages. The reparations they were placing on Germany were far too punitive and would destroy the country's currency as well as their economy, and leave both sides in a lose‐lose position. Keynes wouldn't go along with this, so he resigned, writing to Prime Minister David Lloyd George, “I ought to let you know that on Saturday I am slipping away from this scene of nightmare. I can do no more good here.”13
Following his resignation, he spilled his thoughts into what quickly became an international best seller, The Economic Consequences of the Peace. In it he wrote, “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.” Prophetically, he wrote, “If we aim deliberately at the impoverishment of Central Europe, vengeance, I dare predict, will not be limp.”14
With money pouring in from book royalties and speaking engagements, Keynes decided to leverage his knowledge of the economic machine by speculating in currencies. Prior to the war, currencies were fixed, but after they were left to float, giving opportunities to investors with superior insight. He felt that postwar inflation would hurt the French franc and especially the German Reichsmark, so he shorted those currencies and a few others. He earned $30,000 in just a few months—so he took the next logical step. He set up a syndicate in 1920 to manage money professionally for friends and family. This also got off to a good start, they made $80,000 by the end of April 1920.15 But then, over just a four‐week period, a brief wave of optimism spread across the continent, and the currencies he shorted quickly rose in value, wiping out all of syndicate's capital. When he was forced to close it, every single currency position was underwater.16 Keynes was bailed out by his father, and not deterred by this blow up, he was able to rebound, kept speculating, and built up a capital base of $120,000 by the end of 1922, nearly $2 million in today's dollars.17
Keynes then got heavily into commodity speculation, applying the same top down approach that he did to currencies. Instead of investing in the extremely volatile franc and Reichsmark and rupee, he turned to tin and cotton and wheat. This endeavor ended in a similar way to the previous one. When the great crash came and commodities were decimated, Keynes lost 80% of his net worth.
In 1924, Keynes became First Bursar at King's College and took control of the college's finances. He was still finding his way as an investor and his evolution would take a few years. Anybody who has ever tried his or her hand in the market has had the feeling that Keynes did in the 1920s. We open up a newspaper and start constructing top‐down views of how the world is functioning. But figuring out how interest rates affect currencies and how labor affects prices and how all of this affects our investments is tantamount to putting together a three dimensional puzzle where the pieces are always moving.
When Keynes assumed control over the endowment fund, it was severely constrained by what it could invest in. At that time, the world of institutional asset management focused heavily on real estate and bonds. Stocks were seen as too risky and were eschewed by most institutional managers. But he was able to convince them to separate a piece of it into a discretionary portfolio, which left him free to do whatever he wanted. Elroy Dimson, professor at Cambridge, studied the records and concluded that over the period 1922–1946, this portfolio had a 16% average annual return, compared with 10.4% for a market index.18 (Keynes's investing style evolved over the years, and the methods that he employed during the first half of his tenure looked nothing like what he would ultimately use to achieve those outsized returns.)
When he took over the fund, he sold properties so that he could invest in the stock market. Keynes thought he would fare better speculating in an asset that had daily price quotes and liquidity than investing in something over which he had little control. But he was highly levered when the crash came, and the belief that his ability to track credit cycles and economic expansions and contractions had failed him. The fund lost in 32% in 1930 and another 24% in 1931.19 He had misread the current conditions, and his macro insights after the crash were no better. “With low interest rates, enterprise throughout the world can get going again…commodity prices will recover and farmers will find themselves in better shape.”20
Keynes had accomplished more in 10 years than most economists would accomplish in a lifetime, and brilliant as he was, his superior intellect did not provide him with superior insights into short‐term market movements. In studying his commodities trading, it was difficult to get a clear record of exactly how he fared because his turnover was so high. He suffered like I did and so many other investors do, from the illusion of control. He thought that by trading so frequently, he could control his own destiny and achieve success. He was wrong. He took this style with him to the King's College endowment, and delivered negative alpha for the first few years.
It wasn't just the college that suffered at Keynes's hands; he was running an investment pool that was liquidated after the crash. “Although Keynes was well known for his arrogance and his air of intellectual superiority, the humbling experience of having nearly lost two fortunes changed his thinking on the best way to invest.”21 Keynes did a complete 180, shifting his thinking from being a short‐term speculator to a long‐term investor. The psychological forces of the market consumed him, and this made his obsession with the macro economy and the link between currencies and interest rates and stock prices seem completely irrelevant.
He began studying companies, looking at cash flows and earnings and dividends, with a sharp focus on businesses that were selling for less than their intrinsic value. Keynes went from macro to micro, top down to bottom up, and with this new vision, he was able to build a fortune for himself, King's College, and two insurance companies. Keynes put his ego to the side and gave up trying to forecast interest rates and currencies and how they affect the economy. As a long‐term value investor, he bought “Securities where I am satisfied as to assets and to ultimate earning power and where the market price seems cheap in relation to these.”22 Keynes is the father of macroeconomics, but ironically, his investing success occurred once he was able to adopt something that was the antithesis of this.
If you can buy something for less than its intrinsic value, you give yourself a better chance over the long‐term than trying to outguess your competition over the short‐term. Keynes wrote about this in chapter 12 of The General Theory:
If we spea
k frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.23
His leap into value investing, successful as it was, presented its own set of challenges. Value, like anything else, is seasonal, and you'll never know ahead of time when summer will turn to winter. From 1936 to 1938, Keynes lost two‐thirds of his wealth, and the portfolios he was managing didn't fare much better. The boards of two insurance companies whose money he was managing were livid with his performance. National Mutual lost £641,000,24 and when they asked him to explain his performance, he wrote:
I don't not believe that selling at very low prices is a remedy for having failed to sell at high ones…. I do not think it is the business, far less the duty, of an institutional or any other serious investor to be constantly considering whether he should cut and run on a falling market…. The idea that we should all be selling out to the other fellow and should all be finding ourselves with nothing but cash at the bottom of the market is not merely fantastic, but destructive of the whole system.25
This is a quantum leap from where his head was at just a decade earlier.
King's College also wanted answers, so two months later, in a memo to the Estates Committee of King's College, he wrote:
Big Mistakes Page 12