The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing)

by Howard Marks

Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions. Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently.

The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed.

The counterpart of greed is fear—the second psychological factor we must consider.

Thus, the third factor I want to discuss is people’s tendency to dismiss logic, history and time-honored norms. This tendency makes people accept unlikely propositions that have the potential to make them rich . . . if only they held water.

When the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance.

When a market, an individual or an investment technique produces impressive returns for a while, it generally attracts excessive (and unquestioning) devotion. I call this solution du jour the “silver bullet.” Investors are always looking for it. Call it the holy grail or the free lunch, but everyone wants a ticket to riches without risk. Few people question whether it can exist or why it should be available to them. At the bottom line, hope springs eternal.

What makes for belief in silver bullets? First, there’s usually a germ of truth. It’s spun into an intelligent-sounding theory, and adherents get on their soapboxes to convince others. Then it produces profits for a while, whether because there’s merit in it or just because buying on the part of new converts lifts the price of the subject asset. Eventually, the appearance that (a) there’s a path to sure wealth and (b) it’s working turns it into a mania. As Warren Buffett told Congress on June 2, 2010, “Rising prices are a narcotic that affects the reasoning power up and down the line.” But after the fact—after it has popped—a mania is called a bubble.

The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist—even when the herd’s view is clearly cockeyed.

Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. It happens so regularly that there must be something dependable at work, not a random influence.