Tuesday, April 7, 2009

Active Investors Shouldn’t Look for Approval

It’s a natural human trait to look for approval from others. We have a tendency to look for the social evidence of what others are doing to choose our own actions. Unfortunately, this tendency works against active investors who seek to beat the market averages by stock picking or market timing.

In his most recent letter to shareholders of Berkshire Hathaway, Warren Buffett said “[approval] is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”

We’ve heard the perverse truth that investors are most pessimistic about stocks when prices are lowest and destined to rise. Similarly, investors are most optimistic about stocks when prices are highest and destined to fall.

However, many people get the causal relationship backwards thinking that stock prices drive investor opinions. The more direct causal relationship is the reverse; investor opinions drive stock prices.

It is pessimism about stocks that causes prices to drop because it creates an imbalance in the number of buyers and sellers. With an excess of sellers, the market adjusts by lowering stock prices. Similarly, optimism creates an excess of buyers and the market adjusts by increasing stock prices.

It is certainly true that rising stock prices can create optimism and falling prices can create pessimism. When this happens, we have a feedback loop creating or bursting a bubble. But this is not the primary direction of causation. Prices rise because of an excess of buyers and fall because of an excess of sellers.

All this means that it is unavoidable that people will disagree with you if you make a great investing decision that will beat the market. Too many investors think they are trying to beat the market when they are really just following the herd. The late ones to join the herd end up buying high, selling low, and losing money.

Of course, just because people disagree with your strategy doesn’t mean that it will succeed. Piling everything you have into lottery tickets will get little approval and is overwhelmingly likely to fail to get a good return. Beating the market is hard, and by definition only a minority of people can do it. Most investors would get better results with a low-cost indexing approach.

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