Benjamin Graham is the father of value investing. He literally wrote the book on how to analyze a company's value and pick superior investments. Warren Buffett once said that "I really learned all I needed to know about investing" from Graham's book, The Intelligent Investor.
But as I wrote last week, Graham gave an interview shortly before his death in 1976 that calls his own ideas into question. Asked whether he advised selecting individual stocks to beat the market, Graham replied:
In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.
This took me aback. There is exponentially more research being conducted today than there was in 1976. If Graham was skeptical about buying individual stocks then, what would he be doing today?
I had lunch with Wall Street Journal columnist Jason Zweig this week. Zweig wrote commentary and footnotes in the latest edition of The Intelligent Investor and is more familiar with Graham's thinking than almost anyone.
"Would Graham have all of his money in Vanguard index funds if he were alive today?" I asked.
"No, I don't think so," Zweig said.
Instead, Zweig thinks Graham would have advised those who have an edge at stock-picking to do so, while recommending those who don't take a passive approach with index funds. "He would advise knowing your advantages and your disadvantages, and not playing a game you have no advantages in." Zweig said.
This seems obvious, but too many investors fail to honestly ask themselves whether they have an advantage, and if so, what it is.
Fewer investors have an advantage than think they do. The reason is simple: Luck skews our perception of how skilled we are.
I have no medical experience. If you put me in an operating room and told me to perform open-heart surgery, the odds that I could do so successfully are exactly zero percent. Same with building a skyscraper or sequencing a genome. Those without skill in these fields will fail 100% of the time, so most don't bother trying.
Investing is different. Give a monkey $1,000 and a brokerage account, and the odds are decent -- about 50/50 -- that he will make money in the short run. He may even beat brilliant professionals. In his book The Success Equation, Michael Mauboussin writes that the best way to determine whether an activity involves skill or luck is to ask if you can lose on purpose. In short-term investing, you probably can't. There are short-only hedge funds whose goal is to pick losing stocks. Most can't do it consistently. Few other fields are like this.
Short-term luck deludes hordes of investors into thinking they can beat the market when they stand little chance of doing so. Over the long run, luck erodes, and true investment advantages shine through. And the results are clear: Most investors do not have an advantage. The majority of those who try to beat the market end up underperforming it.
This got me thinking: What is my advantage as an investor trying to beat the market?
I think it's simply time. I'm patient to the point of obsessive when it comes to delayed gratification. I bought stocks all the way down in 2008 and 2009, dreaming about what they'd be worth in 2038 and 2039. That's a big advantage over Wall Street, whose definition of "long term" is the time between Lightning Round segments on CNBC. If Wall Street is thinking about the next ten months, and you're thinking about the next ten years, case closed -- that's your advantage. Last year, I asked Rob Arnott, a pioneer of index investing, if anyone should pick stocks. To my surprise, he wasn't against the practice. "It's also not necessarily all that hard because Wall Street is now so obsessed with short-termism that long-term value doesn't matter to the decisions of vast throngs of institutional investors," he said.
Time can be the only advantage necessary for an investor focusing on index funds or wide diversification. If you're picking a smaller number of individual stocks, you need an advantage there, too.
Entire books can (and have) been written on how to gain an advantage picking individual stocks. It's not a topic for one article. But if there's a common denominator of successful strategies, it's thinking about investing in businesses, not stocks, and believing strongly in the concept of reversion to the mean.
My colleague Ron Gross says we should think of the market as a company market, not a stock market. Doing so can change your thinking 180 degrees. Most people understand that businesses will have a bad quarter or a rocky year once in a while. It's a normal part of being a business. But those same people tend to react to a bad quarter in the stock market as a harbinger of doom that should be avoided at all costs. That causes all kinds of bad behavior. Shifting your thinking ever so slightly to asking the question, "Is this a good business?" instead of "Is this a good stock?" alone can be an investing edge, since so few investors do it. It focuses your attention on having an ownership stake in a business's future profits, which you can do, from trying predict the madness of the stock market, which you can't.
A religious faith in the concept of reversion to the mean can also be an advantage. As investor Dean Williams put it, reversion to the mean is the simple idea "that something usually happens to keep both good news and bad news from going on forever." After booms come busts, and after busts come booms. Above-average valuations are followed by below-average results. This story repeats itself again and again throughout history. It's simple stuff, but it's one of the most powerful forces in finance because, by definition, only a small portion of investors can be contrarians. It's much easier to say "I'll be greedy when others are fearful" than to actually do it. But those who can truly can train themselves to be skeptical of outperformance and attracted to underperformance will likely do better than most. They have an advantage.
What matters is that you know what your investing advantage is. Can you articulate your advantage? Are you being honest with yourself when assessing it? If not, think twice about trying to the beat the market. Passive index funds can be a great alternative. I think Ben Graham would agree.
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