One of our favorite value investors here at The Acquirer’s Multiple is Leon Levy. Levy joined the small brokerage firm of Oppenheimer & Company in 1951 and later founded Odyssey Partners with Jack Nash in 1982. Odyssey Partners earned an average annual return for its investors of 22% over 14 years. The two liquidated the business in 1997 after growing it to $3.3 Billion under management. Levy’s successful value investing strategy focused on common sense and an emphasis on the importance of understanding investor psychology.
Levy famously said, “Value investing is an approach to stocks that is as close as it gets to a golden rule”.
And, on investor psychology he said:
“To ignore the psychological component of the flux of the markets is to miss seeing the elephant in the room. Psychology plays a role in all events in the market, from the actions of the day trader riding the momentum of Internet stocks to the broad shifts that become obvious and undeniable only over time.”
Levy wrote one of the best books on investing called – The Mind of Wall Street: A Legendary Financier on the Perils of Greed and the Mysteries of the Market. The book’s introduction provides a number of valuable insights for investors. Here’s an excerpt from the book:
For a good part of my life, I read about the great booms and busts of history—the South Sea bubble, the tulip mania, the 1929 crash—but in the late 1990s, I knew my bubble had finally come.
I’ve had two loves in my life: One is the stock market, the other psychology. Nothing ever happens without people making decisions. Even the bubbles wouldn’t be worth talking about without discussing the psychology that drove them. The moods of the market affect not only stock prices but also the fortunes of business.
The Internet stock craze convinced me that there has never been a more important time to come to grips with what has happened to the markets, what we have brought upon ourselves, and where I think this will lead.
Revisitation points to a larger age-old theme: Good times breed laxity, laxity breeds unreliable numbers, and ultimately, unreliable numbers bring about bad times. This simple rhythm of markets is as predictable as human avarice. Regulatory and accounting laxness is easily ignored when stock prices are climbing, but as companies cut corners and hide expenses (to keep prices rising so that executives can exercise options and get their bonuses), they set up a day of reckoning.
At some point, bankers, bondholders, or other investors will demand proof that a company has the money to pay its debts. That is when the party ends and the hangover begins. Markets fall, and exaggerated earnings and reduced oversight become very important indeed.
At the height of the last bull market, I read that the state pension fund in California fired one of its managers because he had invested in U.S. Treasury bonds. Concerned about the overheated market, the manager simply sought to protect his fund against a market decline.
His bosses thought he was being foolishly conservative. Certainly, the firing of a fund manager is not the most earthshaking news compared with events such as the 1997 collapse of Thailand’s currency, the baht; the Russian default a year later; the accounting scandals of 2001–2002; or other recent events that have sent tremors through the financial world.
The item about the unfortunate fund manager caught my attention, however, because five decades earlier, when I arrived on Wall Street, the protocol was precisely the opposite. In most states it was illegal for a trust fund manager to invest more than a small percentage of fund assets in stocks.
To a fund manager from the 1950s catapulted into the late 1990s, the notion that someone could be fired for investing in bonds would make no sense, somewhat akin to hearing that ice cream was good for you. Back then, with memories of the Great Depression still fresh, those entrusted with other people’s money eschewed stocks as too risky.
One can only hope that with experience will come the ability to recognize those things that do not change, even as fashions come and go. I’m fond of the remark, attributed to Mark Twain, that “history does not repeat itself, at best it sometimes rhymes.” Over time, I’ve noticed that investors tend to invoke “new economies” when they want to justify actions that are unjustifiable by conventional analysis. Rather than heralding a new era, the shift in attitudes toward risk exposed a neglected but hugely important attribute of all markets, past, present and future: namely, the role of psychology.
This pattern of generational forgetting may be obvious and simple, but it has profound effects. Markets affect investor psychology, but investor psychology also affects markets.
Basically, we all live three lives: our life, the life of our parents, and that of our children. Events within our experience, particularly our youth, remain the most visceral in memory, but events that lie beyond the horizon of these generations tend to be more abstract, if only because they don’t have an immediate connection to our lives. I might warn a Young Turk incessantly about the horrors of a crash or bad market, but I will not likely make an impression on one who hasn’t lived through the experience. If societies can forget and then repeat the horrors of war, they can certainly forget the temporary ruination of a stock market crash.
Try to imagine the role of psychology in your investing. What were you thinking or feeling when you bought or sold a stock or bond? What prompted you to pick up the telephone? To what degree did mood and intuition, as opposed to analysis, affect the decision? What assumptions caused you to pay heed to a particular piece of information? Why did you weigh one piece of information over another? What facts did you include in your decision?
Then try to imagine what the person on the other side of the trade was thinking. Investors tend to forget that whoever buys the stock you sell or sells the stock you buy has undertaken his own analysis of the situation. There is a genius on one side of every trade and a dolt on the other, but which is which does not become clear until much later.
Investing is as much a psychological as an economic act. Even hardheaded types who think they are basing their decisions on fundamentals will discover over time that there are fashions in fundamentals. This, in turn, suggests that fundamentals are sometimes not so fundamental after all. In the 1970s, many investors waited each Thursday afternoon for the Federal Reserve to release the figures for M1, an indicator of the money supply, whereupon they might buy or sell depending on whether M1 was exceeding or failing to meet expectations. The crowd that waits for news of changes in M1 before making investment decisions has all but disappeared.
Despite all the evidence that markets float atop an ocean of beliefs and moods, conventional economics minimizes the role of psychology in freely functioning markets. This is odd, since both market seers and economists talk endlessly about the mood of markets. When they sit down to analyze a stock, sector, or market, however, they tend to look upon markets as rational and efficient.
This outlook is very dangerous for one’s economic health. It’s even more dangerous to misconstrue success in the markets for rational analysis. Those most adept at profiting from a particular market are often least likely to notice when the game is over, and probably the least psychologically prepared to profit from the successor market. Why should they change something that has worked so well for them? Most of the heroes of the “go go” years in the 1960s turned out to be goats in the 1970s. How the heroes of the great bull market of the late 1990s will fare in the years to come remains to be seen.
But the market has even crueler twists. It’s not sufficient that a player figure out when the game has changed. When a market shifts, it usually requires the investor to adopt a psychological stance anathema to the precepts upon which he built his earlier success. It will not be easy for the apostles of the so-called new economy to nimbly adjust should the market decide that quaint old-economy obsessions such as earnings and dividends are important after all.
The message is that mood or investor psychology is as important to markets as is information. It requires tremendous discipline to apply this understanding to one’s behavior. I encountered a particularly vivid example of this paradox in 1962. At the time, President Kennedy was jawboning the steel industry not to raise prices, and I believed we were about to enter a recession. My colleagues and I at Oppenheimer and Company brought together our top money managers and asked them for their take on the prospects for the market in general and the particular stocks they followed. All agreed with me that the market was likely to decline. Then I looked at how they rated the expected performance of their particular stocks. I added these estimates and averaged them, to find that these same managers were predicting that their stocks would rise collectively by 15 percent. In fact, our fund fell about 30 percent.
For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value. Piling delusion upon delusion, most people also believe that no matter what happens, they will be able to get out at or near the top of the market.
Both ideas are dead wrong. Demonstrating the latter is a matter of simple arithmetic. Most investors who sell shares are switching their investments from one stock to another. Only a small percentage are switching from stocks to bonds or cash.
Let’s say that each year, turnover is 70 percent of all shares listed on all the exchanges. And let’s say that 10 percent of all stocks sold in a year are by people leaving the market. That means only 7 out of every 100 shares are being sold by people who want cash instead of stock. The odds of cashing out at the top the year the market peaks are thus 7 out of 100 or about 1 in 15. Only a few investors will get out there. The rest will be stuck, either waiting for the price to return to its heights (many people retain the belief that the market somehow knows or cares what price they paid for a stock), or settling for lesser gains or losses. When a stock plummets, money vanishes. The $400 billion in market value of Cisco that disappeared during the Nasdaq swoon and the $70 billion decline in Enron market value represent money that has disappeared, except for the tiny fraction of that amount that went into the pockets of those who sold as the stock plummeted.
The market capitalization that vanished has real effects: There is that much less money to finance investment or consumption.
The market meltdown was a reminder to all of us that no one has a system to beat the market. This is not to say that no one can beat the market, but an investor should greet any promise of automatic returns with great skepticism. Most investors know this, but still, people love systems. I remember once visiting Monte Carlo, where I looked up a friend of my mother’s who loved to gamble. She was the widow of a successful accountant, and she kept her husband’s ashes in a vase on the mantelpiece, along with the ashes of her favorite dog, Gilligan. One day, watching her play roulette and feeling a little mischievous, I said, “Have you ever noticed that the numbers that come up at the other roulette table often come up at this table a few minutes later?” Without missing a beat, she replied, “Oh, yes, that’s the echo effect. A lot of players use it.”
The example is absurd, of course, but a similar hunger for order in a capricious world causes even very sophisticated investors to impute their success to equally implausible systems. I’ve always been suspicious of theories about the nature of markets, and my experience as an investor has only served to harden this bias. It is highly unlikely that any of us will encounter a unified theory of markets— some equation with variables into which an investor can plug numbers and derive an answer as to where to invest. To the degree that markets are governed by psychology, they resist reduction to some neat theory or system.
Apart from the unfathomable aspects of human psychology, there is never perfect knowledge about the world. Simply put, we don’t know what we don’t know. In the early 1970s, all the calculations for the cost of the Alaska pipeline were thrown out of whack when environmentalists sought injunctions to halt the project until the pipeline’s effects on caribou could be studied and addressed. It was thought that the pipeline as then designed would disrupt the normal migratory patterns of the caribou, which survive by eating lichens in one of the most inhospitable climates on earth. Dealing with the caribou delayed the pipeline for about eight years, and since time is money, the changed timetable forced the pipeline’s owner, Atlantic Richfield, to reprice the bonds that would finance the project. Caribou, or their equivalents, always have a way of turning up in big projects, and ever since then, investment professionals have referred to such unknowns as “the caribou factor.”
If human nature makes markets inefficient and moody, and the caribou factor defeats the most exquisite analysis of financiers, it is natural to ask how anyone might hope to make money in the markets. Markets may be inherently unpredictable—the efficient- market theorists are right about that—but there are always clues in the actions of government and in the behavior of major economic actors that offer guidance for the attentive about developments that offer opportunities.
A good idea, a long-term perspective, and the creativity to implement a strategy to profit from your insight are necessary to prosper in finance, but they are not sufficient. None of these qualities will bear fruit unless you have the discipline to stay with your strategy when the market tests your confidence, as it inevitably will. When you have made a massive bet and markets start to go against you, it is always a good idea to reexamine the assumptions behind your strategy. Even if you are still convinced you are right, however, it is difficult to resist the temptation to cut losses or take a quick profit.
In such circumstances, it is easy to lose sight of the fact that ultimately the market does reflect value, even if it may seem to lose its marbles for unbearably long periods. Investors must decide how long they are willing to wait. Investors also have to be alert to changes in the market that could change their original assumptions. We may not have an efficient market, but we do have a pretty efficient market. Or as the legendary value investor Benjamin Graham once put it: In the short term, the market is like a voting machine, reflecting a company’s popularity, but over the long term, it more resembles a weighing machine, reflecting a company’s true value. This is the aspect of markets that allows the great investors to outdistance those who are lucky.
Why should the market be any more perfect than the very human emotions and calculations that drive it? Investors overreact, and so do markets. Investors get swept up in moods, and so do markets. And this interplay creates investment opportunities.
You can find the complete introduction at The Leon Levy Foundation website here.
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