Seth Klarman: “Value Investing Is At Its Core The Marriage Of A Contrarian Streak And A Calculator.”

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We’ve just been re-reading Michael Mauboussin’s book – The Success Equation. There’s a great passage in the book with discusses investor psychology, and some of the findings of Daniel Kahneman and Amos Tversky. There’s also an great explanation of one of Seth Klarman’s most famous investing quotes:

“Value investing is at its core the marriage of a contrarian streak and a calculator.”

Here’s an excerpt from the book:

The second part of a skillful process is psychological. This part deals with Kahneman and Tversky’s work on biases. These include overconfidence, anchoring, confirmation, and relying on what is most recent. Kahneman and Tversky emphasize that these biases arise automatically and are therefore very difficult to overcome.

For example, when making a prediction, people tend to give disproportionate weight to whatever has happened most recently. In investing, there is a strong tendency to buy stocks that have done well or to place bets on a money manager who seems to have a hot hand. This is just as true for professional money managers as it is for everyone else. Individual investors consistently earn returns that are 50–75 percent of those of the market as a result of bad timing.

Kahneman and Tversky also developed the idea of prospect theory, or how people make decisions when they are uncertain about gains and losses. Prospect theory reveals behavior that is at odds with classical economic theory.

Compensation provides a good example of the difference between these two theories. Ideally, you should consider your salary for a new job in the context of your aggregate wealth rather than comparing it with what other employees are making. But, of course, few of us do that. In one study, researchers asked people which new employee was happier, the person making $36,000 in a firm where the average starting salary is $40,000 or the one making $34,000 in a firm where the average starting salary is $30,000. Eighty percent of the respondents said the employee earning $34,000 would be happier.

In investing, the reference point is what you paid for a stock. When you buy a stock at $30, for instance, you effectively open a mental account. You have a gain if the stock rises above $30 and a loss if it drops below that price.

Rather than viewing the value of the stock in the context of a larger portfolio, the natural tendency is to consider each stock relative to its reference point. Loss aversion is another feature of prospect theory. We suffer roughly two times more from a loss than we enjoy a gain of the same size. The combination of the reference point and loss aversion leads investors to hold on to losing stocks and sell winners, because it is painful to take losses.

Because good decisions can have bad outcomes, not everyone has a temperament that is well suited to making decisions about activities that involve luck. But Seth Klarman has the right temperament. He’s the founder and president of a highly successful hedge fund called the Baupost Group. Klarman has a wonderful line: “Value investing is at its core the marriage of a contrarian streak and a calculator.” He’s saying that you have to be different from others and focus on gaps between price and value. This idea extends well beyond the world of investing.

When most people come to believe the same thing, large gaps open up between price and value. That’s what happened during the dot-com euphoria of the late 1990s and during the spring of 2009, when despondency established the low point for the market. The first part of Klarman’s line properly emphasizes the importance of being willing to go against the crowd. Most people know that it is more comfortable to be part of the crowd than to be alone. But it’s also hard to distinguish yourself if you’re doing the same thing as everyone else.

Skillful investors heed Benjamin Graham’s advice: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.” However, Klarman correctly observes that it is insufficient to be a contrarian because sometimes the consensus is right. The goal is to be a contrarian when it allows you to gain an edge, and the calculator helps you ensure a margin of safety.

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