Whitney Tilson: Selected Published Columns

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Whitney Tilson: Selected Published Columns
Whitney Tilson

people into trouble in investing.”

Numerous studies have shown that human beings are extraordinarily irrational about money. There are many explanations why, but the one I tend to give the most weight to is that humans just aren’t “wired” properly. After all, homo sapiens have existed for approximately two million years, and those that survived tended to be the ones that evidenced herding behavior and fled at the first signs of danger — characteristics that do not lend themselves well to successful investing. In contrast, modern finance theory and capital markets have existed for only 40 years or so. Placing human history on a 24-hour scale, that’s less than two seconds. What have you learned in the past two seconds?

People make dozens of common mistakes, including:

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  1. Herding behavior, driven by a desire to be part of the crowd or an assumption that the crowd is omniscient;
  2. Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money;
  3. Excessive aversion to loss;
  4. Fear of change, resulting in an excessive bias for the status quo;
  5. Fear of making an incorrect decision and feeling stupid;
  6. Failing to act due to an abundance of attractive options;
  7. Ignoring important data points and focusing excessively on less important ones;
  8. “Anchoring” on irrelevant data;
  9. Overestimating the likelihood of certain events based on very memorable data or experiences;
  10. After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome;
  11. Allowing an overabundance of short-term information to cloud long-term judgments;
  12. Drawing conclusions from a limited sample size;
  13. Reluctance to admit mistakes;
  14. Believing that their investment success is due to their wisdom rather than a rising market;
  15. Failing to accurately assess their investment time horizon;
  16. A tendency to seek only information that confirms their opinions or decisions;
  17. Failing to recognize the large cumulative impact of small amounts over time;
  18. Forgetting the powerful tendency of regression to the mean;
  19. Confusing familiarity with knowledge;
  20. Overconfidence

Have you ever been guilty of any of these? I doubt anyone hasn’t.

This is a vast topic, so for now I will focus on overconfidence. In general, an abundance of confidence is a wonderful thing. It gives us higher motivation, persistence, energy and optimism, and can allow us to accomplish things that we otherwise might not have even undertaken. Confidence also contributes a great deal to happiness. As one author writes (in an example that resonated with me, given the age of my daughters), “Who wants to read their children a bedtime story whose main character is a train that says, ‘I doubt I can, I doubt I can’?”

But humans are not just robustly confident-they are wildly overconfident. Consider the following:

  • 82% of people say they are in the top 30% of safe drivers;
  • 86% of my Harvard Business School classmates say they are better looking than their classmates (would you expect anything less from Harvard graduates?);
  • 68% of lawyers in civil cases believe that their side will prevail;
  • Doctors consistently overestimate their ability to detect certain diseases (think about this one the next time you’re wondering whether to get a second opinion);
  • 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed;
  • Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The average guesses were 27.4 days, 33.9 days, and 48.6 days, respectively. The actual average turned out to be 55.5 days.
  • Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement and how much the average person in the room would have. The average figures were $5 million and $2.6 million, respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1.

Importantly, it turns out that the more difficult the question/task (such as predicting the future of a company or the price of a stock), the greater the degree of overconfidence. And professional investors — so-called “experts” — are generally even more prone to overconfidence than novices because they have theories and models that they tend to overweight.

Perhaps more surprising than the degree of overconfidence itself is that overconfidence doesn’t seem to decline over time. After all, one would think that experience would lead people to become more realistic about their capabilities, especially in an area such as investing, where results can be calculated precisely. Part of the explanation is that people often forget failures and, even if they don’t, tend to focus primarily on the future, not the past. But the main reason is that people generally remember failures very differently from successes. Successes were due to one’s own wisdom and ability, while failures were due to forces beyond one’s control. Thus, people believe that with a little better luck or fine-tuning, the outcome will be much better next time.

You might be saying to yourself, “Ah, those silly, overconfident people. Good thing I’m not that way.” Let’s see. Quick! How do you pronounce the capital of Kentucky: “Loo-ee-ville” or “Loo-iss-ville”? Now, how much would you bet that you know the correct answer to the question: $5, $50, or $500? Here’s another test: Give high and low estimates for the average weight of an empty Boeing 747 aircraft. Choose numbers far enough apart to be 90% certain that the true answer lies somewhere in between. Similarly, give a 90% confidence interval for the diameter of the moon. No cheating! Write down your answers and I’ll come back to this in a moment.

So people are overconfident. So what? If healthy confidence is good, why isn’t overconfidence better? In some areas — say, being a world-class athlete — overconfidence in fact might be beneficial. But when it comes to financial matters, it most certainly is not. Overconfidence often leads people to:

1) Be badly prepared for the future. For example, 83% of parents with children under 18 said that they have a financial plan and 75% expressed confidence about their long-term financial well being. Yet fewer than half of these people were saving for their children’s education and fewer than 10% had financial plans that addressed basic issues such as investments, budgeting, insurance, savings, wills, etc.

2) Trade stocks excessively. In Odean and Barber’s landmark study of 78,000 individual investors’ accounts at a large discount brokerage from 1991-1996, the average annual turnover was 80% (slightly less than the 84% average for mutual funds). The least active quintile, with average annual turnover of 1%, had 17.5% annual returns, beating the S&P, which was up 16.9% annually during this period. But the most active 20% of investors, with average turnover of more than 9% monthly, had pre-tax returns of 10% annually. The authors of the study rightly conclude that “trading is hazardous to your wealth.” Incidentally, I suspect that the number of hyperactive traders has increased dramatically, given the number of investors flocking to online brokerages. Odean and Barber have done another fascinating study showing that investors who switch to online trading suffer significantly lower returns. They conclude this study with another provocative quote: “Trigger-happy investors are prone to shooting themselves in the foot.”

3) Believe they can be above-average stock pickers, when there is little evidence to support this belief. The study cited above showed that, after trading costs (but before taxes), the average investor underperformed the market by approximately two percentage points per year.

4) Believe they can pick mutual funds that will deliver superior future performance. The market-trailing performance of the average mutual fund is proof that most people fail in this endeavor. Worse yet, investors tend to trade in and out of mutual funds at the worst possible time as they chase performance. Consider that from 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have made nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying and holding an S&P 500 index fund. Factoring in taxes would make the differences even more dramatic. Ouch!

5) Have insufficiently diversified investment portfolios.

Okay, I won’t keep you in suspense any longer. The capital of Kentucky is Frankfort, not “Loo-ee-ville,” an empty 747 weighs approximately 390,000 lbs., and the diameter of the moon is 2,160 miles. Most people would have lost $500 on the first question, and at least one of their two guesses would have fallen outside the 90% confidence interval they established. In large studies when people are asked 10 such questions, 4-6 answers are consistently outside their 90% confidence intervals, instead of the expected one of 10. Why? Because people tend to go through the mental process of, for example, guessing the weight of a 747 and moving up and down from this figure to arrive at high and low estimates. But unless they work for Boeing, their initial guess is likely to be wildly off the mark, so the adjustments need to be much bolder. Sticking close to an initial, uninformed estimate reeks of overconfidence.

In tests like this, securities analysts and money managers are among the most overconfident. I’m not surprised, given my observation that people who go into this business tend to have a very high degree of confidence. Yet ironically, it is precisely the opposite — a great deal of humility — that is the key to investment success.

–Whitney Tilson

P.S. If you wish to read further on the topic of behavioral economics, I recommend the following (I have drawn on heavily on the first two in this column):

Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich.
– “What Have You Learned in the Past 2 Seconds?,” paper by Michael Mauboussin, CS First Boston.
– In May and June this year, David Gardner wrote four excellent columns in The Motley Fool’s Rule Breaker Portfolio: The Psychology of Investing, What’s My Anchor?, Tails-Tails-Tails-Tails, and The Rear-View Mirror.
– There’s a great article about one of the leading scholars in the field of behavioral finance, Terrance Odean (whose studies I linked to above), in a recent issue of U.S. News & World Report: “Accidental Economist“
The Winner’s Curse, by Richard Thaller.
– The Undiscovered Managers website has links to the writings of Odean and many other scholars in this area.

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected] To read his previous guest columns in the Boring Port and other writings, click here.

A Little Perspective

Guest columnist Whitney Tilson recently visited Ethiopia, where he saw startling human poverty and adversity firsthand. Away from cell phones and stock quotes, he came away with a renewed appreciation for his good fortune.

By Whitney Tilson
Published on the Motley Fool web site, 4/17/01

(http://www.fool.com/news/foth/2001/foth010417.htm)

I live, eat, and breathe investing, in part because it’s my job, but mostly because I love it. Even when I’m on vacation, I typically have a cell phone and laptop with me and I’m regularly checking the market and keeping abreast of developments — often to the annoyance of my family.

Thus it was an unusual experience for me to disconnect from the stock market for the past two weeks and visit my parents, who live in Ethiopia. Tonight, I’d like to share a few stories from my trip and how it has affected my perspective on investing.

Ethiopia

In the span of a day, I went from my parents’ home in the Ethiopian capital of Addis Ababa to my home on the Upper East Side of Manhattan. I lived in Tanzania and Nicaragua for a good part of my childhood, so I’ve seen third-world countries, but it was still a striking, sobering contrast. I probably don’t need to tell you much about the Upper East Side — overpriced stores, luxury apartments, and the highest income census tract in the United States, with an average income of over $300,000 annually — so let me instead tell you about Ethiopia.

I really enjoyed the country, which has friendly, proud people, a wonderful climate, and a fascinating history. It used to be the kingdom of Abyssinia and is the only African country never colonized. Yet Ethiopia is desperately poor, with average annual per capita income just above $100, among the lowest in the world. Roughly speaking, the average American earns in one day what the average Ethiopian earns in an entire year.

Such poverty means that Ethiopians are subject to famine, diseases, and other misfortunes unheard of in developed countries. Remember “Do They Know It’s Christmas?” and “We Are the World” in 1984 and 1985? Those pop-star fundraising crusades came about because of terrible famines in which hundreds of thousands of Ethiopians perished.

Income per capita is a pretty dry number, so let me give you some examples of what real poverty is all about.

Dereje

Dereje is 19 years old and works full-time for my parents, caring for their horses, accompanying them riding a few times a week, and doing other miscellaneous tasks. He’s handsome, intelligent, athletic, and has a warm and compelling personality. Kids, mine included, love him.

He lives in the tack room at the stable, not because my parents require him to but because it’s better than the single small room in a dilapidated hut the other six members of his family share. Until my parents found his brother a similar job, Dereje was supporting his entire family on the salary he earned from my parents, which is 50% higher than the going rate for this type of work.

So take a guess at how much Dereje earns. Nope, lower. How about $44. Not per day, not per week, but per month. The cost of living in Ethiopia is low — a bottle of Coke, for example, costs 20 cents — but seven adults living on $1.50 per day is tough no matter where you are. Yet Dereje considers himself fortunate, and he is, especially compared with the people I met at two charities my parents support, the Cheshire Home and the Fistula Hospital.

Cheshire Home

When was the last time you saw someone crippled by polio? Probably never, as an inexpensive vaccine has eliminated it in the developed world. But in Ethiopia, many awful diseases such as polio — which strikes children and generally causes terrible deformities — are still common. With few people able to afford wheelchairs, Ethiopia’s polio victims have to pull themselves along the ground in crablike fashion. When even healthy people struggle to survive, imagine how hard life must be for those crippled by polio.

The Cheshire Home helps polio-stricken children walk again, albeit with special braces and crutches. It’s a long and painful process, usually involving multiple rounds of surgery in which doctors cut tendons in the children’s legs so they can be straightened. Between surgeries, the legs have to be in full-length casts so they don’t curl up again.

I’ve posted a Web page with eight pictures of the Cheshire Home. (Dereje is in the first picture.) Look at those kids’ legs, yet also at their faces. It’ll make you cry and smile simultaneously.

Fistula Hospital

Life in Ethiopia is very hard for most everyone, but it’s especially hard on the women. Like women in most of the developing world, they tend to do the most difficult, dirty work, yet generally do not have access to the few opportunities that exist for an education and a good job. Many are married off at a young age — sometimes as young as 10 — and often start bearing children by their early teens. Childbirth rarely occurs with a qualified attendant, much less at a hospital. If there’s a problem during delivery, common given the lack of prenatal care, the babies often die and the mothers can suffer injuries.

A common injury is called an obstetrical fistula, which occurs when the baby tears a hole into the bladder and/or rectum, causing the mother to become permanently incontinent and constantly smelly. When this happens, the husband almost always abandons his wife, who returns to her family, often to be rejected again. These women have lives of unspeakable misery. One didn’t leave her bed, much less her family’s hut, for nine years before making her way to the Fistula Hospital.

The hospital specializes in the relatively simple surgical procedure that repairs the fistulas, allowing the patients to return to normal life and even bear children again. It heals more than 1,000 women annually, at a total cost of a mere $400,000 — a pittance by Western standards, but a fortune in Ethiopia.

Changed perspective

The last two weeks affected my perspective on investing in two ways. First, simply being away, unable to constantly check my portfolio and receive news and messages, was strange — but good for me. Given my passion for investing, I find that it’s easy to get caught up in the day-to-day gyrations of the market, which can affect my mood and judgment. (Based on the dozens of emails I receive weekly from readers, I know that I’m not alone in this regard.)

This isn’t healthy. The last thing I need is more stress, and it’s likely to hurt my investment performance as well. As I’ve written many times in the past, one of the keys to successful investing is tuning out short-term noise. I don’t believe it’s a coincidence that Warren Buffett has built the greatest investment track record in history from Omaha, which is about as far away from the foolishness of Wall Street as one can get in this country.

The last two weeks

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