In his seminal 1994 talk at USC’s Business School, Charlie Munger – the greatest mind ever to apply himself to investing – started by saying “the art of stock picking [is] a subdivision of the art of worldly wisdom”. Munger went on to argue that in order to be a great stock picker, you actually have to know something about a lot of seemingly unrelated fields like mathematics, psychology and even the natural sciences. In other words, Munger was making the case that investing is a liberal art. Robert Hagstrom elaborated on Munger’s talk in a book titled Investing: The Last Liberal Art. People often ask me how I went straight from a Philosophy Phd program to starting Top Gun. The answer is that the two are much more closely related than most people think.
My personal starting point for investing is the great 18th century Scottish philosopher David Hume. In his Treatise On Human Nature (1739), Hume famously argued that “reason is the slave of the passions”. We humans tend to think of ourselves as rational. We think that our beliefs and actions are grounded in reason and evidence. But Hume argued just the opposite. What we believe and do is a function of our temperament and then we come up with reasons to justify them. My premise, therefore, is that you are the type of investor you are not because of a rational examination of the field but because of your temperament. This was implicit in “The Crowd And The Contrarian” (April 6).
To flesh it out, most people are conformists. They think like other people think. As a result, as investors they are momentum players. They buy what’s hot, what’s going up, what’s working. A minority of people, however, are contrarians. For reasons too complicated to get into here, their temperament compels them to think for themselves and – unlike most people – they are comfortable holding views at odds with the crowd. These are pure archetypes. In reality, inviduals exist along a continuum between conformists and contrarians. As I argued in “The Crowd And The Contrarian”, self knowledge is essential. Each temperament has its strengths and weaknesses and so knowing which one you are allows you to maximize the strengths while counteracting the weaknesses of your temperament.
This can be nicely concretized by focusing on two stocks reporting earnings this week: Netflix (NFLX) and Procter & Gamble (PG). The crowd loves NFLX. Contrarians like myself are more enamored of PG. The crowd loves NFLX because of its volatility. The stock is up more than 200% over the last two years. PG – on the other hand – is a much more stable, and therefore boring, stock. While it’s done just fine, it’s return is nothing like NFLX. The crowd doesn’t have the patience for PG. Contrarians aren’t willing to pay up for NFLX’s valuation. To relate this to the foregoing, which stock you like has more to do with your temperament than rational analysis.
The reaction to NFLX’s quarter – announced Thursday afternoon – illustrates the perils of crowd/momentum investing. While the quarter was actually quite good, expectations had grown so high that the stock is actually currently off 6% in the after hours. When PG reports in an hour, the reaction is likely to more muted one way or the other. In all likelihood, the business continues to make slow and steady progress. Perhaps the quarter will be a little better than expected, perhaps a little worse. Either way, the stock likely won’t move more than 2% or 3% in either direction – and over the long term it will continue to trend higher because it’s a high quality compounder. While contrarians are okay with this, it simply won’t happen fast enough for the crowd.
Personally, I am short NFLX and long PG. That’s because I’m a contrarian. Most of you reading this, on the other hand, are more likely to be long NFLX and not give PG a thought. That works during the trend but not at infection points. My strategy, on the other hand, works great at inflection points but lags during the trend. As Humphrey O’Neil wrote in The Art of Contrary Thinking: “The crowd is right during the trend but wrong at both ends.”
There is no right or wrong temperament. Temperament is deeper than rationality. We don’t choose it. The key is to know which one you are and manage the strengths and weaknesses to maximize the gains from the strategies that you are inevitably drawn to based on your temperament. As I wrote in the concluding sentences of “The Crowd And The Contrarian”: “There is more than one way to make money in markets. Know yourself said the Delphic oracle. Self knowledge will set you free – in markets and in life.”