Business Times - 17 Nov 2007
Reading this won't make you great!
Mark Sellers, founder of a Chicago-based hedge fund, argues that the best investors are born with particular psychological traits that others can never learn
By TEH HOOI LING
WHAT makes someone a great investor? It's something you have to be born with, said Mark Sellers, founder and managing member of Sellers Capital LLC, a long/short equity hedge fund based in Chicago.
Apparently, it's not about your IQ, the education you've had, the books you've read, or the experience you've accumulated. 'If it's experience, then all the great money managers would have their best years in their 60s and 70s and 80s, and we know that's not true,' he said in a speech to a class of Harvard MBA students.
Intelligence and learning are obviously necessary too, and are sources of competitive advantage for an investor, but there are structural assets some possess that cannot be copied or learnt by others. 'They have to do with psychology and psychology is hard wired into your brain. It's part of you. You can't do much to change it even if you read a lot of books on the subject,' said Mr Sellers.
He said that there are seven traits great investors share that are true sources of advantage because they cannot be learned. You are either born with them or you aren't.
The seven traits are:
One, the ability to buy stocks while others are panicking, and the ability to sell at a time when other investors are euphoric. 'Everyone thinks they can do this, but then when October 19, 1987, comes around and the market is crashing all around you, almost no one has the stomach to buy,' Mr Sellers said.
'When the year 1999 comes around and the market is going up almost every day, you can't bring yourself to sell, because if you do, you may fall behind your peers.
'The vast majority of the people who manage money have MBAs and high IQs and have read a lot of books. By late 1999, all these people knew with great certainty that stocks were overvalued, and yet they couldn't bring themselves to take money off the table because of the 'institutional imperative', as Buffett calls it.'
Two, the great investor has to be obsessive about playing the game and wanting to win. 'These people don't just enjoy investing; they live it. They wake up in the morning and the first thing they think about, while they're still half asleep, is a stock they have been researching, or one of the stocks they are thinking about selling, or what the greatest risk to their portfolio is and how they're going to neutralise that risk.
'They often have a hard time with personal relationships because, though they may truly enjoy other people, they don't always give them much time. Their head is always in the clouds, dreaming about stocks. Unfortunately, you can't learn to be obsessive about something. You either are, or you aren't. And if you aren't, you can't be the next Bruce Berkowitz.'
(Berkowitz was a managing director of Smith Barney and set up his fund Fairholme Capital Management in 1999. Since inception, Fairholme Fund has returned 18.7 per cent annually on average.)
The third trait of a great investor is the willingness to learn from past mistakes. 'The thing that is so hard for people and what sets some investors apart is an intense desire to learn from their own mistakes so they can avoid repeating them. Most people would much rather just move on and ignore the dumb things they've done in the past.
'I believe the term for this is 'repression'. But if you ignore mistakes without fully analysing them, you will undoubtedly make a similar mistake later in your career. And in fact, even if you do analyse them it's tough to avoid repeating the same mistakes.'
A fourth trait is an inherent sense of risk based on common sense. 'Most people know the story of Long Term Capital Management, where a team of 60 or 70 PhDs with sophisticated risk models failed to realise what, in retrospect, seemed obvious: they were dramatically overleveraged. They never stepped back and said to themselves, 'Hey, even though the computer says this is OK, does it really make sense in real life?'
'The ability to do this is not as prevalent among human beings as you might think. I believe the greatest risk control is common sense, but people fall into the habit of sleeping well at night because the computer says they should. They ignore common sense, a mistake I see repeated over and over in the investment world.'
Five, great investors have confidence in their own convictions and stick with them, even when facing criticism. 'Buffett never get into the dotcom mania, though he was being criticised publicly for ignoring technology stocks. He stuck to his guns when everyone else was abandoning the value investing ship and Barron's was publishing a picture of him on the cover with the headline 'What's Wrong, Warren?'. Of course, it worked out brilliantly for him and made Barron's look like a perfect contrary indicator.'
Mr Sellers said that he is amazed at how little conviction most investors have in the stocks they buy. 'Instead of putting 20 per cent of their portfolio into a stock, as the Kelly Formula might say to do, they'll put 2 per cent into it. Mathematically, using the Kelly Formula, it can be shown that a 2 per cent position is the equivalent of betting on a stock which has only a 51 per cent chance of going up, and a 49 per cent chance of going down. Why would you waste your time even making that bet?'
The Kelly Formula arose from the work of John Kelly at AT&T's Bell Labs in 1956. His original formulas dealt with the signal noise of long-distance telephone transmission. It was then adapted to calculate the optimal amount to bet on something in order to maximise the growth of one's money over the long term.
Six, it is important to have both sides of your brain working, not just the left side - the side that's good at maths and organisation. 'In business school, I met a lot of people who were incredibly smart. But those who were majoring in finance couldn't write worth a damn and had a hard time coming up with inventive ways to look at a problem,' said Mr Sellers.
'I was a little shocked at this. I later learned that some really smart people have only one side of their brains working, and that is enough to do very well in the world but not enough to be an entrepreneurial investor who thinks differently from the masses.
'On the other hand, if the right side of your brain is dominant, you probably loathe math and therefore you don't often find these people in the world of finance to begin with.'
So finance people tend to be very left-brain oriented - and Mr Sellers said that that is a problem. A great investor needs to have both sides turned on, he said. 'As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working. But you also need to be able to do things such as judging a management team from subtle cues they give off.
'You need to be able to step back and take a big picture view of certain situations rather than analysing them to death. You need to have a sense of humour and humility and common sense. And most important, I believe you need to be a good writer.'
He cited Warren Buffett as one of the best writers ever in the business world. 'It's not a coincidence that he's also one of the best investors of all time. If you can't write clearly, it is my opinion that you don't think very clearly,' Mr Sellers said.
And finally the most important, and rarest, trait of all: the ability to live through volatility without changing your investment thought process.
This, said Mr Sellers, is almost impossible for most people to do; when the chips are down they have a terrible time not selling their stocks at a loss. They have a really hard time getting themselves to average down or to put any money into stocks at all when the market is going down.
'People don't like short-term pain even if it would result in better long-term results, he said. Very few investors can handle the volatility required for high portfolio returns. They equate short-term volatility with risk.
'This is irrational; risk means that if you are wrong about a bet you make, you lose money. A swing up or down over a relatively short time period is not a loss and therefore not risk, unless you are prone to panicking at the bottom and locking in the loss.
'But most people just can't see it that way; their brains won't let them. Their panic instinct steps in and shuts down the normal brain function.'
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