Since the market low in March of 2009, I have not managed to keep pace with the passive return of the S&P 500 index. In no year in the last 8 have I met or exceeded the return of the index on a portfolio-wide basis. I would’ve been much richer by now if I had just turned my capital over to Mr. Market almost a decade ago and spent my time and energy worrying about anything but investing.
And I managed to do this primarily by being uninvested throughout this time period. I have not gone back and done a trade-by-trade and year-by-year study of my portfolio returns over this time period (I am including here my personal accounts as well as other accounts I manage) but just eye-balling it I think it’s safe to say the most exposure I’ve ever had to equities over this time period was no more than 25% of any of the portfolios and probably a lot closer to 20% on a gross capital basis. In essence, I sat out one of the biggest bull markets in history and missed an opportunity to capture a 271% total return through passive management. That’s something like 18% a year, an impressive long-term rate of return by most standards.
How did I manage to let this happen? And what have I learned from this experience? More importantly, what do I plan to do differently going forward?
The story of this mishap is complicated in my mind and is over ten years in the making. I was aware of the stock market as a concept since my early teenage years. On Friday nights after dinner my family would watch a battery of shows on PBS including “Wall Street Week with Louis Rukeyser.” I learned nothing about investing from watching this show other than there was this place called a stock market and people had a lot of opinions about what was happening there. My father was no investment guru and my clearest memory of him with regards to the stock market (aside from watching this show beside him) was him coming home during the Tech Bubble — which I did not know it as such at the time, nor did he — and saying things like, “Wow, I can’t believe it, my AOL stock doubled again today” as he set his briefcase down and went to change for dinner. He did not work to understand what was going on with the companies he owned and he did not encourage me to be curious about it.
In high school I never took one of those “business” classes where everyone plays the “stock market game” and creates a fantasy portfolio. In retrospect, this is a terrible way to introduce young people to the idea of common stock investing as most learn from it what I learned– it’s “fun”, it’s “random” (the winner was inevitably some kid who got lucky betting on things that happened to go up during the course of the game) and there are no costs if you’re wrong because everyone was playing with funny money. But I remember being disappointed I didn’t get to play, and excited when I realized I could find the website on my own and play on my own time, although I quickly gave up when I realized I had no idea how to pick a stock and was basically just rolling dice.
When I began working over the summers in between school years and accumulating some savings I began looking for yield beyond my bank account. This was during a time where a “safe” money market fund was yielding just over 5% a year. I put my savings with Vanguard’s MMF and felt quite wealthy watching it grow at 5%, not knowing what a money market fund was or why it offered more than a bank account and not knowing that with a little elbow grease I could earn much more than that as a proper stock investor.
Fast forward to sometime in college and I was much more interested in this idea of investing as a discipline. I was becoming aware of the world of finance, likely in part due to my proximity to the global center of it (“Wall Street”), in part because many classmates and friends were talking about it as a career opportunity and in part because my readings and interests and slowly taken me there. I became aware of the hedge fund industry and the idea that people made their living making investments all day long. I decided that sounded pretty interesting to me (much more on this topic in a future post I plan to write) and might be something I’d like to pursue as well.
And somewhere in there I came across a recommendation to read The Intelligent Investor by Benjamin Graham. Which I proceeded to do, but, despite reading the book from cover-to-cover, including the end chapter commentary by Jason Zweig that many people detest but which I think actually adds some value and can even be enjoyed as a standalone reading, I really did not understand much of what I read. And the even greater sin was that I failed to apply what little I understood.
I did not begin searching for Ben Graham stocks. I did not use his principles of risk management in constructing my own portfolio. I did not look for opportunities to spite Mr. Market and buy stocks when he was panicking and sell them when he was giddy. I did not begin looking at stocks as ownership certificates in real businesses. I did not even do any investing beyond my Vanguard MMF! For whatever reason at this stage in my life investing was a purely academic interest.
This began to change as I neared the end of college and was seriously considering a career in finance. Around this same time, I had been reading deeply of Austrian economics and had become convinced, like many who had, that we were on the precipice of a global economic calamity that would start with the housing sector and quickly come to overwhelm the banking sector. I was obsessed with this End Times prognostication and spent most of my time working to understand what was coming and thinking about an investment strategy that would stand to benefit from macro disruption. I was finally ready to take some action and I ended up doing two things.
The first thing I did was to sow doubt about my parents’ equity holdings in their mind, particularly their heavy concentration in the financial sector (prime offender: Citibank), which their broker was convinced was one of the cheapest parts of the market and thus he had increased the total exposure in their blue chip portfolio. I told them the end was coming and they should liquidate everything and go to cash. I was initially unsuccessful, but when the first hiccup in the markets occurred, my dad got worried and decided to at least follow my advice to sell all his financial stocks, including Citibank, his largest position, which the broker bleated about painfully for weeks afterward.
The second thing I did was to follow Peter Schiff’s strategy regarding the Great Decoupling of the United States from the rest of the world, and what better way than to open an account with Schiff’s firm, Europacific Capital, to buy all these great foreign stocks (especially commodity companies and infrastructure businesses) at rich commissions? I put essentially my life savings to date into this account, naively trusted my broker when he told me he’d help keep an eye on the portfolio and recommend trades to me at appropriate times, and chose five companies (“that should be plenty of diversification!”) from a list of about 15 or 20 he pulled for me on a basis that was then entirely arbitrary and is now completely unmemorable for me. All I know is I did not use any of Ben Graham’s principles or ideas and I think I feigned a knowing approach by saying the P/E ratios of the companies I was about to buy out loud, almost like an invocation, but beyond that I had little idea what these companies did, what valuation I was buying them at and how big my Margin of Safety was.
The way the story turned out is my parents were grateful and I was obliterated. I saved my parents a lot of money with the move to liquidate the financial stocks as that blunted most of the pain that was to come. After the markets had tumbled some 20-25% (and maybe about 30-40% of the total move down) they ended up liquidating the rest of the stock portfolio and held on to their high quality bonds, something that I had no opinion on despite reading Ben Graham and being pretty opinionated about most other credits in the market (I could talk your head off about CDOs and what a danger they were long before Michael Lewis wrote any books on the subject) which was a good move as interest rates went ZIRP. They really thought I was a genius and neither of us knew I just happened to be lucky. I should’ve been more clued in by what happened in my own portfolio.
My own portfolio lost a lot. At one point I was down about 70%. America did not decouple from the world and the world did not decouple from America. Everybody rode the coaster down together and because I picked economically sensitive businesses at near peak valuations it was indeed a painful ride. I had no idea what to do other than to just hold on (actually, not a bad response and much better than the typical mistake of panicking and selling to Mr. Market at the worst time). But after about two or three years of waiting after the crisis, my portfolio was still down about 50% and I decided it was time to admit I had screwed up and realize my losses. If I had just been more patient, I might have been down at most 20-25%– a bad drawdown, for sure, but much different in terms of wounded pride and sucked out capital than a 50% permanent impairment; even my crappy picks which had amounted to little more than throwing darts at a stock table would’ve caught a bid like everything else during the Great Global Reflation.
Being massively right in my parents’ case and massively wrong in my own should’ve been a good indication I didn’t know what I was doing. Instead, I took away the lesson that macro investing worked and I might actually be good at it if I could learn how to do it consistently well, and stock picking on the other hand didn’t seem to work because I had picked stocks and that went poorly for me. It was embarrassing, particularly because I had told a lot of people ahead of time what I was doing and why, but I found myself still interested in the subject and wanting to explore it more.
That was hard to do as a career because the aftermath of the global financial crisis made getting a job in the industry almost impossible. I went to work for another large company and made more idiotic macro bets while I bided my time. Somehow I was able to stifle the cognitive dissonance of reading Security Analysis at my desk at work (covered wrapped in a brown paper grocery bag, and only when I had gotten my paid work finished for the day) while buying things like the 3X leveraged short financial ETF in what was left of one of my personal accounts. I have no idea why I was reading Ben Graham’s magnum opus analyst handbook at this time or how I had even heard of it and once again I understood little of what I read despite going cover-to-cover, and applied none of it. I scraped some short-term capital gains on these stupid trades and then gave it all back and then some when my luck ran out. I finally threw in the towel and swore off “investing” for awhile as a personal practice while I continued to be interested in getting into it as a career.
After months of pestering a small global macro fund I had heard about in Texas about an analyst position, they agreed to hire me and suddenly it seemed my dreams were coming true. I was convinced this was just the beginning of a long and successful career as a professional investor and despite my initial failures at investing I was excited to come on board and learn what it was really all about.
It turned out not to be so. I learned little about financial analysis or portfolio management in a positive sense although my time spent with this firm armed me with an abundance of lessons in what not to do. The gentlemen I worked for were extremely intelligent, talented and honest and had made out like bandits during the crisis with their own successful predictions and even more successful operations, but like me they had been fooled by luck and had failed to appreciate that successful investing is a practical exercise, not a moral one. They could not let go of their critical view of economic events and the connection they had to the market and they became as embittered as they were emboldened to soldier on against the forces that be in hopes of teaching the world a lesson in folly.
That they did, but the folly was their own. Sadly, it was my folly, too, because despite seeing that it wasn’t working, I was also rather gung ho about it. I couldn’t figure out HOW to invest like that in my own portfolio, so I was mostly inactive as an investor. I also began work on another project in cognitive dissonance. This time, I had managed to figure out that Ben Graham had a student, Warren Buffett, and that there was all kinds of information out there about Buffett, his life, his investment record and his method for investing and risk management. I began drinking heavily at this fountain while taking another turn at the writings of Ben Graham. I was beginning to wonder if maybe the macro stuff was a dead end and there wasn’t something to this value investing concept. I was thinking about doing it in my own account. My timing was again almost impeccable, but I did not know it!
First though, I decided to pitch my bosses on value investing. Maybe we could balance out some of the short exposure in the portfolio with some of this Ben Graham stuff? There seemed to be a lot of opportunities out there based on some quick screens I ran. That’s when I got the dumpster diving speech.
Value investing is a lot like dumpster diving– every once in awhile you come up with a Picasso, but most of the time you come up smelling like garbage!
And besides, everyone knows Warren Buffett is an asshole and just lucky, he’s been on the side of the establishment which has put the wind in his sails, he got a bailout when his house of cards almost came tumbling down in the crisis and no one has been able to replicate his success, likely because he is working some kind of fraud. You don’t want to go there, kid, and neither will we!
My confidence was completely shot! This turned out to be the second best time to get into value investing besides the March 2009 low itself, but I had just been told this was basically the stupidest idea a person could come up with– and since I hadn’t managed to learn much from them, this was about the only idea I had. I was burned out on them, burned out on my broken dream and burned out on how bad I seemed to be at investing in general. So I called it quits.
I ended up joining the family business while I licked my wounds, egotistical and otherwise. The idea was to have a hideout while I figured out where my next heist would be. I was trying to figure out how to go be an analyst somewhere else but I didn’t know where. It seemed like I needed an education, so I began what I came to call my “Personal MBA” program, an intense, year-long effort of reading everything I could get my hands on about business, finance and investing. I’ve written about that earlier on this blog.
Buffett talks about value investing as something that a person either takes to immediately or rejects outright. While I hadn’t yet successfully employed the concepts in my investment practice, it had clearly infected my mind. The macro thing did not make sense to me at a conceptual level but the idea of studying stocks as businesses and looking for indications of cheapness that lent a margin of safety did. I think this is why I kept pushing on and went through my Personal MBA despite having no track record otherwise.
A few interesting things happened during this time period and shortly thereafter. First, I began doing real research and analysis on individual companies– I built spreadsheets and collected operating data, I read SEC filings and books about industry and company history and began to appreciate what it meant to approach the process of investing like a businessman. Second, I actually made some investments– some net-nets in the US (what remained at this stage in the game), some good companies at great prices and even a wonderful company at an un-fair price and later, a basket of foreign net-nets (my JNet strategy), along with a few special situations and some capital structure arbitrages I was coattailing on with another investor friend. While there were a few flops that either went nowhere or I lost a little on, for the most part my results on an individual investment basis were good to great and a few were even outstanding. Third, I continued believing I had some kind of crystal ball as far as market timing was concerned and I let that dominate my overall investment program– as described at the beginning of this essay, I took small, almost meaningless positions in most of the companies I invested in (aside from the JNet basket) such that when they worked, they didn’t have much of an impact on my portfolio overall and when they failed, they also didn’t have much of an impact. It was an excellent way to have nothing to show for the effort I put into it!
While this exercise helped me to build intellectual confidence, I was still not matching it with practical confidence and I doubted myself a lot along the way. What’s worse, my obligations in the family business continued to compete with my interest and efforts in investment management such that they were not only a serious distraction at times from a more meaningful and concentrated effort in this space but they were also a suitable rationalization for why I couldn’t just go all-in and really commit to my investment activity.
At one point I changed operational roles within our business and finally had no bandwidth to spare for investing. I went functionally inactive on investing for almost two years and decided ahead of time that it would be irresponsible to have the portfolios exposed even the minor amount they were at that point in time (especially because I kept not liking what I was seeing as I gazed into my crystal ball!) while I wasn’t paying any attention to them so I liquidated to concentrate on operational issues full time. Incredible, given that sitting on one’s hands is said to be the hardest part of managing a well-constructed portfolio and I missed out on even more returns, meager as they were, with this decision.
Recently I have returned to a more strategic role in the family business and it is more clear now than ever that we need someone to be working on sound capital allocation for us. The most logical person to do this is me, in part because I was the person to point out the need and in part because I’m the only person with that kind of knowledge base. But do I have the experience?
This is where we come to some of the learnings I have taken away from my journey to date. As I mentioned before, I made some grievous errors early on in my investment career. I violated the first rule of investing countless times and I am lucky to still be standing thanks in large part to my extreme propensity to save which has allowed me to accumulate savings faster than my early rate of depletion. But since that time period, when I have actually applied the value investing framework knowingly and cautiously, my results have been good and within expectation. If I had not been so lacking in confidence and tried to make up for my initial indiscretion by being over-conservative, my investment operations at scale would’ve yielded an agreeable rate of return on the capital employed. Just as I must be honest with myself about my initial mistakes, I must be honest about some of my virtues and I think I can count these decisions as part and parcel.
One standard I tried to live by in my earlier investing was perfection. I often failed to act because I could not be sure of absolutely safety and I had determined that if I ever made another mistake in my investment operations, particularly with regard to the macro environment and crystal-ball gazing, that these mistakes would be unforgivable and would reveal how I was in actuality no better, in a moral sense, than any of the other petty mortals plying this trade.
This is, after much contemplation, an unreasonable standard to try to live up to because it is impossible to act at all under this standard. To be a successful investor, one does not need to be the best– one needs to simply act prudently according to sound methods. But, as my re-reading of Benjamin Graham’s classic text recently helped me to appreciate, one must act. Facing this fact, what can I do? The best I can, is the only answer I’ve found. Given that I know how I made my earlier mistakes, and I believe I understand how I succeeded the few times I did, there is really little risk for me of reprising the role of the vaunted “fuck up artist”.
I’ve also decided to give up my crystal ball and related esoteric knowledge I don’t actually possess. In exchange, I will accept Ben Graham’s portfolio maxim of the 25/75 split, ie, that the maximum exposure to stocks or bonds in one’s portfolio at any one time ought to be no more than 75%, and the minimum exposure ought to be no less than 25%. (And I read “cash and cash-like instruments” as part of the bond allocation, which I think of as “cash yield”.) Having more than 75% exposure suggests a kind of enthusiasm which is, short of a few specific scenarios, likely to involve a speculative-gambling attitude about the future and its risks. And having less than 25% exposure (specifically to stocks) makes it hard to even consider oneself an investor and seems to be evidence of falling prey to crystal ball reading.
This part is really hard right now. “But aren’t we at all time highs for the market?” Yes, we are. It’s very painful to consider that and I feel very nervous about taking the plunge now, so to speak, only to find myself suspended in mid-air as I see the plug being pulled from the pool. I comfort myself a bit by realizing that I am not making a timing “call” in trying to follow this approach, ie, the water is fine, come on in! In fact, I am trying to do the opposite, to resist the temptation of thinking I know and to allow myself an opportunity to take risk, prudently, regardless of what I think of the “market.” The other thing I remind myself is that I will not simply start making investments to achieve some arbitrary portfolio exposure level as quickly as possible. Instead, I now have granted myself “permission” psychologically to invest up to 25% of our capital in appealing opportunities if I should find them. Before, I would’ve had to stop and ask my crystal ball for directions first.
Another thing I’ve learned is that successful investing takes patience no matter what. Even the ideas that worked out well for me on an annualized basis took several years to play out or ripen to their full value. Part of the pressure I used to put on myself in this space was figuring out how I was going to generate X% a year, that year. I didn’t know where to find such an opportunity that was that quick and that safe. It doesn’t exist. Another investment chimera. If I pick safe ideas with a strong upside option and can wait patiently fortune will favor me in time.
There are many people, value investors especially, who have outstanding long term track records who are not Warren Buffett. They are unlikely to be doing something corrupt and they do not have his unique genius. They never seem to have set out for themselves the goal that they must be the best or perfect. They’ve all made mistakes. And they’ve all continued investing in a variety of market conditions, with the wind in their face and the wind at their backs. If they can do it, I can, too.
There are also many obviously lesser people trying their hand at this. They are the gambling fanatics who aren’t even trying to hide it, and the weak minds who have donned the clothing and the diction of the sage investor but do not realize they’re only engaging with the methods at a superficial level. These people are bound for disaster, and yet many of them manage to practice as investors and even confuse other people into letting them run their money. It would be a shame to let the world be dominated by those types and it boggles the mind why they should live with confidence and cheerfully go about their business and I should not.
It has been a long, odd journey to get where I am today. Of course I wish that I had learned these lessons earlier, or in some other way and in so doing to have been spared this trying ordeal to manifest my own confidence. But one of my goals is to learn to live my life without apology or regret and I’ve come to realize that taking the path I took is simply one of the data of my life. I’ve accepted it and I am ready to make good on what I’ve learned by putting the lessons learned to work today, not “when the time is right.” The best time to live life as wisely as one knows how is always today, not tomorrow.
A House Rises 