Every so often there’s an investor who has staying power– people like Warren Buffett or Peter Lynch at Fidelity, whose track records remain strong for decades. Bill Miller, the chief investment officer of Legg Mason Capital Management, seemed like one of those people.
His investments beat the market every year for15 years straight.
But Miller’s fortunes turned when the recession came. He bet big on housing and Bear Stearns. In 2008 his fund went from best performing to one of the worse performing in its class. The fall was complete. Bill Miller, once a star, had failed.
Except, that by 2012, Miller had righted himself. His fund was once again the best performing in its class: the king of mutual funds was back, declared the Wall Street Journal.
Miller’s life hasbeen a lesson for anyone with investments. The stories that dominate coverage are the great trades, the comebacks, the big wins that they focus on.
Here’s the real story of the markets: we all love a success story, but the real story is in the failures.
Failure is a test of resilience, which is the No1 quality required for successful investing.
Professional stock investing, with its sharp ups and downs, can teach us a lot about life. Money brings out the insecurity, fear and irrationality that we might otherwise keep hidden in polite society. Investing isn’t just a test of strategy– it’s a test of character, and what we do when investing is very often what we believe about ourselves.
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Focusing on the negative
For instance, we are predisposed to focus more on the negative. Research has shown that negative emotions are handled differently by the brain. Negative emotions involve more thinking, and we remember them in greater detail, than the positive ones.
In a study that demonstrates the emotions of stock traders, researchers Daniel Kahneman and Amos Tversky looked at what happens to emotion when people lose or gain money. The result: people were more distressed by losing money than they were made happy by gaining it.
Once confidence is gone, it starts to “manifests in long slumps and even depression”, says Dr Alden Cass, a therapist who sees many Wall Street traders in his practice, and who wrote on the subject in his book, Bullish Thinking: The Advisor’s Guide to Surviving and Thriving on Wall Street.
But then there are people like Donald Trump, who, despite many advantages, has had repeat ventures fail, filing for bankruptcy for various businesses four times. However, he kept trying, until he finally hit upon his most marketable asset: Donald Trump the personality. Making himself the product, Trump could finally say he succeeded at business.
Just like there are two sides to any story, there are two sides to any setback.
According to the research of psychologist Carol Dweck, how we handle setbacks comes down to how we attribute failure. In an elegant experiment in 1975, Dweck took a group of school kids who had been identified by their teachers as helpless when it comes to math.
She divided the kids into two groups. One group of kids were repeatedly told that the reason they could not solve the problem was because they had not worked at it hard enough, and if they just kept going they would get there. Those kids started to improve, and solve problems they had never previously been able to master.
The control group of kids, on the other hand, continued to struggle and give up after getting to the hard problems.
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Fear
John C Thompson, chief investment officer at Vilas Capital Management, has lived this dynamic. Thompson worked for his father for 16 years, investing in equity and bond mutual funds. He eventually made the cover of Barron’s – the pinnacle of public recognition for investors.
But the “reality of the business” caught up with him. In 2008, his investments in value stocks– including financial services– were “slaughtered”, he says.
His returns suffered, but Thompson felt that his investing philosophy was still sound. He was willing to take the hit and keep working till he got back to his high returns. But his father “could not handle being wrong,” and told him to invest in index funds or leave the firm.
The reproach felt like a failure. “I had the rug pulled out from underneath me,” said Thompson. Index funds do nothing more than track the market, and they don’t require any investing brains to work.
These days Thompson runs his own fund, outperforming the market, continuing the investment philosophy he developed when growing his father’s fund. His father continues to invest in index funds since the 2008 crisis– getting lower returns than Thompson’s Vilas Capital Management, according to Thompson.
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Success is mine, failure is an accident
When people get frustrated, emotional and react to market events, “it bites them in the rear,” says James Scheinberg, founder and chief investment officer of North Pier Fiduciary Management, who has worked for over 20 years evaluating portfolio managers. During the 2008 crisis, the portfolio managers who panicked and rushed to become more conservative in their investments ended up with the worse returns, said Scheinberg. When Scheinberg is hiring at North Pier Fiduciary Management, he does not look at one good quarter: he evaluates people on a three-year rolling basis.
When investors are not able to deal correctly with that bad bet, they end up seeing the world as “black and white, right or wrong, which sets them up for failure”, explains Dr. Cass, adding that “they never learn to operate in the grays.”
Not being able to operate in the grays of life, leads to traders having “one failure and it becomes a self fulfilling prophesy and creates a feedback loop that everything will be bad,” explains Dr. Cass.
“There is evidence that we attribute our success to abilities and our failures to external factors,” says Brad Barder, Professor of finance and Director of the Center for Investor Welfare and Corporate Responsibility at the UC Davis Graduate School of Management.
But while luck may seem to be this magical quality we all seek, luck is not the answer, says Thompson. “In the short term luck plays a meaningful role, but it plays almost no part in long term results,” he tells me.
For the rest of us who get discouraged after we hit setbacks, whatever our line of work, the good news is that how we view our mistakes can be changed, according to Dweck’s research. Just like the children in her experiment who learned how to not give up in the face of a difficult math problem, it is possible to some degree to rewire our brains, to teach ourselves not to get discouraged. And that change can be very beneficial in all aspects of our lives.
Though when it comes to investing, it pays to be realistic. While professionals like Miller and Thompson can read the market, “skill in stock picking is actually very rare,” cautions Barder. “The bottom line is that index investing is the best solution for the majority of retail investors.”
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