As usual, this spring, the famous investor Warren Buffet (photo) invited shareholders to Berkshire Day; the annual general meeting of his holding company Berkshire Hathaway in Omaha, Nebraska. More than 35,000 shareholders attended, although for the first time the meeting was also live-streamed around the world. They came because they hoped to gain insights into the Berkshire business. But also because they adore Buffett and he likes to divulge some of his wisdom on investing at the AGM. "Stay away from investment advisors!" he advised this time. He is also known for the sentence: "Risk comes from not knowing what you are doing.”
Investors can recall statements like this time and again when making investment decisions. But Buffett is not the only one who explains with poignant remarks how stock exchanges and stockbrokers tick. Professional investors like Peter Lynch or Benjamin Graham and academics like Daniel Kahneman or Eugene Fama have also looked deep into the complex workings of the capital markets and passed on their insights. We introduce 10 grand masters of the stock market and explain their most important lessons.
Eugene Fama was barely 20 years old when he studied Romance languages at Tufts University in Boston. But trudging through Voltaire's texts bored him. So, fortunately for all of us, the grandson of Sicilian immigrants switched to economics. In 2013, at the age of 74, he received the Nobel Prize for Economics - for a paper he had already presented in the 1970s. Fama is the godfather of the "efficient market hypothesis", one of the most important theories in capital market research. In essence, it states that all relevant information is already contained in stock market prices. That is, that the current price is always the best estimate of the true value of a share. Fama thus introduced the idea of herd intelligence into the financial economy.
In the world of markets he outlines, it is pointless to look for promising stocks. No one can take advantage of squeezing corporate balance sheets and checking valuations because prices already reflect all the data and future prospects. Stock-pickers, i.e. money professionals who try to beat the market by sifting out the best stocks, are therefore compared by Fama to astrologers.
I would compare stock-pickers to astrologers, but I don't want to badmouth astrologers.
Nor does he think much of "irresponsible talk" (Fama) about price bubbles. Because bubbles cannot form in efficient markets. Fama even cancelled his subscription to the Economist because the editors had written so often about bubbles. His idea of the perfect market has bitter opponents, and markets are certainly not 100% efficient. However, they are often quite efficient, so Fama's work contributes a lot to the understanding of the stock market.
Daniel Kahneman received the Nobel Prize in Economics in 2002. However, the psychology professor from Princeton University initially researched the topic of how people make decisions. The result sounds disturbing: people use intuition to make obvious but often wrong judgements in order to minimise mental effort. This is explained in the following task:
A bat and a ball cost 1.10 dollars.
The bat costs one dollar more than the ball.
What does the ball cost?
The tempting but wrong answer is 10 cents. Because then the bat and ball together would cost 1.20 dollars. The correct answer is 5 cents. More than half of the students surveyed at the elite universities of Harvard, MIT and Princeton got this question wrong. It's as if there are two systems competing in every brain, one lazy and one industrious, and the lazy one frighteningly often takes command. When it comes to investing money, such misjudgements can have nasty consequences with both professional and private investors being affected.
The most successful funds in any given year are simply the luckiest. They rolled the dice well.
However, Kahneman gives professionals a particularly bad review. For they also suffer from an "illusion of competence" - another result of his studies. In his book " Thinking, Fast and Slow", Kahneman describes how an asset management company for very wealthy clients once gave him a list of the annual profits that 25 advisors had achieved over a period of eight years. Kahneman wanted to know if some of these advisors were particularly good. So he calculated the correlations between the rankings that the money professionals achieved in different years. The correlation was almost zero. The returns achieved fluctuated randomly. Over the eight-year period, there was not a single advisor who stood out.
Such a result would be expected "in a game of dice, not in a game of skill", Kahneman writes. Of course, the advisors didn't want to know anything about that, they ignored the result. This is an attitude that the Nobel Prize winner has also observed among fund managers. Hardly any of them manage to beat the market in the long run (see also John Bogle below). According to Kahneman, it is a misconception to be able to beat the market by selecting stocks. For him, it is therefore clear that those who fill their portfolio with actively managed funds are not doing themselves any favours.
Just copy the index - John Bogle revolutionised the financial industry with this recipe. He launched the first index fund 40 years ago with his investment company Vanguard. An index fund replicates a stock market barometer such as the DAX or the S&P 500. Today, these funds are known by the abbreviation ETF and around 3 trillion US dollars are invested in these securities worldwide.
Don't look for the needle in the haystack, just buy the haystack.
It took a lot of stubbornness to help index funds achieve their success. And Bogle, who died in 2019 aged 89 years old, undoubtedly deserves a lot of the credit. In interviews and articles, he raged against the investment industry, which in his view primarily lined its own pockets instead of increasing its clients' money. Specifically, he accused money managers of charging investors far too high fees - with the spurious justification that in return they always have the most promising stocks in their portfolios. Bogle calls this "witchcraft".
Numerous studies prove him right and Bogle concludes that it is no use looking for the needle (read: share) in the haystack (read: index), as active fund managers do. It is better to buy the whole haystack, also known as passive investing. Ever since Bogle launched his low-cost index funds, this approach has also been available to investors with small investment sums.
Warren Buffet's success story began with a misstep. At least, that is how the star investor himself sees it. In 1965 he took over the majority of the textile company Berkshire Hathaway but business was miserable. Despite several attempts to get the unprofitable company back on track, Buffett had to close down the textile business. The Berkshire deal turned out not to be a failure due to the fact that Buffet had already taken over several insurers at that time. Berkshire thus became a holding company that had already invested in dozens of well-known companies: from Coca-Cola to Goldman Sachs to IBM. And because Buffett, whose fortune is estimated at 65 billion dollars, increased the value of the company by an average of more than 20 percent annually over 51 years, he has risen to become the most famous investor of all time. Every year, tens of thousands of investors make a pilgrimage to the Berkshire annual general meeting in Omaha in the US state of Nebraska.
Don’t ask the barber whether you need a new haircut
Buffett provides insights into his profound knowledge of the capital markets in the Berkshire shareholder letter - and with snappy sayings, such as the one about investment bankers and barbers (see above). In this amusing quotation, Buffett points to the conflict of interest in which financial professionals find themselves. They and their employers - banks and brokerage firms - earn handsomely when investors frequently shift their portfolios and make new investments. After all, they collect fees for every purchase and sale. So it stands to reason that the recommendations of the commission-driven advisors should constantly tempt the investor into action.
In 1939, 27-year-old John Templeton submitted an unusual order to his broker Fenner & Benne in New York: "Buy me $100 worth of every American stock that costs less than a dollar." Normally, the trader would have refused the instruction. But because Templeton had previously worked as an apprentice at Fenner & Benne, the broker placed the orders. What Templeton got was a motley portfolio of 104 companies, many on the verge of bankruptcy. But that was exactly what he wanted: to bet that the majority of the companies would recover. 34 of them actually went bankrupt. But because the others got their act together, Templeton was able to quadruple the 10,000 US dollars he had invested in just four years. He used the money to build his own investment company, which he sold to the Franklin Group in 1992.
The only investors who shouldn't diversify are those who are right 100 percent of the time.
Templeton died in 2008, but his guiding principles are still worth reading. His coup with penny stocks - the name given to shares costing less than a dollar - only worked because he followed one of his most important principles: Diversification. The term refers to spreading one's invested money over many securities so that the price gains of one stock can offset the losses of another. If Templeton had only bet on one stock, there was a probability of 33 percent that he would have lost his entire stake - a complete gamble. But through his diversification strategy, the gains on two-thirds of the stocks far exceeded the losses from the bankrupt companies.
Of course, diversification into 100 penny stocks still involves a lot of risks. That is why investors should spread their money across different asset classes such as shares, bonds, real estate and commodities and, on top of that, diversify regionally. This is all the more true as financial markets today are highly interconnected - and assets show a kind of tendency to crash en masse. In other words, in times of crisis, correlations often spike, while at the same time security prices plummet. This does not mean that diversification no longer works. On the contrary: anyone building a portfolio today should diversify their assets even more, for example with the help of ETFs, in order to benefit from the positive effect of offsetting losses & gains.
Financial advisor, publicist, neurologist: William Bernstein has practised many professions simultaneously. As a financial advisor, he looks after wealthy clients with assets of more than 25 million dollars. As a book author, he makes unwieldy topics such as asset allocation or retirement planning accessible to a large circle of readers. Vanguard founder John Bogle is one of his role models. "Without his support, I probably wouldn't have managed to write about investing ...and without Vanguard, I would be much poorer," says Bernstein.
Asset allocation is the only factor affecting your investments that you can actually influence.
For Bernstein too, Wall Street's financial institutions thrive primarily at the expense of the ordinary investor. "You are in a life and death struggle with the financial industry," he warns his readers. "Every dollar in fees you pay comes directly out of your pocket." This makes it all the more important, he believes, to follow a few basic rules when investing. The focus should be on low costs and asset allocation, i.e. the proper distribution of assets across different asset classes. Of all the factors that determine the performance of a portfolio, the investor can only control the asset allocation. This is because market timing and stock picking do not lead to success in the long run. And all external events - the next bank crash, the next technological revolution or the strength of the US dollar - cannot be influenced by individuals anyway.
From caddy to fund legend - this could be the header for the curriculum vitae of Peter Lynch. In 1966, Lynch, who had studied history, philosophy and psychology, joined the fund company Fidelity. He got the job because he worked as a caddy on a golf course where he met the then Fidelity president D. George Sullivan. Thus began Lynch's rise. In 1977, he took over Fidelity's Magellan fund. When he stepped down as manager 13 years later, Magellan had grown from $18 million to $14 billion. During that time, Lynch had generated an average return of 29 per cent per year - about 18 percentage points more than the S&P 500 (including dividends). Whether he was simply very lucky, a real high flyer or a little bit of both, remains to be seen. In any case, the 72-year-old is one of the very few fund managers in stock market history who managed to outperform the index over the long term.
Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.
For Lynch, patience was one of the most important keys to stock market success. His statement that you have to ignore the worries of the world in order to be successful on the stock market (see above) seems more relevant than ever in times when information is always just a click away. Whether Brexit, the euro crisis or the cooling of the Chinese economy: those who follow the headlines in the media always get the impression that economic collapse is imminent. Only those who remain true to their investment strategy amidst this news hubbub can make it in the stock market over the long term. This is enormously difficult, because people act quickly when they see themselves (or their investments) threatened. But reacting emotionally to financial market events is counterproductive.
The best investment book ever written? If you ask Warren Buffett, you will get a clear answer: "The Intelligent Investor" by Benjamin Graham. Buffett allegedly read the book on his honeymoon. And not only that: Buffett also studied with Graham and worked for two years in his company, the Graham Newman Corporation. Who was the man who trained Buffett to become arguably the most successful investor of all time?
Benjamin Graham, who died in 1976 at the age of 82, is considered the forefather of securities analysis. He identified fundamental variables such as dividends, liquidity, earnings growth and book value as important valuation criteria. Today, they are immediately incorporated into share prices. It is no coincidence that it was Graham who introduced these ratios into stock market analysis as he gathered some key relevant experiences throughout his investment life. He began his Wall Street career as an errand boy at the brokers of Newburger, Henderson & Loeb. For a few dollars a week, he wrote securities prices on a blackboard. In 1929, when he was already running his own investment firm, he experienced the stock market crash and then the Great Depression. He had to watch many investors fall into ruin because they had blindly bet on shares. He almost went bankrupt himself. Graham therefore wanted to put equity investment onto a quantitative foundation.
The essence of investment management is the management of risks, not the management of returns.
He was also far ahead of his time in another area: risk management. Graham recognised early on that successful investors do not have to manage returns, but risks. An idea that is still valid today, but which hardly any money manager has successfully implemented. On the contrary, so-called risk management usually follows the same pattern. When the stock market is creaking, the portfolio manager shifts a few percentage points of the equity positions into bonds. Once prices have risen again, he turns the tables. Those who practise risk management professionally must clearly quantify the risk of loss and adjust the weighting of the securities accordingly. In doing so, it is important to take into account the latest findings of stock market research. This is the only way to keep the risk of financial markets under control.
James O'Shaughnessy is also a pioneer - in the field of rules-based equity investing. He has analysed large databases to test dozens of investment strategies, going back to 1926. He published the results in his book "What Works on Wall Street", a 680-page tome first published in 1997. Even if, unlike O'Shaughnessy, we are convinced that you can't beat the market by picking stocks, the US asset manager has made an important advance by bringing quantitative investing to a wide range of investors. O'Shaughnessy has analysed huge databases such as Compustat and CRSP (Center for Research in Security Prices) and always invests with a strictly rules based approach, i.e. according to an algorithm in order to eliminate instinctive and emotional decisions.
Models are never moody, never fight with their spouse, are never hungover from a night on the town, and never get bored.
For humans, this is almost impossible. Those who are exposed to the daily flood of news and their resulting emotions, will usually throw their investment strategy out the window. That's why O'Shaughnessy relies on computers, which have "no moods", as he says. Today, computers can make a much greater contribution to investment success. For example, Monte Carlo simulations can be used to run through tens of thousands of scenarios of the future performance of a portfolio in a very short time and derive accurate risk forecasts. Such methods can be used to control the risk of a portfolio, which protects investors from large price declines that are emotionally difficult to bear.
"I have travelled alone so often and for so long that I no longer mind at all," Benoit Mandelbrot once said. And there is probably no better way to sum up the life of the mathematics professor who died in 2010. He worked in many fields of science: theoretical physics, meteorology, aeronautics and neurology, to name but a few - and of course finance. Mandelbrot has always distanced himself from the mainstream, often antagonising the established scientific establishment. Depending on whom you ask, he is regarded as a self-promoter, a maverick or a universal genius.
The financiers and investors of the world are, at the moment, like mariners who heed no weather warnings.
Mandelbrot waged a particularly fierce battle in the financial industry. He accused the money industry of adopting obviously false scientific theories in their models. His criticism was directed above all against the normal distribution assumption. It states that the daily price jumps on the stock market follow the pattern of the Gaussian normal distribution. What is "normal" about this distribution is that large price jumps up or down almost never occur. Under this assumption, the Dow Jones Index should only fall by more than 5 percent in one day out of every 3,500 years. The naked truth is, however, that such price falls occur on average every 20 months. The stock market is therefore much rougher than the normal distribution would suggest.
Mandelbrot first pointed this out about 50 years ago. Nevertheless, this fact is still ignored by the majority of money managers today. In their risk models they still assume a "soft" stock market - simply because it is much easier to calculate. Mandelbrot therefore compared the financial professionals to seamen who build their ships as if there were no heavy storms. Those who entrust their money to an asset manager should in any case make sure that their risk model is up to date with the latest financial research.
Everyone who owns assets thinks about how to invest them. Whether they manage it on their own, leave it to their bank or use one of the new online managers. When making a decision, it can help to remember the insights of the 10 grand masters. You should question your emotional stability in stock market transactions and distrust commission-driven financial advisors who pretend to know which stocks and markets will gain the most. One thing is certain: stock market prices cannot be predicted. The famous physicist Isaac Newton already suspected this. In 1720, he gambled with shares of the South Sea Company in one of the biggest speculative bubbles in history and lost 20,000 pounds. His conclusion: "I can calculate the motion of heavenly bodies, but not the madness of people."