Why following successful investors can lead to failure

Let’s say you want to know how to become rich or how to become a good investor. What would you like to do?

The logical way to do this seems to be to look at the richest people in the world or the most successful investors, study the techniques they used, and apply them to your own life.

Seems logical, doesn’t it? If you want to succeed in the markets like Warren Buffett, Rakesh Jhunjhunwala or Ray Dalio, for example, you just need to study and replicate their methods. It seems simple enough.

In fact, this strategy is not logical at all! There are some inherent, major logical errors here (several of them, in fact) that can lead to completely wrong conclusions.

Before we jump in, the examples chosen here are simply chosen based on which investors and their methods have been extensively well-studied, i.e. basically the best known methods. They were never chosen to prove a point or exemplify the ‘worst in the category’.

First, are they buying the kinds of stocks you think they are buying?

Ask any follower of Warren Buffett to elaborate on what types of stocks they buy, and I’m sure they can give you a checklist. Mainly a steady business with a great brand, predictable cash flow that can be predicted decades into the future, with: They might add that they don’t buy businesses they don’t understand or are vulnerable to technological change. All of these are ‘principles’ extracted from writings about him. Coca-Cola was one of his big businesses. The holdings are illustrative of these types of stocks. (It’s another matter that Coca-Cola has underperformed significantly for 30 years.) Let’s take a look at what stocks he actually owns.

As I write this in early 2024, nearly 50% of Berkshire Hathaway’s total investments are in a single stock: Apple.

Does Apple really fit the bill? Of course, it plays a dominant role in mobile phones and certain devices. At least on the higher end models. But can anyone say with any degree of certainty what that business will look like at an industry level in 10 or 15 years?

When it comes to dominance, there was a time when Nokia and little BlackBerry were considered unbeatable in the devices business. Now it has disappeared into the dustbin of history.

Now that artificial intelligence and many other new technologies are advancing so rapidly, who knows who will be the biggest winner in the next round? As technology has advanced over the last few decades, it is very rare for the winner of one round to remain the leading player in the next round.

And Apple is not the only example. Berkshire Hathway has invested quite extensively in derivatives, structured transactions, etc. for many years. And often it makes a lot of money.

This isn’t the value stock everyone thinks they’re buying. Favorite deals like Goldman Sachs after the 2008 financial crisis and later Bank of America are examples of this.

In fact, Warren Buffett’s folksy and quirky image allowed him to succeed in transactions that would classify others as eagles or sharks. He always smells water when there is blood around him.

Is the holding period what you think it will be?

Again, ask anyone who follows Buffett how long they think he holds on to stocks. The answer is that his favorite holding period is forever. He considers himself a part owner of the business and has no intention of ever selling.

reality? Most of the shares Berkshire purchases are sold within a year. More than 60% sell within four months and nearly 90% within two years.

The proportion of stocks held for more than 10 years is less than 4% based on the number of cases. This is data based on a study conducted on all activities from 2006 to 2015. (‘Overconfidence, Underreaction, and Warren Buffett’s Investment’ study by John S. Hughes, Jing Liu & Mingshan Zhang)

So the holding period is not forever. In fact, in one of his interviews, he made it clear that he meant the ‘hold forever’ mantra only for companies in which Berkshire is a majority shareholder. This is obviously only a small portion of the holdings. And this is actually making a virtue out of necessity. Because unless he makes a strategic sale, Berkshire is unlikely to get out of that business.

Are the results that great?

Another fact that we accept as a matter of faith without actually verifying the data is that certain investors such as Warren Buffett/Charlie Munger and Ray Dalio are ‘successful’. But what does the data actually show?

Berkshire Hathaway, which was Warren Buffett and Charlie Munger’s show, failed to beat the S&P 500 not just for one or two years, but for 10 and 15 years through March 2023. This is the latest point where data is available for Dalio’s Bridgewater. This should have provided alpha for their openly risk-averse strategy despite a massive collapse in US markets in 2022.

While Berkshire’s results were at least somewhat in line with market returns, Dalio’s Bridgewater has, frankly, had a very miserable performance for a long time. The fund has compounded only 5.7% over 15 years, compared to 10.1% for the S&P 500. This means that $100 invested in the fund 15 years ago would have grown to $230 instead of the $424 the same amount would have reached. I invested in the S&P 500.

But the shine of a smart and successful person continues around these names. Because they can tell stories.

Do you really understand how value is defined?

Many of the well-known investors I’m talking to are considered value investors, and I think most people in the public markets know what value investing means. That is, it mainly involves buying stocks at low prices to make a profit or book at low prices.

However, this is too limited a definition of value and cannot be said to be a portfolio dominated by low valuation multiples or value stocks when Apple is the top holder, as you can see in the example above.

What’s interesting is that Benjamin Graham is considered the patron saint of value investing. But with each book he wrote, he continued to refine his definition of value, and in subsequent editions he talked about the increasing contribution of intangible assets such as brands and technologies. To the company’s values.

The article itself was written almost half a century ago, and I’m sure he would have redefined what values ​​are if he were alive. But I think people understand what the value is by just looking at the key or Cliff Notes version without going into the depth of what he wrote.

More importantly, Graham made almost all of his money from the insurance company Geico, not the value stocks he was associated with!

It’s all about timing!

We also preach a lot about failing to time the market, quoting famous investors. But the success stories of well-known investors are almost always a function of how long they were in the market.

In India, if you had invested in Sensex in 1980, 100 rupees would have become worth about 700 rupees in 10 years. In 10 years from 2010, there are only 230.

If we look at well-known US indices, we see the same pattern, with very marked differences in compound interest calculations not only for individual years, but also for decades. So the S&P 500 rose 4.7% in the 1960s, 4% in the 1970s, 9.3% in the 1980s, and nearly 15% in the 1990s.

Even over a 20-year period, if you had invested $100 in the S&P 500 in the early 1960s, it would have gone up by only $230 over the 20 years through 1980.

But over the next two decades in the 80s and 90s, stock investments increased nearly tenfold, which seemed great to some investors and fund managers.

It was a time when investors like Warren Buffett saw the greatest effects of compound interest. Not only that, the opportunity thrown in has made others, like Fidelity’s Peter Lynch, look outstanding.

As a side note, my respect for Lynch lies less in his stock-picking skills than in the fact that he recognized that the 14-year super run he had with the Magellan Fund could not and would not be replicated. The peak of his game was still in his 40s.

Not only do markets compound at different rates for decades at a time, but different types of stocks perform well at different times.

Many of the people who taught you the business buying philosophy you understand (for example, Peter Lynch talks about buying the company whose pantyhose his wife loved), great brands, predictable cash flow, etc., came from books written in the 1980s. I’m just following the content like a parrot. Stocks that perform.

The truth is, no sector can outperform forever. This applies even to well-established consumer goods companies. In India alone, there have been decades of steady FMCG (fast-moving consumer goods) companies like Hindustan Unilever and Nestle India significantly underperforming the market.

Now we know that the investor you respect may not actually be holding the kinds of stocks you think they are, their holding periods may be very different than you think, and worse, their results may not be anywhere close to spectacular levels. I know it might not be possible. You’ve earned market-beating returns than you ever thought possible.

In short, their money may be made very differently than public perception and may have a little more to do with what phase of the market they capture.

But there is something much more fundamentally wrong with the very question we started with.

Let’s say these investors have had great success over the past 10 or 15 years, but there’s still something fundamentally wrong with the question we started with.

If you want to become rich or successful, should you first follow the methods of the richest and most successful investors?

To understand the flaws in this reasoning, you need to read the second part. Get out in a few days.

Note: This is Part 1 of this column series.

(Disclaimer: Expert recommendations, suggestions, views and opinions are their own and do not represent the views of The Economic Times.)