Lessons from Buffett’s Partnership on Measuring Investment Results

The emerging field of behavioral finance offers valuable insights into how our actions – whether innate or acquired – can be powerful impediments to optimizing our investment results. For example, we have all heard anecdotally that people are reluctant to open their brokerage statements during a bear market and prefer to simply let the unopened envelopes stack up – perhaps we’ve done it ourselves. This behavior is potentially suboptimal because it may impede taking action in the account that would obviously – from a rational viewpoint – improve our results.

It appears this tendency is widespread and strong. Nachum Sicherman, a professor of Finance and Economics at Columbia has been studying the behavior of about a million account holders at Vanguard. Without knowing the identity of Vanguard customers, which Vanguard carefully safeguards, Sicherman is able to see when people login, how long they stay online, and what they do. His data confirm that when markets are down, the frequency of checking accounts goes down, and that precisely the opposite happens when markets go up.

To be a successful investor it is important to take steps to try to overcome those behavioral tendencies which are counterproductive. We need to find simple ways to overcome our limitations much like we do in other areas, for example, leaving a Post-It note on the door so we don’t forget something the next morning or making a grocery list so we don’t forget an important item. One simple way to improve our investment results is to measure them, which is all the more important if you are an active investor trying to beat a particular benchmark.

The reason for being an active value investor (in contract to a passive investor who buys an index fund) is to outperform readily available alternatives for your capital. If you cannot do this over time, you should probably “hang it up” and either put your money in an index fund or with a select investment advisor who not only has a good track record, but also, and more importantly, has a solid investment process and discipline in place.

Not measuring your investment results makes you susceptible to a number of misjudgments.

Self-deception and denial. This is wishful thinking and not accepting reality. Buffett tells us that, “Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience–a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.”

Status quo bias. This is what author Peter Bevelin calls the “do-nothing syndrome – keeping things the way are. Includes minimizing effort and a preference for default options.”

Overoptimism tendency. This is the tendency to simply think you are doing better than you actually are.

I suggest a simple system of measuring your own results based on how Buffett did it when he ran his partnership.

Select an appropriate objective, such as beating the S&P500. For Buffett, it was to achieve a long-term performance record superior to that of the Dow Jones Industrial Average. Buffett selected the Dow because it was widely known and, in his view, representative of investing alternatives available to his partners. Note that some value investors, such as Seth Klarman, prefer an absolute return as a benchmark, rather than a relative benchmark such as beating a given index.

Look at results every six months to see how you are doing. Track both performance for the six-month period and cumulative performance. The cumulative performance figure is useful because it reinforces how small differences in a given period add up to big differences over time.

Allow at least three years before you judge the results. The short term movements of stocks can be highly volatile and random, being driven by the psychology of market participants. It takes a meaningful period of time to judge if your investment approach is truly adding value. Here’s Buffett from his January 18, 1963 partnership letter: “While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.”

Compare yourself to other value investors. In addition to your benchmark, compare yourself to a handful of respected value-oriented equity funds such as Longleaf Partners, Fairholme and Dodge & Cox.

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