The Pitfalls of Early Success – A Personal History
Reflections on two decades of investing
“Success makes people think they’re smart. That’s fine as far as it goes, but there can also be negative ramifications.”
— Howard Marks
The investing profession tends to attract individuals who, to put it politely, have a healthy sense of self esteem. After all, anyone who actively invests is essentially saying that their views regarding investments are superior to the collective wisdom of the rest of the market. Without this underlying belief, it would not be possible to think that one can outperform a passive index and it would make no sense to spend a career pursuing superior performance. However, investors often get into trouble when they permit a healthy self esteem to evolve into arrogance and hubris that allows no intellectual room for the possibility of being wrong. There is a huge difference between conviction in one’s skills and delusions of infallibility.
Contrary to what many may wish to believe, random luck plays a major role in one’s life experiences and prospects for overall success. As Warren Buffett often says, he won the “ovarian lottery” by being born into a successful and prominent family in the United States in 1930. His unusual numeracy at a young age served him extremely well whereas it would have been of limited value had he been born into a small hunting and gathering tribe in Africa in 3000 BC. His success is a combination of the circumstances and timing of his birth, his innate intelligence, and hard work. Only the hard work was under his direct control.
Howard Marks makes many important observations in his latest book, Mastering the Market Cycle, but perhaps the most intriguing points have to do with the role of human nature and emotion. Chapter 16 deals with the cycle in success, much of which has to do with human nature. The seeds of failure are often planted during periods of success due to the extent to which our mentality changes when we are doing well. To the extent that success makes us arrogant, we are more likely to tune out evidence contrary to our own beliefs without a thorough examination of the facts. We always need to remember that when we make the decision to buy or sell an investment, we are making an affirmative statement that we know more than the market and that even though the market often seems “crazy”, it is made up of thousands of investors just like us who are trying to achieve the same objective – outperformance. We must always be thinking about what makes our views better than the market consensus – in other words, what is our edge?
Warren Buffett was born in 1930 and came of age during the post World War II boom and inflation and the subsequent economic expansion of the 1950s. These early experiences shaped his outlook and also presented him with a set of opportunities. Would his career have been different if he had been born in 1910 rather than 1930? He would have come of age right at the tail end of the 1920s boom and his formative experiences would have been in the context of the Great Depression rather than the post-war economic boom. What if he had been born in 1950 rather than 1930? He would have come of age during the turbulent late 1960s, possibly have been drafted into the Vietnam War and, from an investing perspective, would have started out in the Nifty Fifty era followed by the dismal 1973-74 bear market. It is likely that Mr. Buffett would have joined the ranks of the super rich no matter which era in the 20th century he was born into, but being born in 1930 probably was an advantage over being born 20 years earlier or later. Of course, we will never know for certain.
Clearly, the timing of one’s career plays a big role in the type of opportunities available. However, the experiences of a particular era probably have an even greater impact on how we see the world. In the context of the stock market, if we start out in a bull market, we are likely to see the world much differently than starting out in a bear market. Furthermore, if we have early success in any type of market that was really the product of luck rather than skill, we are almost certain to attribute this success to skill anyway and draw the wrong conclusions from the experience. Those incorrect conclusions could very well lead to extremely negative consequences. As Mr. Marks says, “success isn’t good for most people”, especially if that success is due to luck rather than skill.
Would you rather have a string of successful outcomes early in your career, or is it better to be tested with various types of adversity? Obviously, early success can be much more pleasant. And certain individuals will just give up if there is too much early failure. However, we need to keep in mind that from an investing perspective, most individuals have much less to work with early in their career. Granted, small amounts of money early in life can potentially compound into huge sums later on so decisions at an early age are important. However, there is also something to be said for making a major mistake with $10,000 of capital rather than $10 million at stake.
As a member of Generation X who was interested in making money from a very early age, I was clearly impacted by the economic boom of the 1980s and, although I had no money invested in stocks during the 1987 crash, I still remember watching Wall Street Week on the Friday after the crash. Louis Rukeyser’s opening is still worth watching today. Having no real understanding of stocks, my natural reaction was amazement that so much money could be lost in the blink of an eye and I had no desire to lose my morning paper route and after school job earnings. However, the crash was fascinating enough to get me to follow stocks and eventually major in finance in college.
My first venture into investing was the Vanguard Wellington fund sometime in the early 1990s. Wellington was one of the oldest mutual funds in existence which, along with its “balanced” portfolio seemed like an appealing place to put some money. However, it was boringly conservative by the time I graduated in 1995 armed with what seemed like “all the answers” that I needed to outperform. I decided to take higher paying work in software with the idea that I would live frugally and invest my savings. By the mid 1990s, the technology boom was well established but had not yet reached the insanity of the late 1990s, and I was immersed in the technology world since I worked in software in the Silicon Valley. I sold my mutual funds and went to the library to read Value Line on Saturday mornings, but 60-80 hour weeks in software limited my free time. Eventually I purchased Intel stock and let it ride for a number of years. I also purchased real estate and benefited from the late 1990s housing boom in the Silicon Valley.
Having the good fortune to read The Intelligent Investor and Buffett: The Making of an American Capitalist in 1995 made a lasting impression and allowed me to see the bubble of the late 1990s for the insanity that it was. I was not tempted to purchase dot com stocks and when the value of my Intel stock rose spectacularly, I was not blinded by that success and kept an eye on the valuation. Through a combination of luck and thanks to Benjamin Graham, I sold my shares of Intel in early 2000. My reading about Warren Buffett’s career as well as the decline in Berkshire Hathaway stock led me to put the proceeds of my Intel sale into Berkshire in February and March 2000. My second purchase of Berkshire stock, on March 9, 2000, represented perfect timing. I had come very close to nailing the bottom tick and had substantial paper gains after the annual report was released shortly after my purchase. Although I’ve made plenty of subsequent mistakes, I still hold those original shares of Berkshire that were purchased with nearly perfect timing. I did not nail the timing of the Intel sale quite as well but a year later I felt like a genius for sidestepping the large decline in Intel shares. The combination of avoiding loss by selling Intel and achieving gains in Berkshire was the mental equivalent of taking drugs: I viewed myself as an investing genius for many years thereafter.
A heavier workload in my software career put me on the investing sidelines for the most part for several years but I continued to save the majority of my income and opportunistically purchased Berkshire Hathaway shares when they looked attractive, and also sometimes when the shares were not that attractive. Nevertheless, I posted a respectable overall record during the period leading up to the 2008-09 market crash. The combination of returns on my investments, new savings and the sale of another real estate property caused my portfolio size to be far larger as I approached the 2008 crash than it had been in 2000. My success in early 2000 was real, but partly due to luck and only partly due to my insights from reading Graham and Buffett. But whether due to skill or luck, my capital base was tiny in 2000 compared to 2008. The “genius” of my moves in 2000 on a small capital base made me feel invincible with a much larger capital base in 2008.
My results in 2008 were horrific but I still managed to beat the S&P 500 by 8 percent. Although the magnitude of my losses were great, I was still “winning” relative to the market averages and I finally went into investing full time almost exactly at the early 2009 market lows (which is also the time when I launched The Rational Walk). I had every reason to believe that I had substantial skill due to my track record and while I was not oblivious to the role of luck, I viewed skill to be the paramount factor in my historical success.
In retrospect, it seems obvious that early 2009 was a time to buy, and it also seems obvious that at that type of inflection point in a market cycle the biggest gains would accrue to those who aggressively purchased leveraged companies that were viewed as being at risk of bankruptcy but subsequently pulled through. In other words, it paid to be very aggressive at that time. My decision was to become increasingly conservative. Part of the reason had to do with becoming a full time investor. I knew that I would have to live off my investments so my level of risk aversion increased at precisely the time that I should have become more aggressive. However, I also believed that greater bargains would likely be available later. I thought that the market had further to fall.
The short story is that I underperformed the S&P 500 by nearly 21 percent in 2009. I missed one of the greatest buying opportunities of my lifetime and did so with a capital base far greater than I had in 1999-2000. The experience of 2009 forced me to reassess my strengths and weaknesses and to be more introspective regarding my abilities. I did not reflexively lose all of my confidence but I had more humility at the end of 2009 than I did at the beginning. I went back to the basics and re-read Graham, studied Buffett and his letters to shareholders, and fundamentally sought to learn from my experience. I went on to post respectable performance in subsequent years, but I will never have 2009 back and the drag from the underperformance of that year cannot be undone.
In retrospect, my early success with a small capital base in 1999-2000 resulted in a level of overconfidence and hubris that made me think that I had the ability to time the market in 2008-09. After all, I had almost perfectly timed my purchase of Berkshire in 2000 so I must have had a “knack” for these things. The early success on a small capital base played an important role in a major failure in 2009 on a much larger capital base. Earning returns in 2009 of less than 6 percent when the S&P 500 rose more than 26 percent is a mistake that cannot be undone but one can learn from such experiences and seek to improve in the future. Ultimately, we are products of our experiences as well as luck. Sometimes what seems like good fortune, in the form of early success, can actually be worse than the reverse. Had I encountered more adversity in 1999-2000 with a small capital base, perhaps my results with much more capital in 2009 would have been better.