In the world of finance and investing, we often hear about the spectacular successes of legendary investors. Their stories of turning small investments into fortunes captivate our imagination and inspire us to try our hand at the stock market. However, what we don't often hear about are the colossal mistakes these same investors have made along the way. In his book "Big Mistakes," Michael Batnick pulls back the curtain on some of the biggest financial blunders made by the most renowned investors in history.
Introduction
Investing is a complex and often unpredictable endeavor. Even the most successful investors have made significant errors that have cost them millions, sometimes billions, of dollars. By examining these mistakes, Batnick offers valuable lessons for both novice and experienced investors alike. The book serves as a reminder that no one is infallible when it comes to investing, and that learning from others' mistakes can be just as valuable as studying their successes.
The Fallibility of Investment Methods
One of the key themes in "Big Mistakes" is that no investment method or technique is foolproof. Batnick illustrates this point through the story of Benjamin Graham, widely considered the father of value investing.
Benjamin Graham and Value Investing
Benjamin Graham's book "The Intelligent Investor" is often hailed as the most influential investment book ever written. Warren Buffett, one of Graham's most famous disciples, has called it "the best book on investing ever written." Graham's most significant contribution to the field was the concept of value investing.
At the core of value investing is the observation that a company's stock price often fluctuates more than its intrinsic value. This discrepancy occurs because humans, with their emotions and biases, set prices, while businesses determine values through factors like revenue, assets, and future potential.
Graham noticed this phenomenon during the 1930s when he watched General Electric's valuation plummet from $1.87 billion to $784 million in a single year. He realized that nothing catastrophic had happened to the company's fundamentals; instead, it was investor sentiment driving these dramatic price changes.
The Limits of Value Investing
Despite the power of his insights, even Benjamin Graham couldn't create a foolproof formula for beating the market. His philosophy nearly ruined him during the Great Depression. After observing skyrocketing prices in the 1920s, Graham sensed that prices and values were out of sync. He decided to bet against the market, predicting a fall in prices.
While Graham was correct about the direction of the market, he severely underestimated the extent of the fall. By 1930, the stock market had taken a significant hit. Graham, assuming the worst was over, began investing heavily again. However, prices continued to fall, and the market didn't reach its bottom until 1932. By that time, Graham's portfolio had lost 70 percent of its value.
This experience demonstrates that even the most well-thought-out investment strategies can fail in extreme market conditions. It's a stark reminder that while understanding value is crucial, investors shouldn't rely on it as an infallible guide. As Batnick puts it, "Cheap can always get cheaper."
The Importance of Risk Management
Another crucial lesson from "Big Mistakes" is the critical importance of managing risk in investing. Batnick illustrates this point through the cautionary tale of Jesse Livermore, a legendary trader known for both his spectacular successes and devastating failures.
Jesse Livermore's Rollercoaster Career
Jesse Livermore, born in 1877, moved to New York at age 23 and quickly made a name for himself in the stock market. In his first week as a stockbroker, he made an impressive $50,000. However, his early success was followed by a series of disastrous miscalculations.
In 1901, Livermore shorted 1,000 shares each of U.S. Steel and Santa Fe Railroad stock. Shorting is a risky strategy where an investor bets on a stock's price declining. If the price rises instead, the investor loses money. Unfortunately for Livermore, the prices of these stocks rose, and he lost his entire fortune of around $50,000. He was left not just broke, but in debt to his employers.
Undeterred, Livermore worked to repay his debt and returned to New York to start trading again. Over the next few decades, he experienced dramatic ups and downs, making and losing millions of dollars. The 1929 stock market crash created the perfect environment for Livermore's skeptical approach, and he amassed a fortune equivalent to $1.4 billion in today's money.
The Dangers of Excessive Risk-Taking
However, Livermore's success was short-lived. When the stock market hit its lowest point in 1932, it had fallen so far that a rebound seemed likely. Indeed, days later, the market experienced its most significant bounce in history, with the Dow Jones Industrial Average surging 93 percent in just 42 days.
The problem was that Livermore had bet his capital on further losses. This miscalculation crushed him financially. In a desperate attempt to recover, he reversed his position, hoping stocks would continue to rise. They didn't.
Livermore's story ended tragically. After struggling in poverty for several years, he committed suicide on November 29, 1940. While Livermore is often quoted for his financial wisdom, his own life serves as a stark warning about the dangers of failing to manage risk properly.
The Power of Diversification
Batnick emphasizes that one of the most effective strategies for managing risk is diversification. By spreading investments across multiple assets or companies, investors can limit their exposure to any single investment's poor performance.
To illustrate this point, consider two scenarios:
- If you split your investment among ten stocks and one crashes to zero, you lose 10 percent of your capital.
- If you split your investment among 100 companies and one crashes to zero, you only lose one percent of your capital.
This simple example demonstrates how diversification can significantly reduce the impact of a single investment's failure on your overall portfolio.
The Perils of Concentrated Investments
While diversification can protect against catastrophic losses, some investors prefer to make large, concentrated bets on a small number of companies. Batnick explores this strategy through the story of the Sequoia Fund, one of the most successful investment firms of all time.
The Sequoia Fund's Approach
The Sequoia Fund is known for its preference for long-term, large-scale investments. This approach is the opposite of diversification, but it has been incredibly successful for the fund. A $10,000 investment in Sequoia in July 1970 would have grown to $4 million today.
The Valeant Pharmaceuticals Disaster
However, in 2010, the Sequoia Fund made a decision that would prove disastrous. They began purchasing shares of Valeant Pharmaceuticals at $16 per share. By the end of the year, Valeant's stock price had increased by 70 percent. The following year was even more impressive, with Valeant gaining 76 percent in the first quarter alone, becoming the fund's largest holding.
Sequoia described Valeant to its stakeholders as a company that cut corners on research and development (R&D) but invested heavily in its sales force. In reality, Valeant's business model revolved around purchasing existing drugs and dramatically increasing their prices. For example, after acquiring Medicis in 2013, Valeant raised the price of a lead poisoning treatment from $950 to $27,000 overnight.
This practice eventually caught up with Valeant. Negative press began to accumulate, and when presidential candidate Hillary Clinton pledged to prevent price gouging in the pharmaceutical industry, Valeant's shares dropped 31 percent. A month later, Citron Research accused Valeant of accounting fraud, causing the stock to tumble another 19 percent.
The fallout was catastrophic for Sequoia. They were forced to sell their entire position in Valeant, taking a 90 percent loss. The fund's assets plummeted from $9 billion to under $5 billion in just a few months.
This case study illustrates how concentrated holdings can generate wealth quickly but can also decimate it just as fast. It serves as a powerful reminder of the importance of diversification in managing investment risk.
The Role of Emotions in Investment Decisions
Batnick also explores how emotions can cloud judgment when it comes to business deals and investments. He uses the example of Mark Twain, the renowned American novelist, to illustrate this point.
Mark Twain's Investment Misadventures
Mark Twain, known for his sharp writing style and wry humor, was ill-suited for the world of investing due to his emotional and passionate nature. Yet, he frequently sought to invest in what he believed would be the "next big thing."
In the 1870s, Twain invested $42,000 (equivalent to about $953,000 today) in a new technological process called a kaolotype. The inventor, Charles Sneider, claimed it would revolutionize the illustration and engraving industry. Twain was so convinced that he put Sneider on a salary and funded a workshop in Manhattan without any agreement on deadlines. Unfortunately, the kaolotype proved ineffective, Sneider was dishonest, and Twain lost his entire investment.
The Missed Opportunity of a Lifetime
Ironically, Twain's biggest investment mistake came from not investing. Bitter from his previous losses and wary of inventors, Twain passed on an opportunity to invest in Alexander Graham Bell's telephone.
Twain's friend, General Joseph Roswell, invited him to hear a pitch from Bell. Despite Bell's passionate presentation and even an offer of discounted stock, Twain declined, stating he "didn't want anything more to do with wildcat speculation."
This decision, driven by emotion rather than rational analysis, cost Twain the opportunity to invest in one of the most transformative inventions in history.
The Importance of Emotional Control in Investing
Twain's story highlights the danger of allowing emotions to drive investment decisions. His previous failures made him overly cautious, causing him to miss out on a potentially lucrative opportunity.
Batnick suggests that one way to avoid such emotional decision-making is to set hard limits on investment amounts before committing to a deal. By deciding in advance how much you're willing to lose, you can ensure that logic, rather than fear or excitement, drives your business decisions.
The Danger of Overconfidence
Another crucial lesson from "Big Mistakes" is the peril of overestimating one's abilities as an investor. Batnick illustrates this point through the story of Jerry Tsai, a rising star in the investment world of the 1960s.
Jerry Tsai's Meteoric Rise
Jerry Tsai became a manager at Fidelity Capital Fund before he turned 30. He was known for his confidence and aggressive investment style, which involved making many rapid, often instinctive trades. From 1958 to 1965, Tsai delivered impressive annual gains of 296 percent for Fidelity.
Riding high on his success, Tsai left Fidelity in 1965 to start his own fund: The Manhattan Fund. The fund's initial public offering was a massive success, raising $247 million in capital – the largest offering ever for an investment company at the time.
The Economic Context of Tsai's Success
Tsai's success came during a period of significant economic expansion. The post-war austerity was over, and many early tech companies were beginning to flourish. Between 1964 and 1968, the earnings of companies like IBM and Xerox grew by 88 and 171 percent, respectively.
Tsai, like many investors of his generation, had only known extraordinary growth and affluence. This environment led to an inflated sense of his own abilities.
The Fall from Grace
However, the market downturn of 1969-1970 caught Tsai completely off guard. His aggressive trading style, which had been so successful in the bull market of the 1960s, was ill-suited to the new economic reality.
One of Tsai's investments, National Student Marketing, saw its share price plummet from $143 to just $3.50 in seven months. In 1969, the Manhattan Fund ranked 299th out of 305 funds, leading to a mass exodus of investors.
The Lesson: Beware of Overconfidence
Tsai's story is a cautionary tale about the dangers of overconfidence in investing. He mistook his success in a bull market for personal genius, failing to recognize how much of his performance was due to overall market conditions.
As Batnick puts it, "A rising tide raises all boats." It's a mistake to assume that one's success in a booming market is solely due to personal skill. This overconfidence can lead to poor decision-making when market conditions change.
Learning from the Mistakes of Legends
One of the most powerful aspects of "Big Mistakes" is how it shows that even the most successful investors are not immune to errors. Batnick uses the example of Warren Buffett, often considered the greatest investor of all time, to drive this point home.
Warren Buffett's Track Record
Warren Buffett's investment acumen is legendary. Between 1957 and 1969, his partnership returned gains of 2,610 percent. In 1972, Buffett's company, Berkshire Hathaway, purchased See's Candy for $30 million. Since then, it has generated $1.9 billion in pretax revenue.
The Dexter Shoe Company Debacle
However, even Buffett is not infallible. In 1993, riding high on his long list of successes, Buffett made what he later called his worst investment. Berkshire Hathaway purchased the Dexter Shoe Company for $433 million.
Buffett was so confident in this purchase that he wrote to Berkshire shareholders, "Dexter, I can assure you, needs no fixing: It is one of the best-managed companies Charlie and I have seen in our business lifetimes."
Unfortunately, Buffett failed to see the significant changes coming to the shoe manufacturing industry. The rise of manufacturing powerhouses like China and Taiwan devastated the US domestic shoe market. By 1999, Dexter's revenue had declined by 18 percent. The company ended its US shoe production in 2001, and Berkshire eventually folded it into its other shoe firms.
The Danger of Overconfidence
Buffett's mistake with Dexter Shoe Company illustrates how even the most successful investors can fall prey to overconfidence. After a string of successful deals, Buffett failed to be sufficiently vigilant in assessing the changing landscape of the shoe industry.
This example serves as a powerful reminder that past success does not guarantee future performance. It underscores the importance of remaining humble and continually reassessing one's assumptions and strategies, regardless of one's track record.
The Importance of Avoiding Unforced Errors
Batnick emphasizes that one of the key differences between professional and amateur investors is their ability to avoid unforced errors. He uses the analogy of a chess game between grandmasters to illustrate this point.
The Chess Analogy
In a chess match between two grandmasters, the outcome is rarely determined by brilliant moves. Instead, it's often decided by which player makes fewer mistakes. The professionals focus on not losing points rather than trying to win points through risky maneuvers.
Stanley Druckenmiller's Unforced Errors
To illustrate this concept in the world of investing, Batnick tells the story of Stanley Druckenmiller, a successful fund manager who made a series of unforced errors during the dot-com bubble.
Druckenmiller had a strong track record managing George Soros' Quantum Fund, with annual growth never dipping below 24 percent in his first four years. His expertise was in understanding the world economy and foreign currencies.
However, in 1999, Druckenmiller ventured outside his area of expertise and made a series of costly mistakes:
- He bet $200 million of Quantum's capital on a decline in tech stocks, which continued to rise.
- After hiring young, tech-savvy employees who were successful with tech stocks, Druckenmiller felt pressured to prove himself and invested $600 million in the networking company VeriSign.
- When the tech bubble burst, VeriSign's value plummeted, leaving Druckenmiller with a half-billion-dollar loss.
Lessons from Druckenmiller's Mistakes
Druckenmiller's story illustrates several important lessons:
- Stick to your area of expertise: Druckenmiller's success was built on his understanding of foreign currencies, not tech stocks.
- Don't let ego drive investment decisions: The pressure to prove himself led Druckenmiller to make risky investments outside his comfort zone.
- Beware of the fear of missing out (FOMO): Seeing others succeed with tech stocks pushed Druckenmiller to abandon his usual caution.
By focusing on avoiding these types of unforced errors, investors can significantly improve their performance over time.
The Importance of Perspective in Long-Term Investing
One of the most challenging aspects of investing is maintaining perspective during periods of significant loss. Batnick uses the example of Charlie Munger, Warren Buffett's long-time partner and the vice-chairman of Berkshire Hathaway, to illustrate this point.
Charlie Munger's Investment Philosophy
Charlie Munger is known for his intellectual approach to investing, often using mental models and inverse thinking to solve problems. He's famous for his witty aphorisms, known as "Mungerisms," such as "All I want to know is where I'm going to die so I'll never go there."
The Blue Chip Stamps Investment
Despite his wisdom, Munger wasn't immune to significant financial setbacks. In 1974, he made a highly concentrated investment, putting 61 percent of his fund into Blue Chip Stamps, a company that produced loyalty tokens redeemable for consumer goods.
This decision flew in the face of conventional wisdom about diversification. When an economic downturn hit, companies producing non-essential goods like Blue Chip Stamps were hit hard. An investment of $1,000 in Munger's company in January 1973 would have been worth just $467 by January 1975.
The Turnaround
However, Munger didn't panic. He maintained his conviction in the investment, and his patience paid off. By December 1975, his investment company had posted gains of 73.2 percent. Moreover, Blue Chip Stamps went on to acquire several companies that became some of Berkshire Hathaway's most valuable assets, including See's Candies, Wesco Financial, and the Buffalo Evening News.
Lessons from Munger's Experience
Munger's experience with Blue Chip Stamps offers several valuable lessons for long-term investors:
- Patience is crucial: Short-term losses, even significant ones, don't necessarily indicate a poor long-term investment.
- Conviction matters: Having a strong understanding of and belief in your investments can help you weather short-term volatility.
- Market downturns can create opportunities: Blue Chip's acquisitions during a difficult economic period turned out to be extremely valuable in the long run.
- Don't panic sell: The worst time to sell investments is often during a panic after a drop in value.
The Endowment Effect and Overconfidence
Batnick also explores psychological factors that can lead to poor investment decisions, particularly the endowment effect and overconfidence.
The Endowment Effect
The endowment effect is a psychological phenomenon where people ascribe more value to things simply because they own them. This can lead investors to hold onto losing positions longer than they should, simply because they're reluctant to give up something they own.
Overconfidence in Decision-Making
Once we've made a decision, our confidence in that decision tends to increase, even if the underlying facts haven't changed. This can lead investors to double down on poor investments or ignore warning signs that their initial assessment may have been wrong.
Warren Buffett and Dexter Shoe Company
Batnick revisits the story of Warren Buffett and Dexter Shoe Company to illustrate these points. Buffett's overconfidence in his assessment of Dexter led him to ignore the changing dynamics in the shoe industry. His strong conviction in the investment, possibly influenced by the endowment effect, caused him to hold onto the losing investment longer than he should have.
Key Takeaways and Actionable Advice
As Batnick wraps up "Big Mistakes," he offers several key takeaways and pieces of actionable advice for investors:
No one is infallible: Even the most successful investors make mistakes. Learning from these mistakes is crucial for improving your own investment strategy.
Avoid unforced errors: Focus on not losing money through avoidable mistakes rather than always trying to hit home runs with your investments.
Manage risk through diversification: Spreading your investments across different assets can help protect you from catastrophic losses.
Be wary of overconfidence: Past success doesn't guarantee future performance. Always remain humble and open to new information.
Maintain perspective during downturns: Short-term losses don't necessarily indicate a poor long-term investment. Patience is often rewarded in investing.
Stick to your area of expertise: Venturing outside your circle of competence can lead to costly mistakes.
Don't let emotions drive your decisions: Fear, greed, and ego can all lead to poor investment choices. Try to remain rational and objective.
Exercise due diligence and avoid over-trading: Thoroughly research every company you plan to invest in, and don't be afraid to walk away if something doesn't feel right.
Treat each investment decision as if it were one of only 20 you're allowed to make in your lifetime: This mindset encourages careful consideration and helps prevent impulsive decisions.
Learn from others' mistakes: By studying the errors of even the most successful investors, you can gain valuable insights without having to pay the price of those mistakes yourself.
Conclusion
"Big Mistakes" by Michael Batnick offers a unique perspective on investing by focusing on the errors made by some of the most successful investors in history. Through these cautionary tales, Batnick demonstrates that investing is a challenging endeavor, even for those with exceptional track records.
The book serves as a humbling reminder that no one is immune to investment mistakes. However, by learning from these errors, investors can improve their own strategies and decision-making processes. Batnick emphasizes the importance of managing risk, avoiding overconfidence, maintaining perspective during market downturns, and making rational, well-researched investment decisions.
Ultimately, "Big Mistakes" encourages investors to approach the market with a combination of caution and curiosity. By studying the failures of others, we can hope to avoid similar pitfalls in our own investment journeys. The book's lessons are valuable not just for those actively managing their own portfolios, but for anyone seeking to understand the complexities and challenges of the financial markets.
In a world where financial success stories often dominate the headlines, Batnick's focus on mistakes provides a refreshing and educational counterpoint. It reminds us that behind every success story are likely numerous failures and setbacks. By embracing these lessons, investors can strive to make more informed decisions and potentially achieve better long-term results in their financial endeavors.