In an advanced undergraduate economics class at Cornell, 22 students in alternating seats were given coffee mugs that sell for $6 at the bookstore. When sellers were given the option to sell, and buyers given the option to buy, the study found that the median owner was unwilling to sell for less than $5.25, while the median buyer was unwilling to pay more than $2.25. Once something belongs to us, objective thinking flies out the window.
The main effect of this “endowment,” the authors found, “is not to enhance the appeal of the good one owns, only the pain of giving it up.” In other words, to go back to the example of the gambler who was tossing a mental coin between two teams, had the gambler been asked if they would like to change their mind, it's highly unlikely they would say yes. Confidence grows exponentially once you've decided on something you were previously unsure about.
Overconfidence is so ingrained in our DNA that even if we're aware of it, shielding ourselves from it becomes supremely difficult. Robert Shiller has written, “Our satisfaction with our views of the world is part of our self‐esteem.”2 This applies to everyone, but especially to people in the financial business. David Dreman shows how overconfident financial analysts are in his book, Contrarian Investment Strategies:
Analysts were asked for their high and low estimates of the price of a stock. The high estimate was to be the number they were 95 percent sure the actual price would fall below; the low estimate was the price they were 95 percent sure the stock would remain above. Thus, the high and low estimates should have included 90 percent of the cases, which is to say that if the analysts were realistic and unbiased, the number of price movements above and below the range would be 10 percent. In fact, the estimates missed the range 35 percent of the time, or three and a half times as often as estimated.3
It's not just the average Joe investor or even financial professionals that fall victim to this embedded blind spot, it's everyone who has ever bought or sold a stock, including one of the greatest investors of all time, Warren Buffett. The Oracle of Omaha, as he is colloquially known, has the most impressive long‐term track record of anybody to ever play the game. Since 1962, when he first purchased stock in Berkshire Hathaway, a small textile manufacturing company in New Bedford, Massachusetts, the Dow Jones Industrial Average is up 30 fold. Berkshire Hathaway is up 33,333 fold.
Buffett took control of Berkshire in 1965, and over that time, it's grown 1,972,595%, or 20.8% annually. To give an idea of what a feat this is, $10,000 compounded at 20.8% for 52 years grows to $185,131,161.
Before he became the company‐gobbling, folksy billionaire that we know him as today, this stock‐picking wizard ran a limited partnership from 1957 to 1969. In that 12‐year stretch, his gross returns were 2,610%, versus 186% for the Dow. His limited partners received 1,400%, or 25%, annually, net of fees! Buffett's investors would receive the first 4% that he could generate, and they would share any remaining profits – 75% to the clients and 25% to Buffett.4 All of Buffett's net worth was invested alongside them, so to say he ate his own cooking is an understatement. He accomplished this magnificent lifelong track record across more than four decades, regardless of whether the markets were bullish or bearish, through nine presidential administrations and in spite of every economic cycle and groundbreaking technology.
One of the underrated things about Warren Buffett is his ability to communicate his investment philosophy. Before there were blogs and long before the Internet, he was writing client letters, which have become appointment reading for thousands of investors around the globe. While operating the partnership, one of the messages that was repeated over and over was setting a proper benchmark and having realistic expectations. As time went by and his performance got better and better, he warned his partners not to get too confident that he would continue with such spectacular results.
Lowenstein pulled highlights from Buffett's annual forecasts to illustrate how he aimed to temper expectations:
1962: “If my performance is poor, I expect my partners to withdraw.”
1963: “It is certainty that we will have years when…we deserve the tomatoes.”
1964: “I believe our margin over the Dow cannot be maintained.”
1965: “We do not consider it possible on an extended basis to maintain the 16.6 percentage point advantage over the Dow.”
1966: “We are going to have loss years and are going to have years inferior to the Dow – no doubt about it.”
July 1966: “Such results should be regarded as decidedly abnormal.”5
In 1967, he wrote to his clients sentiments that he would echo 30 years later, in the dot‐com bubble:
When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don't fully understand, have not practiced successfully and which, possibly, could lead to a substantial permanent loss of capital.6
Buffett revised his goal of beating the Dow by 10 percentage points to a 9% annual gain, or 5% above the Dow, whichever was lower. And then in 1968, warnings be damned, he returned 58.8%, or 45.6% net of fees. The Dow was up just 7.7% that year. He wrote to his partners that the result “should be treated as a freak – like picking up thirteen spades in a bridge game.” In 1969 he had had enough, at just 39 years old, he shut down the partnership, before his warnings ever came to fruition.
It's funny that despite his monstrous returns and his youth, two things that tend to favor the brash, Buffett's confidence level was kept in check. It's funnier still, that at 63, oozing with confidence, he would make the single costliest mistake of his investing career.
The Oracle became the second wealthiest man in the world by buying and holding great businesses.7 In 1972, after arm wrestling with his partner Charlie Munger over the price, Berkshire Hathaway purchased See's Candy for $30 million. They could have paid multiples of the $25 million Buffett wanted to and done just fine, because See's Candy has generated $1.9 billion pretax since 1972.8 In 1983, Berkshire bought 90% of Nebraska Furniture Mart, for $55 million. It's now the largest furniture store in the country. In 2011, the company earned 10 times as much as it did when they first purchased it. In 2015, Nebraska Furniture Mart opened a store in Texas, which did $750 million in sales in its first year alone.
Buffett purchased very nice companies in his career, but it wasn't See's or the Furniture Mart that landed him a top the Forbes 400; it was insurance.
Buffett took to insurance early. In 1951, while in business school, he took a trip to Washington where the Government Employees Insurance Company, or GEICO, was located. Ben Graham, the dean of security analysis and Buffett's teacher at Columbia, was the chairman of the company. At the time, their sales were $8 million annually. Today, they do that every three hours9 and own 12% of industry volume. Buffett first bought the stock in 1952 and sold it a year later for a 50% profit.10
In 1967, Buffett bought National Indemnity for $8.6 million, and today it's the world's largest property/casualty insurance company. He continued to track GEICO from his days as a business student and when he was finally given a fat pitch, he swung for the fences. In 1976, GEICO announced they lost $126 million in the previous year, and the stock traded down to 4 ⅞, after being as high as 42 two years earlier. He bought 500,000 shares and continued to add, quickly becoming a controlling owner.11 In early 1996, Berkshire bought the remaining half of GEICO that it didn't own for $2.3 billion (he spent just $46 million for the first 48%12). Today, GEICO does $462 million in underwriting profit, and has $17 billion in float.
Buffett outlined his interest in GEICO in Berkshire Hathaway's 2016 annual letter. GEICO,
like other property/casualty insurers, collects premiums from all clients up front. Then, they pay claims as they are submitted. Buffett explains:
This collect‐now, pay‐later model leaves P/C companies holding large sums – money we call ‘float’ – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume.13
But not every purchase would be a winner. In 1987, there was the $700 million investment in Salomon Brothers, their biggest investment up until that point, which turned out to be lucrative but was mentally and emotionally depleting, after a scandal with the Treasury was uncovered in 1991.
In 1990, they took a 12% stake in US Air, which eventually would stop paying dividends on preferred shares. Berkshire's stake which was acquired for $358 million, was valued at just $86 million a few years later, a cool 76% decline. Charlie Munger said, “It was a humbling experience. To sit there and watch that net worth melt away – $150 million, $200 million…It worked out fine for Berkshire. But we're not looking for another experience like it.”14
These less‐than‐stellar experiences pale in comparison to Buffett's costliest mistake. In 1993, Berkshire agreed to buy Dexter Shoes for $433 million. But it wasn't just that this business would be worth zero a few years later that was the problem, it was the stock that Berkshire issued to pay for it. The shares were trading for $16,765 at the time of the transaction. Today, at $242,000, the 25,200 shares that they exchanged for Dexter have grown 1350%. At the time, Berkshire's market cap was $19 billion. I could only imagine what Buffett would have thought had someone told him the shares he just gave to a business destined for zero would end up being worth $6 billion, one‐third of its market cap at the time of this transaction.
Buffett knew what he was doing. This was not his first time buying an entire company – it wasn't even his first time buying a shoe company. In July 1991, Berkshire acquired H. H. Brown, which was the leading North American manufacturer of work shoes and boots, and had “a history of earning unusually fine margins on sales and assets.”15 So when he had the opportunity to buy Dexter, which made reasonably priced men's and women's shoes, he jumped at it.
Buffett told the New York Times that “Dexter Shoe Co. is exactly the type of business Berkshire Hathaway admires…it has a long, profitable history, enduring franchise and superb management.”16
Berkshire shareholders were told about Dexter in the 1993 annual letter:
What we did last year was build on our 1991 purchase of H. H. Brown, a superbly‐run manufacturer of work shoes, boots and other footwear. Brown has been a real winner: Though we had high hopes to begin with, these expectations have been considerably exceeded thanks to Frank Rooney…. Because of our confidence in Frank's team, we next acquired Lowell Shoe, at the end of 1992. Lowell was a long‐established manufacturer of women's and nurses' shoes, but its business needed some fixing. Again, results have surpassed our expectations. So we promptly jumped at the chance last year to acquire Dexter Shoe of Dexter, Maine, which manufactures popular‐priced men's and women's shoes. 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.17
Buffett certainly was aware of some of the business challenges Dexter faced, but as Alice Schroeder described in her wonderful biography, The Snowball, “Here he was a little outside his ‘circle of competence,’ making a bet that demand for imported shoes would wane.”18 In looking at the language Buffett used to describe Dexter to his shareholders, it's clear that the whiz‐kid investor who warned his investors not to be overconfident had grown into a confident, company‐guzzling businessman. Buffett wrote:
Five years ago we had no thought of getting into shoes. Now we have 7,200 employees in that industry, and I sing “There's No Business Like Shoe Business” as I drive to work…. Finally, and of paramount importance, Harold and Peter can be sure that they will get to run their business – an activity they dearly love – exactly as they did before the merger. At Berkshire, we do not tell .400 hitters how to swing.
In Charlie Munger: The Complete Investor, Tren Griffin writes, “In doing their due‐diligence analysis for Dexter Shoes, Buffett and Munger made the mistake of not making sure the business had a moat and being too focused on what they thought was an attractive purchase price.”19
Psychologists Dale Griffin and Amos Tversky wrote, “Intuitive judgments are overly influenced by the degree to which the available evidence is representative of the hypothesis in question.”20 The evidence Buffett had available, other than Dexter's financials and the proposed purchase price, was the success he experienced less than two years earlier with his purchase of H. H. Brown. Buffett did what every person on earth does, he reached for whatever was easiest to remember in deciding whether or not to do something; in the case of buying Dexter's shoes, it was the success of purchasing H. H. Brown.
Buffett was overconfident in Frank Rooney, who headed H. H. Brown and helped broker the Dexter acquisition. Buffett also put too much stock in Harold Alfond, the leader at Dexter. Finally, he had too much confidence in himself. But things would quickly go south at Dexter, and there was no mention of the company in any of Berkshire's letters for the next five years.
Then, troubles started to surface. For five years, starting in 1994, the company's shoe profits and revenues had been in decline. By 1999, revenue had declined by 18% and operating profits were down 57%.21 In his annual letter that year, Buffett wrote:
We manufacture shoes primarily in the U.S., and it has become extremely difficult for domestic producers to compete effectively. In 1999, approximately 93% of the 1.3 billion pairs of shoes purchased in this country came from abroad, where extremely low‐cost labor is the rule.22
By 2000, it was no longer a question of whether he could turn the shoe manufacturer around:
I clearly made a mistake in paying what I did for Dexter in 1993. Furthermore, I compounded that mistake in a huge way by using Berkshire shares in payment. Last year, to recognize my error, we charged off all the remaining accounting goodwill that was attributable to the Dexter transaction. We may regain some economic goodwill at Dexter in the future, but we clearly have none at present.23
Buffett might have been blinded by confidence when he purchased Dexter, but he was quick and forthcoming when acknowledging the mistake. In 2014, he wrote, “As a financial disaster, this one deserves a spot in the Guinness Book of World Records.”24
Buffett devoted more words on the mistake at Dexter in 2007, 2014, and 2016. In fact, one of Buffett's strengths is in recognizing that mistakes are part of the game. Buffett has included the word “mistake” 163 times in his annual letters. He, like everybody else who has ever put a dollar into the market, is no stranger to lousy investments.
Buffett earned the right to be confident, but his overconfidence cost Berkshire Hathaway $6 billion. For the rest of us, it behooves us to take a minute and think about why we're investing and what we really know. Do you know more than the person on the other side of the trade? Do you know something that's not in the newspaper or on the Internet? Will we know when we're right? What about if we're wrong? Overconfidence is so ingrained in us that just being aware of it does nothing to prevent it.
Buffett has a great way for investors to deal with overconfidence. If you were given a punch card with just 20 holes, and those represented all the investments you could make for the rest of your life, you would think much more carefully about what you were doing. Now this is not practical advice, in real life nobody is this disciplined, but it's a great way to think about how much thought and care should go into each investment. By taking the time to think something through, we can slow down and suppress impulsive actions. But take too much time, and process too much information, and we're likely to become more confident! It all leads back to thinking we know more than we possibly can, and this
is very difficult to overcome.
The best way to guard against overconfidence when making speculative investments is to have a plan ahead of time. Know when you're wrong; use price levels, dollar loss levels, or percentage loss levels. Making decisions ahead of time, especially decisions that involve admitting defeat, can help conquer one of the biggest hurdles investors face; looking in the mirror and seeing an ability that we just do not possess.
Notes
1. Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias,” Journal of Economic Perspectives 5, no. 1 (Winter 1991): 193–206.
2. Robert Shiller, Irrational Exuberance (Princeton, NJ: Princeton University Press, 2000), 60.
3. David Dreman, Contrarian Investment Strategies: The Psychological Edge (New York: Free Press, 2012), 176.
4. Roger Lowenstein, Buffett (New York: Random House, 2008), 62.
5. Ibid., 93.
6. Warren Buffett, Partnership Letter, October 9, 1967.
7. Warren Buffett, 2016 Berkshire Hathaway annual letter, February 25, 2017.
8. Warren Buffett, 2014 Berkshire Hathaway annual letter, February 25, 2015.
9. Buffett, 2016 Berkshire Hathaway annual letter.
10. Lowenstein, Buffett, 49.
11. Ibid., 195.
12. Snowball 540.
13. Buffett, 2016 Berkshire Hathaway annual letter.
14. Janet Lowe, Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Mungre (New York: Wiley, 2000), 183.
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