Seth Klarman Investing: Devastating Mistakes to Avoid

This article on Seth Klarman Investing was written by Net Net Hunter member John Hatley. John is a private investor based in South Korea. His passion for deep value investing led him to ultra cheap stocks relative to net assets and he approaches investing in the style of Seth Klarman. Article image (Creative Commons) by Iman, edited by Broken Leg Investing.

There are many traps and pitfalls for investors—both inexperienced and seasoned professionals alike—to fall victim to in the stock market. No matter which category of investor you are in, you can bet your bottom dollar that you need to know what you are getting yourself into when you decide to deal on Wall Street. In this article we are going to take a look at Seth Klarman investing advice to help us avoid some of these traps.

One fantastic source of information on these stumbling blocks is Klarman's Margin of Safety. Since Klarman is one of the world's greatest value investors, it goes without saying that he is a very experienced individual worth taking advice from. Let's take a look at Seth Klarman's investing advice on “Where Most Investors Stumble.”

Seth Klarman Investing Advice: Investors versus Speculators

It is well known among investors and other financial experts that there is a stark difference between investing and speculating. This is exactly the foundational concept that sets a successful investing career apart from an unsuccessful one. As Klarman makes clear, investors see stocks as ownership of companies, while speculators see stocks merely as objects to trade back and forth:

“To investors, stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities. … Investors believe that over the long run, security prices tend to reflect fundamental developments involving the underlying businesses. … Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals. … Speculators are obsessed with predicting — guessing — the direction of stock prices.”

According to Klarman, it is this difference in mindsets between investors and speculators that leads to long-term success or failure in the stock market. But if you already know this distinction, you may ask why it matters. Klarman goes on to say:

“Indeed, many ‘investment professionals’ actually perform as speculators much of the time because of the way they define their mission, pursuing short-term trading profits from predictions of market fluctuations rather than long-term investment profits based on business fundamentals. … Investors have a reasonable chance of achieving long-term investment success; speculators, by contrast, are likely to lose money over time.”

There are two important takeaways from the above. One, having a short-term, profit-making mindset is a characteristic of speculation; and two, even many professional investors are prone to speculation much of the time. If you are going to take advice from any given investor, you are going to have to be aware that he or she may actually be speculating, even if they are known to be a good investor.

Even though he doesn't expressly say it, the big picture that this Seth Klarman investing advice is painting is that you, being an individual investor, should take advice from other investors always with a grain of salt. You especially shouldn't depend solely on others to manage your money, particularly institutional investors and money managers on Wall Street.

Seth Klarman On The Fallacies Of Wall Street Thinking

There is an entire chapter of Seth Klarman investing advice on how Wall Street actually works against the best interests of the investor. The problem that arises is due to the fact that Wall Street is made up of institutions--and the individuals working for them--that need to make profit for themselves. These institutions end up working counter-productively for the individual investors that rely upon them. Simply stated, it is a conflict of interests. Klarman begins with pointing out the obvious:

“Wall Streeters get paid primarily for what they do, not how effectively they do it. Wall Street's traditional compensation is in the form of up-front fees and commissions. Brokerage commissions are collected on each trade, regardless of the outcome for the investor… While their customers might be best off owning (minimal commission) U.S. Treasury bills or (commission-free) no-load mutual funds, brokers are financially motivated to sell high-commission securities. Brokers also have an incentive to do excessive short-term trading on behalf of discretionary customer accounts (in which the broker has discretion to transact) and to encourage such activity in non-discretionary accounts.”

As we can see here, stock brokers are motivated by their own interest in collecting fees, regardless of whether the recommendations they offer to their clients are good for the clients themselves or not. Many investors think that their brokers know more than they do and follow their advice to their detriment. Later in the chapter, Klarman points out that there is another prominent conflict of interest to be found in the underwriting of new securities:

“A significant conflict of interest also arises in ….  raising money for corporate clients by selling newly issued securities to customers. Needless to say, large fees may motivate a firm to underwrite either overpriced or highly risky securities and to favor the limited number of underwriting clients over the many small buyers of those securities… By acting as investment bankers as well as brokers, most Wall Street firms create their own products to sell. A stock or bond underwriting generates high fees for an investment bank.”

Klarman points out that Wall Street firms make more money from underwriting securities and selling them than they do from acting as intermediary brokers for secondary transactions in the stock market. As a result, they look for opportunities to underwrite more securities to sell and often create overpriced IPOs. Therefore, brokers have even more incentive to sell these overpriced securities to the investing public, who foolishly lap them up. Klarman goes on to say:

“Indeed, the underwriting of a new security may well be an overpriced or ill-conceived transaction, frequently involving the shuffling of assets through ‘financial engineering’ rather than the raising of capital to finance a business’s internal growth. Investors even remotely tempted to buy new issues must ask themselves how they could possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting.”

As we can see here, the financial institutions are focused more on self-interests than on the people they deal with. This is a strong warning to anyone who does business with them.

Other than the conflict of interests we have just examined, perhaps the most foundationally toxic mindset that Seth Klarman investing reveals is that of Wall Street’s propensity towards focusing on the short term. Unfortunately, being influenced by Wall Street, this is one of the biggest mistakes that the majority of individual investors also fall victim to. This short-sightedness pervades every aspect of Wall Street activity from the top down and causes the actions of those who work on Wall Street to work against the best interests of their clients. Klarman cites Wall Street's up-front fee orientation as the foundation of this short-term focus.

Sadly enough, it makes perfect sense. Why should your broker or money manager look out for your best interests when he makes money from your trading activity regardless? Klarman refers to the job climate on Wall Street during the late ’80s and early ’90s as an example of just how far this line of short-sighted thinking can go. He refers to the period thusly:

“A time when fees were enormous and when most Wall Streeters felt less than secure about the permanence of their jobs, and even their careers, in the securities industry. Some people work on Wall Street solely to earn high incomes, expecting to depart after a few years. Others, doubting their own ultimate success … are unwilling to forego short-term compensation for long-term income that may never arrive. … A great many of those who work on Wall Street view the goodwill or financial success of clients as a secondary consideration; short-term maximization of their own income is the primary goal.”

This all goes to show that having a short-term perspective is possibly the most destructive force among those working on Wall Street. Surely putting your trust in your broker or money manager is not the way to go, not when you can’t even be sure of whether or not they are putting your needs and expectations first. Take Seth Klarman investing advice and invest for yourself.

Seth Klarman Investing Advice: The Problem with Going with the Crowd

Because we as humans are flawed social creatures, we have a tendency to go with the crowd. We see others acting in certain ways and we follow. This is good for society in general, but not when it comes to investing. There are many psychological factors involved with investing, and you don’t want to get caught up in someone else’s wash. The fact is that most investors invest poorly due to speculation and mindsets focused on short-term gains.

The propensity for people to do what others are doing — especially if everyone is seemingly in on it — is without a doubt one of the worst traps you could fall into as an investor. Klarman makes this point implicitly through a myriad of historical examples of Wall Street fads and trends. Portfolio insurance, tactical asset allocation, junk bonds, and index funds are some examples that you may be familiar with. According to Klarman, all of these are stumbling blocks to investors because they become trendy and get blown out of proportion:

“The value of a company selling a trendy product … depends on the profitability of the product, the product life cycle, competitive barriers, and the ability of the company to replicate its current success. Investors are often overly optimistic about the sustainability of a trend, the ultimate degree of market penetration, and the size of profit margins. As a result, the stock market frequently attributes a Coca-Cola multiple to a Cabbage Patch concept. All market fads come to an end. Security prices eventually become too high, supply catches up with and then exceeds demand, the top is reached, and the downward slide ensues. There will always be cycles of investment fashion …”

As Klarman points out, the excessive optimism of investors about an ongoing trend is what drives stock prices higher and higher until eventually it all comes crashing down. This is exactly what has — and does — continue to happen. It is in this same way that bubbles form and stock prices become inflated.

Another fantastic example of how going with the crowd can lead you astray can be found by examining the junk bond craze of the 1980s. On junk bonds, Klarman writes:

”… the short-term orientation of institutional investors, and the tendency of Wall Street to maximize its self-interest above all, came together in the 1980s to allow a $200 billion market to develop virtually from scratch. Although unproven over a complete economic cycle, newly issued junk bonds were hailed as a safe investment that provided a very attractive return to investors. By 1990, however, the concept of newly issued junk bonds had been exposed as seriously flawed, defaults reached record levels, and the prices of many issues plunged. Even so, the junk bond market staged a surprising recovery in early 1991; many of the flaws that had resulted in tens of billions of dollars of losses were once again being ignored.”

As Klarman points out, even major mistakes that are made en-masse in the stock market can quickly be forgotten and ignored. The individual investor must constantly be aware of this and re-evaluate his past failures and those of others to improve his future investments. Simply put, learn from your mistakes or be destined to repeat them. But in case you were wondering just how large the junk-bond market became, consider the following:

“Even the blue bloods of Wall Street like Morgan Stanley, First Boston, and Goldman Sachs … had by the mid-1980s built extensive junk-bond underwriting, marketing, and trading capabilities of their own. … They too were now beneficiaries of the booming junk-bond market. The greatest irony in the whole junk-bond story may be that one of the biggest financial swindles of all time, newly issued junk bonds, had by the end of the 1980s come to enmesh every major Wall Street firm alongside Drexel Burnham Lambert.”

How is it possible that so many investors could get caught up in junk bonds even after they were revealed as being so unsafe? It’s because people tend to follow the crowd. Even if everyone you know and their dogs are buying junk, it doesn’t mean you should do it too. This is where the old adage, “There's safety in numbers,” doesn’t hold up — at least not for stock market investors.

Conclusion

Seth Klarman’s investing criticism makes it clear that many investors speculate rather than properly invest or trust their money to institutions that don't have their best interests in mind. Speculation on the price movements of securities, as well as trusting short-term oriented people with your money, is never a good idea. It's more wise to do your own analysis and trust your own judgment like Seth Klarman’s investing advice tells us. Finally, and most importantly, don't follow the crowd.

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