Agonizing over errors is a mistake. But acknowledging and analyzing them can be useful, though that practice is rare in corporate boardrooms. There, Charlie and I have almost never witnessed a candid post-mortem of a failed decision, particularly one involving an acquisition. A notable exception to this never-look-back approach is that of The Washington Post Company, which unfailingly and objectively reviews its acquisitions three years after they are made. Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized.

Source:   Berkshire Hathaway Shareholder Letters

Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.)...The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush, and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Source:   Berkshire Hathaway Shareholder Letters

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

Source:   Berkshire Hathaway Shareholder Letters

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there, do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

Source:   Berkshire Hathaway Shareholder Letters

A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.

Source:   Berkshire Hathaway Shareholder Letters

Acknowledging what you don’t know is the dawning of wisdom.

Source:   Poor Charlie's Almanack

Opportunity meeting the prepared mind; that’s the game.

Source:   Poor Charlie's Almanack

Think forwards and backwards – invert, always invert.

Source:   Poor Charlie's Almanack

For years the financial services have been making stock-market forecasts without anyone taking this activity seriously. Like everyone else in the field they are sometimes right and sometimes wrong. Wherever possible they hedge their opinions so as to avoid the risk of being proved completely wrong. (There is a well-developed art of Delphic phrasing which adjusts itself successfully to whatever the future brings.) In our view – perhaps a prejudiced one – this segment of work has no real significance except for the light it throws on human nature in the securities markets. Nearly every-one interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied.

Source:   The Intelligent Investor

…an increase in personal performance (regardless of whether it is caused deterministically or by the agency of Lady Fortuna) induces a rise of serotonin in the subject, itself causing an increase of what is commonly called leadership ability. One is "on a roll". Some imperceptible changes in deportment, like an ability to express oneself with serenity and confidence, makes the subject matter look credible - as if he truly deserved the shekels. Randomness will be ruled out as a possible factor in the performance, until it rears its head once again and delivers the kick that will induce the downward spiral.

Source:   Fooled By Randomness

It is a fact that our brain tends to go for superficial clues when it comes to risk and probability, these clues being largely determined by what emotions they elicit or the ease [with which] they come to mind. In addition to such [a] problem with the perception of risk, its is also a scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the "thinking" part of the brain but largely in the emotional one (the "risk as feelings" theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one's actions by fitting some logic to them.

Source:   Fooled By Randomness

…it is not natural for us to learn from history…It is a platitude that children learn only from their own mistakes; they will cease to touch a burning stove only when they are themselves burned; no possible warning by others can lead to developing the smallest part form of consciousness. Adults, too, suffer from such a condition...This congenital denigration of the experience of others is not limited to children or to people like myself; it affects business decision-makers and investors on grand scale.

Source:   Fooled By Randomness

When you look at the past, the past will always be deterministic, since only one single observation took place…A mistake is not something to be determined after the fact, but in light of the information until that point. A more vicious effect of [hindsight bias] is that those who are very good at 'predicting' the past will think of themselves as good at predicting the future, and feel confident in their ability to do so.

Source:   Fooled By Randomness

Remember that [almost] nobody accepts randomness in his own success, only his failure.

Source:   Fooled By Randomness

Our brain is not cut out for non-linearities. People think that if, say, two variables are causally linked, then a steady input in one variable should always yield a result in the other one. Our emotional apparatus is designed for linear causality.

Source:   Fooled By Randomness

"Satisificing" was [Herb Simon's] idea (the melding together of satisfy and suffice): You stop when you get a near-satisfactory solution. Otherwise it may take you an eternity to reach the smallest conclusion or perform the smallest act.

Source:   Fooled By Randomness

SETH KLARMAN: Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying value in determining securities prices.

Source:   The Most Important Thing

The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself. The process is simple: 1) The economy moves into a period of prosperity. 2) Providers of capital thrive, increasing their capital base. 3) Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.  4) Risk averseness disappears. 5) Financial institutions move to expand their businesses—that is, to provide more capital. 6) They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.   At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.”

Source:   The Most Important Thing

In Field of Dreams, Kevin Costner was told, “If you build it, they will come.” In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.

Source:   The Most Important Thing

Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. However negative the force of greed might be, always spurring people to strive for more and more, the impact is even stronger when they compare themselves to others. This is one of the most harmful aspects of what we call human nature. People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.

Source:   The Most Important Thing

You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

Source:   The Most Important Thing

Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable—although the experienced contrarian takes comfort from his or her position outside the herd.

Source:  

Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. Usually—and certainly at the extremes of the pendulum’s swing—being part of the herd should be a reason for worry.

Source:   The Most Important Thing

One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few winners, the penalty is bearable.

Source:   The Most Important Thing

Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the greatest error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.

Source:   The Most Important Thing

The concept of reflexivity is simple. In situations that have thinking participants, there is a two-way interaction between the participants' thinking and the situation in which they participate. On the one hand, participants seek to understand reality; on the other, they seek to bring about a desired outcome. The two functions work in opposite directions: in the cognitive function reality is the given; in the participating function, the participants' understanding in the constant...I call the interference between these two functions reflexivity.

Source:   The Alchemy of Finance

We live in the real world, but our view of the world does not correspond to the real world. The theory of rational expectations itself provides a striking example of how far our interpretation can stray from the real world. Yet our view of the world is part of the real world - we are participants. And the gap between reality and our interpretation of it introduces an element of uncertainty into the real world. Again, this sounds like circular reasoning, but it accurately describes situations with thinking participants.

Source:   The Alchemy of Finance

Since people's decisions are not based [predominantly] on knowledge, outcomes are liable to diverge from expectations. Events that have thinking participants cannot be understood without taking that divergence into account. In the case of natural phenomena, events unfold irrespective of what anybody thinks - although what people choose to notice is influenced by the prevailing paradigm. In the case of social events, the influence of thinking is more pervasive: it can affect the course of events. The has far reaching implications for [the] scientific method.

Source:   The Alchemy of Finance

Instead of drawing dichotomies between thinking and reality, we must recognize that thinking forms part of reality instead of being separate from it…In other words, reality always exceeds our capacity to understand it [like Gödel's theorem]

Source:   The Alchemy of Finance

I have, in fact, put myself into the position of an outside observer and remain as detached as possible. I realize that is impossible to rid oneself of emotions, yet it is important to keep one's emotional state as stable as possible in order to have a solid platform from which changes in the outside world can be evaluated.

Source:   The Alchemy of Finance

The financial markets are very unkind to the ego: those who have illusions about themselves have to pay a heavy price in the lateral sense. It turns out that a passionate interest in the truth is a good quality for financial success.

Source:   The Alchemy of Finance

People participate in science with a variety of motivations. For present purposes we may distinguish between two main objectives: the pursuit of truth and the pursuit of what we may call "operational success". In natural science, the two objectives coincide: true statements work better than false ones. Not so in social sciences: false ideas may be effective because of their influence on people's behavior and, conversely, the fact that a theory or prediction works does not provide conclusive evidence of its validity. Marxism provides an outstanding example of the first kind of divergence...The divergence between truth and operational or experimental success undermines scientific method in more ways than one. On the one hand, it renders scientific theories to achieve operational success. What is worse, an alchemical theory can profit from assuming a scientific guise.

Source:   The Alchemy of Finance

Most small investors cannot live on the return on their investment no matter how high a yield is obtained, since the total value of their holdings is not great enough. Therefore for the small investor the matter of current dividend return usually comes down to a choice between a few hundred dollars a year starting right now, or the chance of obtaining an income many times this few hundred dollars a year at a later date.

Source:   Common Stocks and Uncommon Profits

More money has probably been lost by investors holding a stock they really did not want until they could “at least come out even” than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous. Furthermore this dislike of taking a loss, even a small loss, is just as illogical as it is natural. If the real object of common stock investment is the making of a gain of a great many hundreds per cent over a period of years, the difference between, say, a 20 per cent loss or a 5 per cent profit becomes a comparatively insignificant matter. What matters is not whether a loss occasionally occurs. What does matter is whether worthwhile profits so often fail to materialize that the skill of the investor or his advisor in handling investments must be questioned.

Source:   Common Stocks and Uncommon Profits

...investment fads and misinterpretations of facts may run for several months or several years. In the long run, however, realities not only terminate them, but frequently, for a time, cause the affected stocks to go too far in the opposite direction. The ability to see through some majority opinions to find what facts are really there is a trait that can bring rich rewards in the field of common stocks. It is not easy to develop, however, for the composite opinion of those with whom we associate is a powerful influence upon the minds of us all.

Source:   Common Stocks and Uncommon Profits

If the huge price changes that occur in individual stocks are made solely because of changed appraisals by the financial community, with these appraisals sometimes completely at variance with what is going on in the real world of a company's affairs, what significance have the other three dimensions? Why bother with the expertise of business management, scientific technology, or accounting at all? Why not just depend on psychologists? The answer involves timing. Because of a financial-community appraisal that is at variance with the facts, a stock may sell for a considerable period for much more or much less than it is intrinsically worth. Furthermore, many segments of the financial community have the habit of playing “follow the leader,” particularly when that leader is one of the larger New York City banks. This sometimes means that when an unrealistic appraisal of a stock is already causing it to sell well above what a proper recognition of the facts would justify, the stock may stay at this too high level for a long period of time. Actually, from this already too high a price it may go even higher.

Source:   Common Stocks and Uncommon Profits

...management stands to gain wisdom and credibility by facing mistakes, why do so many annual reports trumpet only success? If allocation of capital is so simple and logical, why is capital so poorly allocated? The answer, Buffett has learned, is an unseen force he calls “the institutional imperative”—the lemming-like tendency of corporate managers to imitate the behavior of others, no matter how silly or irrational it may be. It was the most surprising discovery of his business career. At school he was taught that experienced managers were honest and intelligent, and automatically made rational business decisions. Once out in the business world, he learned instead that “rationality frequently wilts when the institutional imperative comes into play.”

Source:   The Warren Buffett Way

The Real Measure of Worth In that famous speech about Graham-and-Doddsville, Warren Buffett said many important things, none more profound than this: “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

Source:   The Warren Buffett Way

In recent years we have seen what amounts to a revolution, a new way of looking at issues of finance through the framework of human behavior. This blending of economics and psychology is known as behavioral finance, and it has slowly moved down from the universities’ ivory towers to become part of the informed conversation among investment professionals . . . who, if they look over their shoulders, will find the shadow of a smiling Ben Graham.

Source:   The Warren Buffett Way

Developing an investor’s attitude, Graham said, is a matter of being prepared, both financially and psychologically, for the market’s inevitable ups and downs—not merely knowing intellectually that a downturn will happen, but having the emotional ballast needed to react appropriately when it does. In Graham’s view, an investor’s appropriate reaction to a downturn is the same as a business owner’s response when offered an unattractive price: ignore it. “The true investor,” says Graham, “scarcely ever is forced to sell his shares and at all other times is free to disregard the current price quotation.”

Source:   The Warren Buffett Way

...loss aversion, and it is, in my opinion, the single most difficult hurdle that prevents most investors from successfully applying the Warren Buffett approach to investing.

Source:   The Warren Buffett Way

Intelligence alone is not enough to ensure investment success. The size of the investor’s brain is less important than the ability to detach the brain from the emotions. “Rationality is essential when others are making decisions based on short-term greed or fear,” says Buffett. “That is when the money is made.”

Source:   The Warren Buffett Way

“How did you get here? How did you become richer than God?” Buffett took a deep breath and began: “How I got here is pretty simple in my case. It is not IQ, I’m sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which the motor works—depends on rationality. A lot of people start out with 400 horsepower motors but only get 100 horsepower of output. It’s way better to have a 200 horsepower motor and get it all into output. “So why do smart people do things that interfere with getting the output they’re entitled to?” Buffett continued. “It gets into the habits and character and temperament, and behaving in a rational manner. Not getting in your own way. As I have said, everybody here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For those who won’t, it will be because you get in your own way, not because the world doesn’t allow you.”

Source:   The Warren Buffett Way

Some decisions are consequential and irreversible or nearly irreversible – one-way doors – and these decisions must be made methodically, carefully, slowly, with great deliberation and consultation. If you walk through and don’t like what you see on the other side, you can’t get back to where you were before. We can call these Type 1 decisions. But most decisions aren’t like that – they are changeable, reversible – they’re two-way doors. If you’ve made a suboptimal Type 2 decision, you don’t have to live with the consequences for that long. You can reopen the door and go back through. Type 2 decisions can and should be made quickly by high judgment individuals or small groups. As organizations get larger, there seems to be a tendency to use the heavy-weight Type 1 decision-making process on most decisions, including many Type 2 decisions. The end result of this is slowness, unthoughtful risk aversion, failure to experiment sufficiently, and consequently diminished invention. We’ll have to figure out how to fight that tendency.

Source:   Amazon Shareholder Letters

Expert forecasters were, on balance, deeply unimpressive. But Tetlock found some were better than others. What separated the forecasters was how they thought. The experts who knew a little about a lot—the diverse thinkers—did better than the experts who knew one big thing.

Source:   More Than You Know

Investment philosophy is really about temperament, not raw intelligence. In fact, a proper temperament will beat a high IQ all day. Once you’ve established a solid philosophical foundation, the rest is learning, hard work, focus, patience, and experience.

Source:   More Than You Know

First, in any probabilistic field—investing, handicapping, or gambling—you’re better off focusing on the decision-making process than on the short-term outcome.

Source:   More Than You Know

That leads to the second theme, the importance of taking a long-term perspective. You simply cannot judge results in a probabilistic system over the short term because there is way too much randomness.

Source:   More Than You Know

Probabilities alone are insufficient when payoffs are skewed.

Source:   More Than You Know

In the real world there is no “easy way” to assure a financial profit. At least, it is gratifying to rationalize that we would rather lose intelligently than win ignorantly. —Richard A. Epstein, The Theory of Gambling and Statistical Logic.

Source:   More Than You Know

So an investor who has taken a position in a particular stock, recommended it publicly, or encouraged colleagues to participate, will feel the need to stick with the call. Related to this tendency is the confirmation trap: postdecision openness to confirming data coupled with disavowal or denial of disconfirming data. One useful technique to mitigate consistency is to think about the world in ranges of values with associated probabilities instead of as a series of single points. Acknowledging multiple scenarios provides psychological shelter to change views when appropriate.

Source:   More Than You Know

[For ants], imitation is hard-wired genetic behavior, not cultural. Investors, in contrast, have the ability to think independently. However, Charles MacKay’s famous words from over 150 years ago remind us that avoiding the imitation trap is an age-old problem: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they recover their senses slowly, and one by one.”

Source:   More Than You Know

In markets, a symbiotic relationship between positive and negative feedback generally prevails. If all speculators destabilized prices, they would buy high and sell low, on average. The market would quickly eliminate such speculators. Further, arbitrage—speculation that stabilizes prices—unquestionably plays a prime role in markets. But the evidence shows that positive feedback can dominate prices, if only for a short time. Imitation can cause investors to deviate from their stated fundamental investment approach and likely provides important clues into our understanding of risk. Next time you buy or sell a stock, think of the guppies.

Source:   More Than You Know

Here’s my main point: markets can still be rational when investors are individually irrational. Sufficient investor diversity is the essential feature in efficient price formation. Provided the decision rules of investors are diverse—even if they are suboptimal—errors tend to cancel out and markets arrive at appropriate prices. Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency. So the issue is not whether individuals are irrational (they are) but whether they are irrational in the same way at the same time.

Source:   More Than You Know

Humans have a deep-seated desire to link cause and effect. Unfortunately, markets do not easily satisfy this desire. Unlike some mechanical systems, you can’t understand markets by looking at the parts. Reductionism doesn’t work.

Source:   More Than You Know

Is there a mechanism that can help explain these episodic lunges? I think so. As I have noted in other essays, markets tend to function well when a sufficient number of diverse investors interact. Conversely, markets tend to become fragile when this diversity breaks down and investors act in a similar way (this can also result from some investors withdrawing). A burgeoning literature on herding addresses this phenomenon. Herding is when many investors make the same choice based on the observations of others, independent of their own knowledge. Information cascades, another good illustration of a self-organized critical system, are closely linked to herding.

Source:   More Than You Know

In investing, our innate desire to connect cause and effect collides with the elusiveness of such links. So what do we do? Naturally, we make up stories to explain cause and effect. The stock market is not a good place to satiate the inborn human desire to understand cause and effect. Investors should take nonobvious explanations for market movements with a grain of salt. Read the morning paper explaining yesterday’s action for entertainment, not education.

Source:   More Than You Know

Practitioners spanning the centuries have documented the role of sentiment in investing and speculation. Perhaps the best way to think about sentiment is Ben Graham’s Mr. Market metaphor. Graham suggested imagining market quotes coming from an accommodating fellow named Mr. Market, who never fails to show up and offer you a price to either buy or sell your interest in a business.

Source:   More Than You Know