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The Investing Enigma

Investing is the most supremely arrogant thing that you can do. In effect, whenever you buy or sell an individual stock — or even if you trade an index fund with the intention of timing the market — you’re placing your judgment ahead of the judgment of the entire world. You’re saying that you’re right, and that everyone else is wrong. It doesn’t get any more arrogant than that.

But after almost three years of a crushing bear market, most investors have had the arrogance knocked out of them. Many have quit investing altogether, because they’re disappointed to have learned the hard way that they aren’t smarter than everyone else on the planet. It was a costly lesson.

Let’s start with growth investing. A growth investor thinks he knows something about a company’s future prospects that no one else is smart enough to appreciate. Is it really arrogance, then, if you have some actual expertise? Perhaps. There are a lot of other experts out there, and the chance that you have them all beat is pretty slim. And you really do have to beat them all, because if your expert idea isn’t unique, if it’s already baked into the price you pay for the stock because other people already know it, then you’re not going to make much money from it.

But it’s beyond arrogance if you don’t really have the expertise yet still think you can beat all the experts out there — that’s just plain stupid. Yet that’s precisely what a lot of investors thought during the great bull market that ended in March 2000. Perhaps they all must have thought they were the only ones who could envision a future of boundless growth driven by astonishing new technologies. Did each of them really believe that he was the only subscriber in the world to the Gilder Technology Report?

Truth be told, most growth investors then weren’t looking to the future at all, so it didn’t matter whether they had a unique vision of it or not. Take Cisco Systems, for example. Did very many Cisco investors really take seriously whatever they thought they knew about Internet routers — how they worked, what they did, who would buy more and more of them and why? No. Most were really looking at Cisco’s past, not its future. They were looking at the years of 50% annual revenue growth that had given Cisco the highest market capitalization in the world. And that’s information everyone could see. So what made anyone ever think it was possible to make money on that tidbit of information?

Growth investing is out the window now, and value investing is in — but the value investor is no less arrogant than the growth investor. And sometimes he’s no less gullible.

Value investors don’t think there’s some great future that only they can see. Instead, they think the rest of the world fears some horrible catastrophe that they don’t think is really going to happen. They believe the rest of the world has made the stocks they want to buy cheap.

Warren Buffett might try to tell you that this kind of investing doesn’t involve a trace of arrogance. And he’s so aw-shucks humble and wholesome you might fall for it. Sure, I suppose you don’t have to think of yourself as a genius to figure out that nothing really all that horrible is going to happen to Coca-Cola or Gillette. So if you wait for a bear market and buy them cheap, how can you lose?

Well, ask Buffett that question about bankrupt US Airways Group. Or ask everyone who went down with the WorldCom ship. When it was trading for $1, I wondered out loud whether it might be “too big to fail.” Thank goodness my arrogance was limited to my public ruminations and not my investing — I never bought any. WorldCom failed: It was cheap at a buck, but it turned out it was cheap for a reason.

So whether you’re a growth investor or a value investor, you’ve got to have the arrogance to think you’re the smartest person in the world. Unfortunately, the whole idea of “smart” in the stock market turns out to be a terribly slippery concept.

During the bull market many people thought they were pretty smart, but they weren’t. How many investors bragged when they made a stunning return like, say, 65% on their tech-stock portfolios in 1999? Lots. Too bad the Nasdaq returned 89% that year.

To be truly smart you had to do 90% or better. If you were taking the risk of tech stocks and earning less than that, then you weren’t just not smart but you weren’t even lucky. You were just a leaky little boat on a rising tide. Only the people who did better than 89% earned the right to wonder whether they were lucky or smart. But none of them did — they all thought they were smart, of course.

Are you stupid if you’ve lost money in the bear market? Not necessarily. Let’s say you’ve been investing in tech stocks all the way down, and you’ve watched 70% of your stash go up in smoke since the top in March 2000. You must be pretty smart because the Nasdaq has lost 74%, so at least you did better than that.

Am I saying you were a blockhead in 1999 when you made 65% and a genius after March 2000 when you lost 70%? Yep. I told you it’s a slippery concept.

Maybe a better way to look at it would be to say you were ill-advised to invest in tech stocks after March 2000 to begin with. If you’d been smart, you’d have diversified into the whole S&P 500, and you’d only have lost 41%. But is it really so smart to lose 41%? Well, it’s better than losing 70% or 74%.

But it’s certainly preferable to lose nothing at all if you don’t have to. And no one held a gun to your head in March 2000. If you’d been really smart, you would’ve gotten out altogether and lost nothing. But is it really so smart to have made nothing on your money for almost three years? If you’d been a genius you would have bought long-term Treasury bonds in March 2000 — you’d be up about 25% on that one!

As you can see, to be an investor you not only have to pit your knowledge against the wisdom of the whole world, but you also have to possess the arrogance to completely set your own standards of success or failure. You have to be confident enough in your own judgment to sometimes pat yourself on the back when you lose “only” 70% — or to excoriate yourself when you fail to make anything less than 25% during the worst bear market in 70 years.

Investing is the toughest game in the world. And I’m arrogant enough to say that I wouldn’t have it any other way. I intend to keep playing, and I know I’m going to win. If you’re reading this column, then you’re probably pretty arrogant, too. So let’s just admit that arrogance is what it takes and go out there and get back in the game. Only try not to be just arrogant, but smart too.

– The author, a principal of Trend Macrolytics LLC, holds a position in the shares of Cisco Systems. This commentary is Luskin’s “Ahead of the Curve” column for SmartMoney.com.