Circle of Competence

We all know that intelligent investing works.  Finding businesses, analyzing their worth, paying less… The whole deal.  Even the academics have pretty much realized that they’ve been wrong.  You can only tack on so many sigmas.

But the burning question for so many investors is why.  Why in the heck isn’t this market, comprised of millions of different investors all with reliable information, why the heck isn’t this market efficient?  How come Buffett, Munger, Ruane, Klarman, Whitman and all of the other Superinvestors keep beating the market year after year?

Actually, Seth Klarman answered this for us in a speech at MIT in 2007.  According to Mr. Klarman, a legendarily successful investor to the tune of 20% net compounded after 25 years, it’s as simple as human nature:

“Institutional constraints and market inefficiencies are the primary reasons that bargains develop. Investors prefer businesses and securities that are simple over those that are complex. They fancy growth. They enjoy an exciting story. They avoid situations that involve the stigma of financial distress or the taint of litigation. They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil.

Institutional selling of a low-priced small-capitalization spinoff, for example, can cause a temporary supply-demand imbalance. If a company fails to declare an expected dividend, institutions restricted to owning dividend-paying stocks may unload shares. Bond funds allowed to own only investment-grade debt would dump their holdings of an issue immediately after it was downgraded below BBB by the rating agencies. Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index. These causes of mispricing are deep-rooted in human behavior and market structure, unlikely to be extinguished anytime soon.”

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