Seth Klarman’s Baupost Group recently released their latest shareholder’s letter. It’s a long one at 31 pages, but it’s full of introspective analysis on why Klarman thinks he and Baupost Group have been successful. The reasons include maintaining a long-term perspective, maintaining a sufficient margin of safety, and analyzing investor psychology. Nothing groundbreaking, but it’s always useful to peer in the mind of a great investor.
To my surprise, Klarman spends a significant portion of the letter discussing the work of Nobel Prize winning psychologist Daniel Kahneman and the various mental models and cognitive biases that have been developed from Kahneman’s resarch:
Understanding how our brains work–our limitations, endless mental shortcuts, and deeply ingrained biases–is one of the keys to successful investing. A Baupost, we believe that it is sometimes easier to predict how investors will behave in certain situations than it is to predict a company’s bottom line. At times of market extremes, by avoiding emotional overreaction and remaining aware of our biases, it may be possible to know market participants better than they can know themselves.
How can we improve our thinking? Kahneman, notes that the voice of reason (System Two) may be much fainter than the loud and clear voice of an erroneous intuition (System One). Questioning your assumptions is unpleasant when you face the stress of a big decision; more doubt is the last thing you want when you are in trouble. We would all like to have a warning bell that rings when we are about to make a serious error, but no such bell is available. It turns out that it is much easier to identify a minefield when you observe others wandering into it than when you are about to do so yourself. Observers are less cognitively busy and more open to information than actors.
Investing lies at the intersection of economics and psychology, the place where net present value meets greed and fear. It is important to know the numbers—but that is not sufficient. And it is important to know how people think-but that, too, is not enough. Both matter; it is, of course, good to buy investment bargains, but it is far better if you know why they are bargain-priced. Kahneman helps us understand some of the reasons why markets can be inefficient and thus why bargains exist.
Other things that casual observers may not know is that Baupost Group regularly maintains a large percentage of its portfolio in cash (on average, around 33 percent of NAV and sometimes up to 50 percent!) and may take up to a year in deciding whether an investment is worthwhile.
Download the full letter here.