Berkshire Hathaway
The Trading Mentality

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By nsw2093
September 1, 2004

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From index options thread, which veered onto a tangential topic:

nsw, responding to HB: "Miller's comments evidence a trading mentality. 'The most likely path of the market...' - investors don't endeavor to forecast such things. It's not a sin to be a trader in whole or part; it's just much easier to be an investor."

MadCapitalist: "Miller might talk about the general market, but he certainly isn't a trader. He quite often owns stocks for many years. / In the 2nd Qtr of 2004, his fund (Value Trust) showed only one portfolio change in the shareholder report. He added Countrywide Financial Corporation. There were no sales. This doesn't sound like a trader to me."

owekrj: "It's amazing how facts can trump conjecture. I'm sure Miller would appreciate the comment."

MadCapitalist and owekrj: I've enjoyed several of your other posts.

You know Miller manages both the Value Trust and Opportunity Trust (and may oversee fund managers and SMAs). The comments that HB quoted concerned his short sales in the latter fund. Reported primary class Value Trust turnover was between 3.8% and 27% in years ended March 2001-2004; in years ended December 2000-2003 it ran somewhat higher, between 25.9% and 59.6%, in the Opportunity Trust primary class. Those are the facts.

And they have nothing to do with whether Miller's comments evidence a trading mentality. Let me distinguish between investing and trading, share ~three examples, and close with the primary point of my recent posts.

I've defined an investment elsewhere as capital outlay with rational expectation of a satisfactory expected return. In distinguishing between investing and financial trading, however, by investing I basically mean endeavoring to profit from (a) the cash flows of a security or (b) reduced gap between its market price and reasonably estimated value without regard to interim market price changes, whereas a financial trader may endeavor to profit from (c) a security price change due to any other reason, including without limitation market participants' psychology or macroeconomic or industry- or security-specific events that only modestly impact its probabilistic value, or from (d) an ostensive investment that'd be liquidated, regardless of its underlying value, given certain adverse market price developments.

Now a pure investor may have immense portfolio turnover, especially in a non-taxed account, if her security appraisals change rarely while their market prices fluctuate considerably and she endeavors to maximize the difference between her securities' prices and appraised values subject to some allocation parameter that mitigates her risk. Conversely, a trader's turnover may be nominal as he scours charts and waits patiently to identify the perfect trend. It's not the amount of activity that demarcates investing from trading in this framework; it's the rationale of it and ability to see it through.

Example 1. Suppose in mid-1998 we formed a partnership that went long Berkshire and shorted an equivalent amount of SPY, "designed to trade at roughly 1/10 the level of the S&P 500" according to some description, and gave our strategy 6 years to play out. Let's say we started with $1 million, bought 12 BRK, shorted 8,143 SPY, withdrew interest on our cash balance and paid no commissions. Suppose our broker required account equity of 25% of longs and 30% of shorts. Let's use Berkshire's low and (slightly above) SPY's high on 7/1/1998 and closing prices thereafter.

(Date, BRK, SPY: 7/1/1998, 78,000, 114.94; 3/10/2000, 41,300, 140.13; 6/30/2004, 88,950, 114.53. SPY dividends ~$2.11/share mid-1998 to mar-2000, ~$6.41/share mar-2000 to mid-2004. Those figures may be off somewhat but suppose they are right.)

The evening of July 1, 1998 we'd have had $1 million account equity, a comfortable ~$485,000 in excess of our margin requirement. Six years later we'd have had around 6.5% more equity plus our withdrawn interest. But on 3/10/2000 we'd have had ~$337,000 equity, below the ~$466,000 then required. If at the outset we acknowledged the possibility that our equity could plummet and were prepared to add as much cash as might be necessary to maintain the paired position, then it could be deemed an investment � depending on our reason for establishing it. But if we'd have had to liquidate the paired position prematurely given adverse price developments, then it could only be deemed, by the above definition, a trade.

Example 2. Some time ago I analyzed a security for several months and then invested a double-digit percent of my net assets in it in one transaction. It would have been silly to buy less than that in the hope of increasing that position at prices lower than I was delighted to pay � no trading was necessary then. Now, in contrast, I've been accumulating a security for over a year and recently did something really stupid. A snippet of news excited me one morning to the extent that, in several transactions, I paid up to ~9% more than its opening price for before anyone else bought a share of it. My impatience cost me the opportunity to subsequently acquire more of that security near previously clearing prices.

While folks may generally think investors are patient and traders are impatient, in proper practice they should be the opposite. Once an investor estimates what securities are worth and determines the maximum allocations to her best ideas that'd be prudent, she should want to acquire them instantly. As a practical matter, of course, investors with a bit of capital often can't acquire desired positions near prevailing prices without spreading their purchases/sales over weeks, months, or years. Their determinations of how much of a security to buy/sell on any given day and how to do it are *trading* decisions, incorporating suppositions of how other market participants will respond to their actions independent of underlying values. Because of the general necessity of trading in material open market investing, almost every institutional investor may rationally want to adopt a trading mentality to a degree.

Example 3. It's one thing to trade in the service of investing; it's another to seek profit purely from psychology- or news-driven price changes or to publicly predict whether the S&P 500 will advance or decline over the next 6 or 12 months. An investor may contend that a market would be reasonably priced near $X, but only someone wearing his trading hat may predict that it will rise or fall to near $X in a certain way. So any comment that we're in a "bull market" or "bear market," entailing a prediction that a market will advance or decline in the reasonably near future, evidences a trading mentality.

As I wrote before, it's not a sin to be a trader in whole or part; it's just much easier to be an investor. For most individuals, it's also much *safer*. And since most individuals needn't take trading considerations into account to execute investments, fund managers may do an absolute disservice to most individual investors when they publicize their trading suppositions.

Now Hussman, Tilson, and Miller are smart guys and some of their comments are great. (See, e.g., Hussman's discussion of social security. Tilson recently shared Jim Clarke's incisive thoughts on tech stocks.) But the prudent response to their articulate commentaries isn't to place them on a pedestal. It's to ask, why? Why is Google worth $24/share? Why are S&P 500 puts attractive?

It would be regrettable if a less sophisticated reader shorts or gobbles up puts on Google based on some smart guy's commentary without considering that the ~10% net income margin he used to value it was drawn from a period when its tax provision was 56% of EBT, its EBT ex potentially atypically high stock comp expense was 35%, and it *could* be worth $120/share or peanuts as Jacko2 and I noted. It'd be regrettable if the inquiring member "hedges" his Berkshire with SPX puts before considering why that might be a dubious strategy or if a reader gambles savings he'll require for 2006 living expenses on some equity fund because Bill Miller says we're in a bull market.

Frankly, you shouldn't give a damn what comments these guys would or wouldn't appreciate: board members should be encouraged to question everything fund managers write that may impact our financial well-being. Indeed, newcomers may benefit from posts that are excessively critical of smart folks who share investment-related thoughts freely, especially when their comments evidence a trading mentality.

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