In Search of Temperament III – Patience

In this post, we continue to work our way down the list of traits that make up the ideal investor temperament. Patience is a characteristic shared by successful investors of all sorts. Believe it or not, even short-term traders need to be patient.

Most people naturally associate trading with frenetic activity. The truth is quite different. Many successful trading styles have relatively modest hit rates. That is, the percentage of trades signalled that turn out to be profitable is quite low. Hit rates are often less than 50 per cent. Unprofitable trades are a drag on performance (which is why risk management or cutting losses short is essential).

How do traders overcome the headwinds of a low hit rate and the cost of mistakes? Patience.

Firstly, patience is required to wait for higher conviction trades. Waiting for higher conviction trades improves a trader’s hit rate.

Secondly, patience is also necessary to let profits run. It’s the winning trades that go on to multiply several times over that pay for all of the false starts and mistakes. And the only way to create this asymmetry between winners and losers is to patiently sit on profitable positions.

Thirdly, all traders experience runs of bad luck and poor performance. Traders need to patiently wait these periods out, sticking to their strategy with discipline, rather than being tempted into high risk/low reward trades.

Jesse Livermore, perhaps the greatest trader of the all-time, sums it up in these quotes:

After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting.

The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages.

Long-term investors also need patience. The following quote from Warren Buffett highlights three important points:

I call investing the greatest business in the world… because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! US Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit.

However, most institutional investors behave like Babe Ruth at bat with 50,000 fans and the club owner yelling, “Swing you bum!” and some guy is trying to pitch him an intentional walk. They know that if they don’t take a swing at the next pitch, the guy will say, “Turn in your uniform.”

The first point is that your probability of success goes up if you “wait for the pitch you like”. Buffett’s comments imply that this requires saying ‘no’ far more often than saying ‘yes’. Most people find this difficult to do.

The second point is that there’s no financial penalty for waiting. Yes, you may miss an opportunity, but there will be others. Great investors understand that success doesn’t depend on having to win them all. The pressure to win them all usually comes from having to explain your results to other people.

The third point is that institutional investors are robbed of their ability to be patient by the expectations of their investors and the constraints of being in business. Institutional investors operate in a context where the investment horizon is set by the most impatient.

Perhaps Buffett’s greatest investment lesson isn’t his stock picking approach, but rather the way he’s organised his environment, the people that he’s chosen to work with and the way that he spends his time. Buffett’s working life has been thoughtfully structured to maximise his ability to be patient.

The most extreme example of patience is Bob Kirby’s “coffee can” portfolio. As Kirby relates, in the Old West, coffee cans were used for storing and hiding valuables. His suggestion was to buy a portfolio of stocks and never sell.

Kirby relates the story of a long-term client whose husband had died leaving her a sizable portfolio of stocks.

I had worked with the client for about ten years, when her husband suddenly died. She inherited his estate and called us to say that she would be adding his securities to the portfolio under our management. When we received the list of assets, I was amused to find that he had secretly been piggy- backing our recommendations for his wife‘s portfolio. Then, when I looked at the total value of the estate, I was also shocked. The husband had applied a small twist of his own to our advice: He paid no attention whatsoever to the sale recommendations. He simply put about $5,000 in every purchase recommendation. Then he would toss the certificate in his safe-deposit box and forget it.

Needless to say, he had an odd-looking portfolio. He owned a number of small holdings with values of less than $2,000. He had several large holdings with values in excess of $100,000. There was one jumbo holding worth over $800,000 that exceeded the total value of his wife’s portfolio and came from a small commitment in a company called Haloid; this later turned out to be a zillion shares of Xerox.

Why don’t more people use the coffee can approach? Kirby explains:

I suspect the notion is not likely to be popular among investment managers, because, if widely adopted, it might radically change the structure of our industry and might substantially diminish the number of souls able to sustain opulent life-styles through the money management profession.

As Kirby points out, there’s a conflict between what’s good for the investment manager and what’s good for the client. A client may benefit from inactivity through lower costs, taxes and letting profits run (i.e. Xerox growing 160x from $5,000 to $800,000). But the investment manager will have to explain why they apparently did “nothing”.

Patience is essential regardless of whether we are a short-term trader or a long-term investor. All investors will improve their results by waiting patiently for opportunities that best match their investment process. Ultimately, whether or not an investor can remain patient depends largely on the environment in which they find themselves. That’s why successful investors seek out environments that promote patience.