Hubris is an ancient Greek word that describes a personal quality of extreme or foolish pride or dangerous overconfidence. In the Greek classics, such as the Odyssey and the Iliad, it described actions that defied the norms of behavior or challenged the gods, which in turn brought about the downfall of the perpetrator of hubris. While the idea of defying the gods may be a bit extreme today, hubris, in the form of overconfidence, is alive and well in the investing world.
If you have been investing for awhile, you’ve probably had an experience where you bought a stock and were convinced it could only go up. Then, over time, the stock declined dramatically. Since you were so sure that the stock would go up, you held onto it, resulting in an even larger loss. Well, it’s not only individual investors that make these mistakes. The latest news about Pershing Square’s misguided investment in Valeant shows that hedge fund managers make the same behavioral mistakes that you and I make.
Pershing Square and Valeant
Bill Ackman is the hedge fund manager at Pershing Square. Pershing Square bought a stake in Valeant in 2015. At the time, Valeant was a high-flying drug company that specialized in buying other drug companies. Valeant’s strategy was to reduce costs at the acquired company, often by eliminating R&D spending. Profits were further enhanced by raising the price of the acquired company’s drugs. Ackman compared Valeant to Berkshire Hathaway, the company founded by Warren Buffet.
In late 2015, Valeant came under attack for some of its business practices, resulting in a big drop in its stock price. Instead of getting out, Ackman, sure that Valeant was a great investment, bought more. The stock continued to decline. In 2016, Ackman joined the Valeant board and bought even more stock. Finally, earlier this week, Ackman through in the towel and sold Pershing Square’s stake in Valeant. Overall, he lost roughly $4 BILLION, as Valeant lost 95% of its value in two years.
There are many investing lessons here. Foremost among them is when buying a stock, always have an exit strategy. Due to our behavioral biases, it may be difficult to sell a stock once it has gone down, especially when we are sure it will go back up. Not wanting to take a loss, we hold onto the stock, just waiting to break even. Even worse, we may do as Mr Ackman did and buy more stock, resulting in much bigger losses. Having an exit strategy ensures losses are limited to manageable amounts. Another important lesson is diversification. Owning just a few stocks, or a large position in the company you work for, exposes you to company specific risk. While the overall market can go down, an individual stock can decline much more, as was the case with Valeant.
Another thing that may be helpful is to talk with others, such as a financial advisor, about your investments and be open to other opinions. While Mr. Ackman was buying more Valeant stock, there were many other people saying that it was a poor investment. It is much easier to be objective about someone else’s investment assets than your own. A financial advisor can be a useful ally in helping you achieve your investment goals.
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