Perspective on Performance

Via Condor Options:

Investors are notorious for chasing performance. If a mutual fund or advisor or trading strategy has done well recently, chances are much greater that traders will commit money to that strategy or product, often independently of the long term performance, general suitability, or distinguishing features of the strategy or product.  I’ve seen the same behavior among the audience for our paid newsletters: after a winning month, new subscribers are more likely to rush in, and if we have a flat or down month, interest from new readers drops. This is exactly the kind of backwards thinking that dooms most investors to underperform even basic market benchmarks: most investors would literally be better off allocating every cent to a plain vanilla index fund, rather than jumping around from one strategy to the next like insects in the lighting section of a hardware store. I get frustrated on behalf of smaller and newer traders in particular, because while they tend to have low risk tolerance and tend to face higher transaction costs – i.e., they’re the group who can least afford to chase performance – they’re also the most likely to do exactly that. You don’t see smart, profitable institutions switching from following commodity trends to selling volatility to trading fixed income every time one of those asset classes has a nice run.

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A Fundamental Confusion About the Nature of Wealth

Via The Economist:

People nevertheless use the stockmarket as a barometer of economic health. So a rise in equity markets can be (and has been) seen by governments and central bankers as evidence that the economy is headed in the right direction. That can lead to policy mistakes, such as a lax monetary stance, and further irrational exuberance.

Housing is more complicated than the stockmarket since people get utility from their homes (shelter, relaxation) while simultaneously treating them as assets. Even so, a rise in house prices that outpaces GDP growth does not make a society richer. Instead, all that is achieved is a transfer of wealth from first-time buyers to retirees exiting the property market.

In theory house prices can rise faster than GDP for a while if citizens decide to devote more of their incomes to housing services (for example, they may prefer a bigger flat to a bigger car). In practice it is hard to disentangle such structural shifts from the speculation that is prominent in all property booms.

It is the link between speculation and asset prices that explains this crisis. The ability to borrow money to buy assets fuelled the rise in asset prices. And the wealth effect of higher prices persuaded those in English-speaking countries to borrow money to sustain consumption.

Not long ago the BBC transmitted a programme about credit-card use. One man said he felt “wealthier” because he was given a credit-card limit of £5,000 ($8,000). Of course, once he used the card he was poorer. Not only did he have to repay the £5,000, but he had to service a double-digit interest rate as well. Similarly those who buy an overvalued asset with borrowed money have not made themselves richer but poorer.

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Economists Need to Study Bubbles, Reinvent Models

A great editorial by Robert Shiller:

The widespread failure of economists to forecast the financial crisis that erupted last year has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying and hence further speculative price increases — until the crash comes.

You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. As the statistician Leonard “Jimmie” Savage showed in 1954, if people follow certain axioms of rationality, they must behave as if they knew all the probabilities and did all the appropriate calculations.

So economists assume that people do indeed use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. They are not influenced by anything but the facts, and probabilities are taken as facts. They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed.

Abundant psychological evidence, however, has now shown that people do not satisfy Savage’s axioms of rationality.

Read the full article here

Eight Mental Traps to Avoid

This is a great article by Paul Larson of Morningstar.com on how investing is as much an exercise in controlling emotions as harnessing the intellect. Mr. Larson covers eight emotions. I provide a summary here:

Anchoring
Anchoring is the act of latching on to a given piece of information and using that as a point of reference for making decisions. Unfortunately, many investors anchor on things that are irrelevant to a business’s value, such as their own personal cost basis in a given stock or the 52-week trading high. Rather, we should focus on the thing that matters the most, the estimated future cash flow of a company.

Availability Bias
This mental shortcut concerns the relative importance of information. The importance our minds attach to information is correlated to how often we see the information. If we see and think about something often, our brains attach greater importance to it.

Endowment Effect
People place a higher value on things that they already own than things they do not own. Meaning, we would sell our possessions at a much higher price than at which we would buy the very same possessions if we did not already own them.

Sunk Cost Aversion
Sunk costs are costs that cannot be recovered once incurred. Once something is paid for in either time or money, our instinct is that we must soldier on and get some benefit for the expense, lest we feel like we are wasting resources. This is a variation of loss aversion, which is a concept that says people feel the pain of a loss at double the magnitude they feel the pleasure of a gain of the same amount. Two tips here. First, if a stock is clearly worth far less than what we originally paid for it, we should be willing to sell if today’s price is above our estimate of current value; that we are realizing a loss should be irrelevant to the decision. Second, if we spend several hours to research a given opportunity, we should still be willing to walk away. Our instinct will be to like the opportunity since we just spent time on it, but our goal should be to have rationality outweigh instinct.

Herd Behavior
Our deepest instincts tell us that there is safety in numbers. Beyond having a desire to do what is perceived to be socially acceptable, we often believe others have useful information from which we can take cues. After all, we all like to be liked, and the bigger group may know something we don’t. Simply, if “everybody’s doing it,” we feel the pressure to take that same action, whatever it may be. Plus, with investing being an activity where having incomplete information is the norm, this instinct to take cues from others can be amplified.

Recency Bias
We live in the here and now, and the ability to contemplate things far in the past and/or future is a uniquely human ability that requires higher cognitive functions. Yet our instincts can still get the better of us on occasion. Recency is the tendency to weigh recent events much more heavily into our decision-making than more distant events. It is a sort of mental short-sightedness where we think much more about our current situation than the much broader historical perspective. This can cause us to assume that the current state of the world–good or bad–persists into the future, rather than reverting to a long-run mean.

Confirmation Bias
Our brains inherently do not like conflict; they prefer to have a consistent, harmonious view of the world. They are wired to avoid cognitive dissonance–having two different ideas that are incompatible with each other. Our instinct is to search out information that confirms our existing views, accepting data that plug neatly into our preconceived biases, while rejecting data that do not support what we already think. Information that is consistent is processed more easily and does not increase stress.

Overconfidence
It’s an unfortunate fact that people tend to believe that their skill level is much higher than what it is in reality. For instance, the vast majority of drivers believe their driving ability is above average, even though this is statistically impossible. Unfortunately, Lake Wobegon is but fiction, and there is not a place where “all the women are strong, all the men are good-looking, and all the children are above average.”

This positive illusion we carry about ourselves allows us to be, as the famous book is titled, “Fooled by Randomness,” and attribute positive outcomes to our personal skills rather than luck or a trend over which we really had no control. Overconfidence can help us get through the stresses of our lives, but it can be deadly in the world of finance by causing one to overplay his or her hand.

Read the full article to learn more about each emotion

Related: Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics

Is The Market Rational?

This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

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Rational Investors? Is There Such a Thing?

“Despite what theoreticians tell us, investing – particularly at the margin – is not the product of rational and objective analysis, but an emotional relative analysis – anxiety about the future. My colleague Bob Ferrell put it this way: ‘Emotions are simply stronger than reason; people do not change and people make markets!’”

- market maven Arthur Zeikel