Montier: Seven Sins of Fund Management

Via SSRN. This is an interesting paper from James Montier that outlines what he considers to be the seven sins of fund management.

From the summary:

How can behavioural finance inform the investment process? We have taken a hypothetical ‘typical’ large fund management house and analysed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses. The results may challenge some of your most deeply held beliefs.

► This collection of notes aims to explore some of the more obvious behavioural weaknesses inherent in the ‘average’ investment process.

► Seven sins (common mistakes) were identified. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

► Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

► Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual love ins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.

► Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

► Fifthly, many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. The average holding period for a stock on the NYSE is 11 months! This has nothing to do with investment, it is speculation, pure and simple.

► Penultimately, we all appear to be hardwired to accept stories. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

► And finally, many of the decisions taken by investors are the result of group interaction. Unfortunately groups are far more a behavioural panacea. In general, they amplify rather than alleviate the problems of decision making.

► Each of these sins seems to be a largely self imposed handicap when it comes to trying to outperform. Identifying the psychological flaws in the ‘average’ investment process is an important first step in trying to design a superior version that might just be more robust to behavioural biases.

You can read the paper here.

Ritholtz: Beware of Naive Contrarianism

Barry Ritholtz has a great post on being contrarian:

One thing you should consider when betting against the crowd: They tend to be right most of the time. There are a several things I disagree with in Surowiecki’s The Wisdom of Crowds, but the basic idea that crowds can determine outcomes is undeniable.

Indeed, markets are essentially the net result of the behavior of crowds. When asked why stocks were going down, the old trading desk joke is “More sellers than buyers.” That is as good a definition of a crowd as I’ve seen.

To better explain contrary thinking, I like to describe Wall Street and Markets as a sports stadium filled with fans. The better the team does, the louder the crowd cheers. The louder they cheer, the better the team does. Hence, markets have a large degree of self-fulfilling prophecy in the way they respond to crowd behavior.

Call it what you like — sentiment, reflexivity, feedback loop — for most of the time, the crowd not only determines market direction, IT IS market direction.

The secret to being a true contrarian is identifying when this excited (but orderly) crowd of cheering fans becomes a an unruly mob; Determining the point at which the fanatics become hooligans. Not throwing paper cups on the court, but overturning cars; When the Wisdom of Crowds becomes the Madness of Crowds.

That is when you short a raging bull market, buy into a crash. You hold your nose and make the purchase.

You can read the full post here.

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.

Read more »

Why Is September Bad for Stocks?

From Morningstar Advisor:

The answer to this question lies in Nassim Taleb’s bestseller Fooled by Randomness. If you haven’t read it (you should), let me sum up the book in one sentence: We humans have this amazing ability to see a pattern where there is none.

The three worst stock market crashes all happened in October. Do you see a pattern here? If you do, you are fooled by randomness. A sample size of three signifies nothing statistically. That does not prevent us from associating October with market crashes.

Now that this “pattern” is public knowledge, thanks to the financial media, guess what investors do in September? They sell. That’s why September is the worst month for stocks on average, even worse than the supposedly crash-prone October.

The Four Dirtiest Words in Trading

Brian Hunt, writing in the Growth Stock Wire, gives some very important advice: use stop losses!

I heard the four dirty words of trading last week…

My friend had recently purchased stock in a small oil company for around $20 per share. Things weren’t going well for the company, so its share value was down to $8 – a 60% loss for my friend.

Here’s what he said: “It will come back.”

I shuddered at his analysis of the situation. I shuddered at those four dirty words.

This is the mantra of stock market losers. If you catch yourself making this statement, immediately sell all your stocks and stick the cash in the bank.

You’ll be much better off financially if you do. You’ll also have a lot less stress in your life.

“It will come back” is a common reaction investors and traders have after seeing a stock fall 30%… 50%… or 70%. Most folks just can’t stand to admit they’re wrong. Saying “it will come back” allows them to convince themselves they aren’t wrong… just “early.”

It allows them to keep hope alive… and to ignore the elephant in the room: They need an absolutely huge, highly improbable gain just to break even.

Read more »

Arthur Zeikel “On Thinking”

These are two great quotes from Arthur Zeikel. Read these and truly think about them.

“Thinking, good thinking that is, is a lonely sport.  This may explain why so many of us do it so poorly.  Good thinking is also an inefficient process.  It takes a lot of thinking to come up with those few good, new ideas that are clearly worth thinking about – ideas that can be exploited in the marketplace.  Particularly, as Seldon so accurately noted in 1912, ‘Most coming events cast their shadow before, and it is on that intelligent speculation must be based.’

At the heart of the thinking process is the need to anticipate change correctly, and on a timely basis.  Investment thinkers must develop for themselves a model, or systematic perception, as to how markets really work.  Those believing strongly in the efficient market hypothesis are, of course, relieved of such undertakings.  However, as is becoming increasingly clear, portfolio theory does not fully explain security price movements, either here or abroad, or tell us too much about how to achieve better-than-average performance.  Most practitioners of active money management need to improve their thinking procedures.”

“The consensus view is usually wrong because it’s based on a more-or-less simple extrapolation of past trends and events and does not effectively incorporate change into expectations.  Theory tells us that value-changing events occur in a random fashion and cannot be predicted with any accuracy or consistency.  This is not so.  There is a flow to the news because there is a flow to the events that make the news.  Stock prices begin reflecting new developments before it is generally recognized that these developments have taken place.”

The Single Best Way to Beat the Market

This is a great article on investing by Dr. Scott Brown of Investment U.

For decades, economists and academics have tried to define exactly how the stock market works – and the best way to profit from its moves.

In the 1950s, one argument stated that short-term market activity results in the law of one price – i.e., that buying and selling mispriced shares of the same stock forces a single price to dominate.

Then came the “modern portfolio theory,” which claimed that investors simply couldn’t beat the market averages. This so-called “market efficiency theory” was the impetus behind the formation of the Vanguard 500 Index Fund (NYSE: VFINX) – the world’s largest mutual fund.

Score one for the stuffy “efficiency theorists.”

But while they congratulated each other over brandy and cigars, a little-known professor spoiled the party in the 1980s with a straightforward study that is still the driving force behind one of the most lucrative wealth-building approaches today…

Read more »

Fundamental Value Investors: Characteristics and Performance

I came across this interesting working paper from the SSRN. From the first paragraph:

This paper adds to the research on the issue of market efficiency. Rather than developing a quantitative trading rule that may or may not be implementable in the real world, or examining the returns of a broad cross-section of mutual fund managers who presumably have no skill on average, we analyze 2912 hedge fund manager investment recommendations posted to the invite-only internet community, Valueinvestorsclub.com from January 2000 to June 2008. The professionals involved with this exclusive site are paid for performance and must discover inefficiently priced assets and determine if the costs of pursuing them (noise-trader risk, liquidity risk, distress risk, macro risks, trading costs, and so forth) are worth the benefits. We answer a simple question: do the value investors in our sample have stock picking skills?

Read the paper here

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

So Much That's False and Nutty

Here is the 16 page hedge fund letter from Howard Marks of Oaktree. It contains some pretty good insights. Below is an excerpt:

Something for Everyone

One thing that caused a lot of people to lose money in the crisis was the popularization of investing.  Over the last few decades, as I described in “The Long View” (January 2009), investing became widespread.  “Less than 10% of adults owned stocks in the 1950s, in contrast to 40% today.”  (Economics and Portfolio Strategy, June 1, 2009).  Star investors became household names and were venerated.  “How-to” books were big sellers, and investors graced the covers of magazines.  Television networks were created to cover investing 24/7, and Jim Cramer and the “Money Honey” became celebrities in their own right.

It’s interesting to consider whether this “democratization” of investing represented progress, because in things requiring special skill, it’s not necessarily a plus when people conclude they can do them unaided.  The popularization – with a big push from brokerage firms looking for business and media hungry for customers – was based on success stories, and it convinced people that “anyone can do it.” Not only did this overstate the ease of investing, but it also vastly understated the danger. (“Risk” has become such an everyday word that it sounds harmless – as in “the risk of underperformance” and “risk-adjusted performance.”  Maybe we should switch to “danger” to remind people what’s really involved.)

To illustrate, I tend to pick on Wharton Professor Jeremy Siegel and his popular book “Stocks for the Long Run.”  Siegel’s research was encyclopedic and supported some dramatic conclusions, perhaps foremost among them his showing that there’s never been a 30-year period in which stocks didn’t outperform cash, bonds and inflation.  This convinced a lot of people to invest heavily in stocks.  But even if his long-term premise eventually holds true, anyone who invested in the S&P 500 ten years ago – and is now down 20% – has learned that 30 years can be a long time to wait.

The point is that not everyone is suited to manage his or her own investments, and not everyone should take on uncertain investments.  The success of Bernard Madoff’s Ponzi scheme shows that even people who are wealthy and presumed sophisticated can overlook risks.  Might that be borne in mind the next time around?

At Ease with Risk

Risk is something every investor should think about constantly.  We know we can’t expect to make money without taking chances.  The reason’s simple: if there was a risk-free way to make good money – that is, a path to profit free from downside – everyone would pursue it without hesitation. That would bid up the price, bring down the return and introduce the risk that accompanies elevated prices.

So yes, it’s true that investors can’t expect to make much money without taking risk. But that’s not the same as saying risk taking is sure to make you money.  As I said in “Risk” (January 2006), if risky investments always produced high returns, they wouldn’t be risky.

The extra return we hope to earn for holding stocks rather than bonds is called an equity risk premium.  The additional promised yield on high yield bonds relative to Treasurys is called a credit risk premium.  All along the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk.  Except for those people who can generate “alpha” or access alpha managers, investors shouldn’t plan on getting added return without bearing incremental risk.  And for doing so, they should demand risk premiums.

But at some point in the swing of the pendulum, people usually forget that truth and embrace risk taking to excess.  In short, in bull markets – usually when things have been going well for a while – people tend to say, “Risk is my friend.  The more risk I take, the greater my return will be.  I’d like more risk, please.”

The truth is, risk tolerance is antithetical to successful investing.  When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear.  This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates.”

In the years leading up to the current crisis, it was “as plain as the nose on your face” that prospective returns were low and risk was high.  In simple terms, there was too much money looking for a home, and too little risk aversion. Valuation parameters rose and prospective returns fell, and yet the amount of money available to managers grew steadily.  Investors were attracted to risky deals, complex structures, innovative transactions and leveraged instruments.  In each case, they seemed to accept the upside potential and ignore the downside.

There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums.  Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.

Read the whole letter here