More Than You Know

More than you know

Michael Mauboussin

 

  • Process & outcome in investing
    • The single greatest error in investing is the failure to distinguish between the knowledge of a company’s fundamentals & the expectations implied by the market price
    • Michael Steinhardt – “I defined variant perception as holding a well-founded view that was meaningfully different from market consensus… Understanding market expectation was at least as important as, and often different from, the fundamental knowledge”
    • Steven Crist – “The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory… This may sound elementary, and many players think that they are following this principle, but few actually do. Under this mindset, everything but the odds fade from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price”
    • Expected value
      • Thinking about an investment in terms of a broad range of potential outcomes provides one with psychological cover when you are wrong
    • The investment industry is too focussed on outcome
      • Robert Rubin – It’s not that results don’t matter. They do. But judging solely on results is a serious deterrent to taking risks that may be necessary to making the right decision. Simply put, the way decisions are evaluated affects the way decisions are made”
  • The Babe Ruth Effect
    • Slugging percentage, not batting average matters most
    • The frequency of correctness does not matter; it is the magnitude of correctness that matters
    • Humans inherently like to be correct more often than they are wrong – in investing, this is a negative bias
      • A loss has about 2.5x the impact of a gain – leading to risk aversion and a need to have a high batting average
  • The importance of experts (or lack thereof)
    • In 1996, Lars Edenbrandt, an artificial intelligence expert, pitted his computer against Dr Hans Ohlin, a leading cardiologist, in a competition to determine whether a patient was having a heart attack, based on an EKG
      • 10,000 EKG’s were selected, exactly half of which showed confirmed heart attacks
      • The computer correctly identified the heart attacks in 66% of cases
      • Ohlin correctly identified the heart attacks in 55% of cases
  • Time is on my side
    • Empirical evidence shows that a lower turnover can increase the performance of a portfolio
    • Many fund managers underperform because their investment horizon does not match up with that of their investment strategy
Turnover 3yr CAGR 5yr CAGR 10yr CAGR 15yr CAGR
<20% 9.8% 8.7% 9.5% 11.2%
20-50% 10.3% 9.1% 9.3% 11.3%
50-100% 10.1% 8.4% 8.1% 10.0%
>100% 9.2% 7.6% 6.6% 8.8%

 

  • Many managers won’t buy a stock they think will do well over 3 years because they don’t know how it will perform over three months
    • May explain the overreactions we see and explain why myopic loss aversion may be an important source of inefficiency
  • Management
    • Learning – a consistent thirst to learn makes a good leader
      • The only way to learn what’s going on out there is to visit employees and customers and listen to what they say
    • Teaching – the ability to communicate a simple, clear vision to the organisation
      • Have no qualms repeating core messages literally hundreds of times
    • Self-awareness – requires a balance between self-confidence and humility
      • Understands their flaws and offsets them by surrounding themselves with exceptional people
  • Stress
    • Market volatility has been relatively stable for 100 years
    • Firm specific volatility has been rising steadily since the 1970s
    • Although volatility hasn’t changed, money managers today have a higher risk than ever of being in the wrong stocks
    • This increase in firm specific volatility is correlated with, and may be causal to, shortening investment holding periods
      • In the 1950s, the average holding period of a mutual fund was 15 years
      • By 2006 this had shrunk to above 4 years
      • There is a similar trend in stock holding periods
    • The physical impact of stress
      • Blood pressure rises, body mobilises energy to the tissues that need it most, short term memory improves and we set aside long term projects such as immune systems
      • Therefore, stress encourages a short-term focus
  • Psychology
    • Studies have found that after bettors place a bet on a horse, they are immediately more confident in winning
      • Endowment and confirmation bias?
    • Affective Psychology of risk
      • When payoffs are vivid, such that they carry substantial affective meaning, subjects tend to place too little emphasis on probabilities and too much on outcome
      • e. lottery players tend to have the same feelings about playing whether the odds are one-in-ten-million or one-in-ten-thousand because the payoff is so affective
      • This also explains why handicappers consistently overestimate the odds of a long-shot at the racetrack and why people fear flying
  • The use and misuse of behavioural finance
    • Behavioural finance is often used as a way to explain why markets are inefficient:
      • Humans are irrational, markets are made up of humans, therefore, markets must be irrational
      • However, markets can still be rational when investors are individually irrational
      • Markets are rational as long as there is sufficient diversity among investors
        • Provided the decision rules of investors are diverse – even if they are suboptimal – errors tend to cancel out and markets arrive at appropriate prices
      • So the issue is not whether individuals are irrational (they are) but whether they are irrational in the same way at the same time
        • This forms the basis of Soros’ theory of Reflexivity
      • One must always distinguish between the individual and the collective…
  • Always keep notes of why you make decisions as you make them, for this is the antidote to hindsight bias
  • Trusting your gut
    • Antonio Damasio gave subjects four decks of cards, two rigged to produce gains (in play money) and two rigged to lose. He then hooked them up to a lie detector machine to measure changes in their body
    • By the time they had turned 10 decks, the subjects started showing physical reactions when they reached for a losing deck
      • But they couldn’t put their hunch into words
    • It took them well over 40 cards before they could verbalise what was happening
    • Even the subjects that could never put their hunches into words showed physical reactions
  • Contingent probability
    • If you believe the probability of a company’s orders being below expectations is 70% and there is a 70% chance that the supplier will suffer as well. The chance that the supplier misses its numbers is less than 50% (0.70 x 0.70 = 0.49)
    • People tend to overestimate the likelihood of two events occurring – conjunction fallacy
  • Innovation
    • The changes driving change are generally small and incremental. So unless you think carefully about innovations cumulative effects, the changes will escape your detection and you’ll end up with yesterday’s favourite
    • There’s a good argument that the pace of innovation is accelerating
    • Stall points & growth projections
      • Inflection point at the top of the S curve
      • 83% of companies that reach the stall point grow sales in the mid-single digits or less over the following 10 years
      • 70% of these companies lose at least 50% of their equity market cap
      • It is extremely rare for companies to generate double-digit (real) top line growth when revenues reach $20bn
      • However, less than 20% of the cause for stall points can be attributed to factors outside of managements control…
  • Chess
    • Don’t think too far ahead
    • Develop options and continuously revise them based on the changing conditions
    • Know your competition
    • Seek small advantages
    • Yet the evidence that high-return persistence does occur, and given the market tends to misprice this persistence, suggests that investors with a strong grasp of competitive dynamics and a sufficient investment horizon, have an opportunity to realise superior returns
    • Only about 25% of companies can maintain sales growth >5.5% (real) for an extended period of time
  • Complex systems
    • A complex adaptive system is such that it is a dynamic network of interactions, who’s relationships are not aggregations of the individual static entities
      • The behaviour of the ensemble is not predicted by the behaviour of the components
      • They are adaptive in that the individual and collective behaviour mutate and self-organise corresponding to the change-initiating micro-event
    • Essential properties of a complex system:
      • Aggregation – the emergence of complex, large-scale behaviour from the collective interactions of many less-complex agents
      • Adaptive decision rules – agents within a complex adaptive system take information from the environment, combine it with their own interaction with the environment, and derive decision rules. In turn, various decisions rules compete with one another based on their fitness, with the most effective rules surviving
      • Nonlinearity – in a linear model, the whole equals the sum of the parts. In nonlinear systems, the aggregate behaviour is more complicated than would be predicted by totalling the parts
      • Feedback loops – a feedback system is one in which the output of one iteration becomes the input of the next iteration. Feedback loops can amplify or dampen an effect
    • Within a stock market agents have different investment styles and time horizons (adaptive decision rules), trade with one another (aggregation), fat tail price distributions (non-linearity) and imitation (feedback loops)
    • When a system becomes complex, a collection of individuals often solves a problem better than an expert
      • This means that the stock market is likely to be smarter than most people, most of the time
      • Innocentive was set up former Eli Lilly employees to try and solve complex problems through the use of large numbers of people
      • Victorian polymath Francis Galton was the first to thoroughly document the group-aggregation capability
        • Collected data from people at a fair regarding their estimate of the weight of an ox
          • Median guess was within 0.8% of the correct weight
          • Mean guess was within 0.01% of the correct weight
        • Simply stated, the errors cancel out and the result is distilled information
        • The necessary conditions for information aggregation to work include an aggregation mechanism, an incentive to answer correctly, and group heterogeneity
      • Successful investing requires creative people (Arthur Zeikel)
        • Intellectually curious
        • Flexible and open to new information
        • Able to recognise problems and define them clearly and accurately
        • Able to put information together in many different ways to reach a solution
        • Antiauthoritarian and unorthodox
        • Mentally restless, intense, and highly motivated
        • Highly intelligent
        • Goal-orientated
  • Fat tails
    • The distribution of market returns differs to a standard normal:
      • Small changes appear more frequently than the normal distribution predicts
      • There are fewer medium-sized changes than the model implies (0.5 – 2 standard deviations)
      • There are fatter tails than what the model suggests. This means that there is a greater than expected number of large changes
    • On the basis of the markets historical volatility, had the market been open evert day since the creation of the universe, the odds would still have been against it falling as much as it did on Monday in 1987
      • In fact, had the life of the Universe been repeated one billion times, such a crash would have still been statistically unlikely
  • St Petersburg Paradox
    • Daniel Bernoulli, came up with a scenario that challenges the classical theory that a player should be willing to pay the games expected value to participate
    • Bernoulli’s game – the house flips a fair coin. If it lands on heads, you receive two dollars and the game ends. If it lands on tails, the house flips again. If the second flip lands on heads, you get four dollars, if it lands on tails, the game continues. For each successive round, the payoff doubles. How much would you pay to play this game?
    • The expected value of the game is infinite!
      • Each round has a payoff of one dollar (probability of 1/2n and payoff of $2n)
      • Therefore, ½ x $2, ¼ x $4, 1/8 x $8 = 1 + 1 + 1 + 1 + 1… = ∞
    • While a normal coin flipping game would give you a normal distribution curve (bell curve) the St Petersburg Paradox gives you a fractal distribution
  • Correlation damnation
    • Confusing correlation for causality
      • Cal Tech’s David Leinweber found that the single best predictor of the S&P500 was butter production in Bangladesh
  • Jackson Pollock
    • His paintings appeal to humans because they actually form fractals, specifically those which humans find most pleasing – with a fractal dimension between 1.3 and 1.5
    • Randomly dropping paint onto a canvas would not result in the same fractal figures