With a new report out from the Yale Endowment, now is a good time to do a heat check on how the so-called “Yale Model” of investing is doing. I have written about the Yale Model numerous times (see here, here, here and here, for example). It emphasizes broad and deep diversification and seeks to exploit the risk premiums offered by equity-oriented and illiquid investments to investors with an investment horizon that’s sufficiently long – in Yale’s case, essentially forever. It has worked exceptionally well for Yale. For others…not so much. Continue reading
Investment Belief #3: We aren’t nearly as rational as we assume
Traditional economic theory insists that we humans are rational actors making rational decisions amidst uncertainty in order to maximize our marginal utility. Sometimes we even try to believe it. But we aren’t nearly as rational as we tend to assume. We frequently delude ourselves and are readily manipulated – a fact that the advertising industry is eager to exploit.1
Watch Mad Men‘s Don Draper (Jon Hamm) use the emotional power of words to sell a couple of Kodak executives on himself and his firm while turning what they perceive to be a technological achievement (the “wheel”) into something much richer and more compelling – the “carousel.”
Those Kodak guys will hire Draper, of course, but their decision-making will hardly be rational. Homo economicus is thus a myth. But, of course, we already knew that. Even young and inexperienced investors can recognize that after just a brief exposure to the real world markets. The “rational man” is as non-existent as the Loch Ness Monster, Bigfoot and (perhaps) moderate Republicans. Yet the idea that we’re essentially rational creatures is a very seductive myth, especially as and when we relate the concept to ourselves (few lose money preying on another’s ego). We love to think that we’re rational actors carefully examining and weighing the available evidence in order to reach the best possible conclusions.
Oh that it were so. If we aren’t really careful, we will remain deluded that we see things as they really are. The truth is that we see things the way we really are. I frequently note that investing successfully is very difficult. And so it is. But the reasons why that is so go well beyond the technical aspects of investing. Sometimes it is retaining honesty, lucidity and simplicity – seeing what is really there – that is what’s so hard. Continue reading
Investment Belief #2: Smart Investing is Reality-Based
Anytime is a good time to talk baseball. I’ve done it pretty much my whole life. If you’re watching a game, its pace is perfectly conducive to discussing (arguing about) players, managers, strategy, tactics, the standings, the pennant races, the quality of ballpark peanuts, and pretty much anything else. In the off-season, the “hot stove league” allows for myriad possible conversations (arguments) about how to make one’s favorite team better. And now that spring training camps have opened, baseball talk about the upcoming season and its prospects has officially begun again in earnest. The coming of Spring means the return of hope — maybe this will finally be the year (Go Padres!) — which of course means talking (arguing) about it.
Our neighborhood quarrels about the National Pastime when I was a kid were incessant and invigorating, and didn’t have to include the vagaries of team revenues and revenue-sharing, player contracts, free agency and the luxury tax, as they do now. We could focus on more important stuff. Who should be the new catcher? Who should we trade for? Do we have any hot phenoms? Who’s the best player? The best pitcher? The best hitter? The best third baseman? Who belongs in the Hall of Fame? Which team will win at all this year? How do the new baseball cards look? Is the new Strat-O-Matic edition out yet?
Early on, my arguments were rudimentary and, truth be told, plenty stupid. They were ideological (the players on my team were always better than those on your team), authority-laden (“The guy in the paper says…”), narrative-driven (“Remember that time…”), overly influenced by the recent (“Did you see what Jim Northrup did last night?”) and loaded with confirmation bias.
Quickly I came to realize that it’s really hard to change an entrenched opinion, and not just because I was arguing with dopes. Slowly it became clear that if I wanted to have at least a chance of winning my arguments, I needed to argue for a position that was reality-based. I needed to bring facts, data and just-plain solid evidence to the table if I wanted to make a reasonable claim to being right, much less of convincing anyone. Arguments and beliefs that are not reality-based are bound to fail, and to fail sooner rather than later.
In the investing world as elsewhere, we face the all-too-human tendency to jump to immediate conclusions, to accept conventional wisdom too eagerly and to fall prey to hyperbolic discounting – valuing now too highly and not yet not enough. But as I often say, hope is not a strategy and lunch is not a long-range plan. This problem was illustrated in a fantastically funny way recently by Super Bowl winning quarterback Russell Wilson of the Seattle Seahawks on Twitter.
I never miss Jeremy Grantham’s quarterly GMO letter, the newest version of which is just out. You shouldn’t miss it either. This time he looks at a variety of issues including energy, commodities, U.S. GDP, an early (then legal) foray into insider trading and eight investment lessons he has learned. All the lessons are valuable, but I was particularly struck by #6, perhaps because it’s a point I make often: painful errors teach you more than success does. Here’s the list, but don’t miss the entire letter.
- Inside advice, legal in those days, from friends in the company is a particularly dangerous basis for decisions; you know little how limited their knowledge really is and you are overexposed to sustained enthusiasm;
- Always diversify, particularly for your pension fund;
- Fraud, near-fraud, or colossal incompetence can always strike;
- Don’t buy stocks yourself if you’re an amateur: invest with a relatively rare expert or in a low-cost index;
- Investing when young will start your brain turning on things financial;
- Painful errors teach you more than success does;
- Luck helps; and finally,
- Have a convenient mother to be the fall guy.
I have often warned against making investment decisions based upon political commitments, and I am hardly alone. A wonderful/dreadful example is provided by Stephen Moore, who announced this week that he is leaving The Wall Street Journal to become Chief Economist for the Heritage Foundation. Quite obviously, Moore opposes the policies of President Obama vociferously (“Everything he’s done has been such a massive failure…”).
That is his right, of course, and I take pains to keep Above the Market away from politics as much as possible. My point is that Moore’s political commitments foolishly override more objective analysis and thus impact his economic and investment outlooks negatively. Continue reading
This past week has offered multiple chances for reflection and retrospective as we saw the 150th anniversary of the Gettysburg Address and the 50th anniversary of the JFK assassination. Five years ago today was significant too, if not nearly at the level of those others.
Five years ago today, the markets were reeling. The most common emotions were fear and dread. Even though no less an authority than Warren Buffet had noticed the buying opportunity just over a month earlier, almost nobody was anxious to buy stocks.
But the Federal Reserve announced an $800 billion stimulus package in an effort to stabilize the financial system that day. This announcement came on the heels of the federal government’s decision to spend over $300 million to rescue Citigroup by agreeing to shoulder possibly hundreds of billions in losses at the stricken bank and to inject $20 billion into the company.
Things would get worse before they got better (the low would come in March of 2009), but an investor who bought the market five years ago would be very happy indeed today.
Taking this sort of look back is a helpful reminder of how our emotions and biases can work against our best interests. Five years ago today, the predominant mood was panic, but buying would have been a very good thing. Today — at much, much higher levels – it’s hard to find many bears. My point here is not that the markets won’t go up from here. They may well go higher and perhaps a lot higher. My point is that market risks are much higher today that they were five years ago. For example, CAPE today is 25.43; it was barely above 15 five years ago. My analytical self tells me to be fearful when others are greedy and to be careful, to hedge, to lighten up or to take profits when others are doubling down.
Even though it feels like I should do exactly the opposite.
Lauren Foster of the CFA Institute has an excellent article up at Enterprising Investor about IPO investing. That I’m quoted is an added bonus. My friends Carl Richards and Michael Kitces show up too.
“For those who are convinced that any particular IPO will be ‘the one’ (after all, it might be), I encourage them to understand both the risks and the odds before they buy, and that they only buy with money they can afford to lose,” Seawright says. “It’s like going to Vegas. The lavishness of the casinos demonstrates that the odds favor the house. But, if you only play with money you can lose (perhaps out of your entertainment budget), it’s not quite so bad.”
I encourage you to read the entire article.
In 2006, the TradingMarkets/Playboy 2006 Stock Picking Contest was won by Playboy’s Miss May of 1998, Deanna Brooks (shown right). Her portfolio, which bet heavily on oil and gold stocks, gained 46.43 percent on the year and every stock in it provided double-digit returns. She liked Yamana Gold because “What girl doesn’t like a little bling? I’m hot for gold this year.…” It wasn’t her only nugget of sterling analysis. She also liked Petrobras because “oil is making money” and IBM because computers “aren’t going away.” She wasn’t the only Playmate to find a rich vein of success. A higher percentage of participating Playmates bested the S&P 500′s 2006 returns than active money managers. Think about that for a moment. Over the course of a full year, a bunch of Playmates outperformed a whopping majority of highly trained and experienced professionals with vast resources who spend all day every day trying to beat the market.
It’s easy to say that the Playmates got lucky, and they did. But we’d never expect a guy swimming laps at the YMCA to beat Michael Phelps across the pool, a girl off the street to beat a Grandmaster in chess, or an unschooled janitor to solve an insanely complex math problem amidst a spot of cleaning in the afternoon that the best and the brightest need years to figure out. Not even once.
If something like that actually were to happen, we’d treat is as a marvel (as the movie, Good Will Hunting, excerpted above, does), not just as a whimsical curiosity to be used for the purposes of garnering a bit of publicity and ogling attractive women.
It’s tempting simply to say that the contest is too small a sample size to be meaningful and move on. Had she stuck with investing, Miss May’s performance would miss and miss by a lot, probably sooner rather than later, as all investment performance tends to be mean reverting. But we also know that sample size doesn’t mean much when little luck is involved. It doesn’t matter how many times I race Michael Phelps. The chances of my winning will always be vanishingly small — effectively zero.
It’s also important to emphasize (as Michael Mauboussin did in his excellent book, The Success Equation and at The Big Picture Conference recently) the paradox of skill when it comes to investing. As overall skill improves, aggregate performance improves and luck becomes more important to individual outcomes. On account of the growth and development of the investment industry, John Bogle could quite consistently write his senior thesis at Princeton on the successes of active fund management and then go on some years later to found Vanguard and become the primary developer and intellectual forefather of indexing. In other words, the ever-increasing aggregate skill (supplemented by massive computing power) of the investment world has come largely to cancel itself out.
These explanations are good as far as they go, but they hardly tell the entire story. Lady Luck is crucial to investment outcomes. There is no getting around it. Managing one’s portfolio so as to benefit the most from good luck and (even more importantly) to get hurt the least by bad luck are the keys to investment management. Doing so well is a remarkable skill, but not the sort of skill that’s commonly assumed, even (especially!) by professionals.
More to the point, if investment returns depend that heavily on luck and real investment skill is that elusive and rare, what should we do with our (or our clients’) money? For some answers, we turn to the world of…poker? That’s right — poker. Continue reading