Point Counterpoint (More on Math)

Josh, you ignorant, misguided slut!

 

Just kidding.

On Tuesday, Josh Brown wrote an interesting and engaging post called Math isn’t an Edge.  In it he reiterated an analyst/PM interaction he found instructive.  Here is the key assertion:  “Math isn’t an investing edge.  Go find something that doesn’t come out of a calculator.”  In Josh’s words, “tell me something I don’t know.” 

I replied (with trepidation) yesterday:  Math is a Major Edge.  To summarize: 

Math isn’t enough on its own.  But it is absolutely necessary for good investing. As the philosophers say, it is necessary but not sufficient. And since it is so often ignored and misinterpreted, it often provides a really big edge.

So, this morning we got Josh’s rebuttal, entitled Math is a Foundation, Not an Edge.  The best part, of course, is where Josh calls me one of his “fave financial bloggers.”  I’ll enjoy that all week-end and beyond.  Thanks, Josh.  I have stated my appreciation of him and his work (including his great blog and terrific book) many times and am pleased to do so again. May the record so reflect. 

But I still think he’s wrong here.  Please allow me to elaborate.  I’ll begin by emphasizing that our disagreements are relatively small yet significant.

Josh argues that enormous amounts of data are readily available to all.  Moreover, “[y]ou could say that the interpretation of how this data will affect a stock’s future price is your edge, but that is NOT MATH, it is ANALYSIS.  Not the same thing.”  I agree.  As my post was careful to state, “facts alone — without context and interpretation — aren’t worth much.” 

Josh continues (my emphasis):

The main reason so many of you have argued with me is based on a misunderstanding – I am not saying the math doesn’t matter, I am saying math is not an edge in and if itself because it is the starting point and the commonality between most experienced investors is that they all understand it.  Again, it is the foundation.

Here is a significant point of disagreement.  In a world where the vast majority of funds and managers underperform, there is little evidence that “experienced investors” really do understand math or the fundamentals of investing.  As I argued in my post, “all in all, we suck at math.  It isn’t just the ‘masses’ either — it’s the vast majority of us and often even alleged experts.  Thus an analyst who understands math and utilizes it correctly will have a major advantage.”

Josh seems to agree in principle because his final assertion makes a similar point (Josh’s emphasis): 

You know who was really good at math?  This fucking idiot [I don’t know if Josh means Meriwether, Merton, Scholes or someone else – I’d have used the plural, “idiots”].  Probably better at math than you are. Again, he has the foundation in that he knows all the calculations and ratios that everyone else knows.  But that was not his edge.

As Josh would have it, the investment world is full of experts that know the math but consistently underperform anyway.

Here is the (probably inevitable) juncture of the dispute where we may simply be arguing semantics.  What I see as knowing and using the math Josh sees as analysis.  In that context, math is not an edge per se, except as against the ignorant few.  Instead, being able to control oneself behaviorally so as to apply the math provides the edge. Or perhaps using the math to come up with a coherent investment approach is the edge.  In other words, essentially everybody agrees on the math but most experts do a lousy job applying it.  In that sense, per Josh, math isn’t an edge – it’s foundational. 

But I remain convinced that our disagreement is more than semantic.

To quote Tadas Viskanta yet again, investing successfully is hard – largely because of behavioral biases – but we can see generally what works and what doesn’t work.  That we see and don’t do (or try to do) what works is partly due to poor analysis and partly due to cognitive biases that limit our success, but it’s also partly a commercial judgment.  In the words of Upton Sinclair, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

It is clear that high fees are a huge drag on returns and hurt consumers.  But they benefit us.  So we generally make our fees as high as we can get away with.  Closet indexing keeps assets sticky while doing right (value, small, concentration, low beta, momentum, etc.) risks underperformance for significant periods and thus losing assets. We want sticky asserts, so….

Ignoring the facts we know is practically and effectively no different from not knowing.  Ignoring the math we know isn’t an analytical problem.  It’s much worse than that.  It’s a moral problem.  Knowing and using the “math” (broadly interpreted to include basic investing principles) is thus a major edge.  Otherwise, how could such dreadful investment management performance be so commonplace?

  • As we are all well aware, managers generally fail to beat their benchmark indices.  In 2010, only about 25% of active managers outperformed.  2011 was even worse.  Among 4,100 funds that invest in large-cap stocks, only 17% beat the S&P 500 for the year.  Moreover, according to Bianco Research, 48% of equity mutual funds underperformed their benchmarks by more than 250 basis points. Those few managers that do outperform in any given year have a very hard time (more here) keeping up the good work.
  • Hedge funds – despite (and in part because of) enormous fees – have also badly underperformed.   Since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved simply by investing in Treasury bills. Performance thus far in 2012 has lagged too. 
  • The Global Market Index (GMI) —a passive, unmanaged but well diversified mix of all the major asset classes weighted by market values — has outperformed nearly everything else over the past decade, providing a 6.0% annualized total return for the 10 years ending December 31, 2011. That puts GMI in the 89th percentile relative to the roughly 1,200 multi-asset class funds with at least 10 years of history (and thus makes it an even better performer overall than the 89th percentile suggests once survivorship bias is factored in). GMI’s rebalanced and equal-weighted counterparts did even better. 

Let these facts sink in for a bit.  

As I emphasized initially, the great Seth Klarman offers a terrific insight: “Value investing is at its core the marriage of a contrarian streak and a calculator.”  Being a contrarian is necessary because if virtually everyone else is doing it there can’t be an edge available.  But the calculator is necessary to prove what we think we know and to check our work.   Depending on (uh-hem) how you do the math, the overall investing failure rate approaches 90 percent.  Maybe, as Josh would have it, that level of failure merely evidences poor analysis.  But I think it’s more foundational than that.  We aren’t using Klarman’s calculator nearly enough and, when we do use it, we aren’t wielding it correctly.  Most fundamentally, the investment world ignores what it knows or should know to be true.

In any event, the real bottom line is this – whether the key problem vis-a-vis the math is foundational or analytical, our industry is failing consumers and failing them in a big way, over and over again.  That’s about as foundational as our business gets.

Math is a Major Edge

I have been ruminating on this idea for a couple of days now and have resisted posting on it because, well, it’s hard to disagree with Josh Brown, even a little.  He’s smart, funny and has a big megaphone.  But I can’t help myself.

Source: xkcd

Josh posted a piece on Tuesday called Math isn’t an Edge.  In it he described an analyst/PM interaction he found instructive.  Here is the key assertion:  “Math isn’t an investing edge.  Go find something that doesn’t come out of a calculator.”  In Josh’s words, “tell me something I don’t know.” 

To be fair, I think I get the point and it isn’t an altogether bad one.  To begin with, a singular data point, even a very valuable one, is seldom reason enough on its own to make an investment decision.  We need lots of data points.  Probably more importantly, facts alone — without context and interpretation — aren’t worth much.  And finally, knowing what everybody else already knows and has factored in isn’t going to help.  As the expression goes, five dollar bills aren’t going to be left sitting on the sidewalk for long — someone is going to pick them up.

But there’s a fair amount to disagree with too.  Let’s start with the premise of the claim.  Is there really good reason to think that any sort of edge is available?  I think so, but such claims are much less well-supported than is commonly assumed and most who advocate active management (which, by definition, asserts that there are edges available) fail to describe what their purported advantage is and how they propose to exploit it. At a minimum, there are many fewer edges than most people think.

Moreover, math is an edge when it’s done right because, all in all, we suck at math.  It isn’t just the “masses” either — it’s the vast majority of us and often even alleged experts.  Thus an analyst who understands math and utilizes it correctly will have a major advantage.

Finally, even those who understand the math and can do it correctly often ignore it.  Most of us (and all us at some point) are willing and even eager to ignore math (and other data points) when our pre-conceived notions are thought to be challenged. That tendency is at the heart of confirmation bias.  We like to think we’re like judges searching for truth impartially when, in fact, we’re much more like attorneys running around hunting for any argument that we think might help.  We may “know” the math.  But have we accurately factored it into our investment “equation”? 

The great investor Seth Klarman, founder of the Baupost Group, makes a terrific insight: “Value investing is at its core the marriage of a contrarian streak and a calculator.”  Being a contrarian is necessary because if virtually everyone else is doing it there can’t be an edge available.  But the calculator is necessary to prove what we think we know and to check our work.   

Math isn’t enough on its own.  But it is absolutely necessary for good investing. As the philosophers say, it is necessary but not sufficient. And since it is so often ignored and misinterpreted, it often provides a really big edge.

Sorry, Josh.

______________

Edited to add:  This discussion continues here (Josh) and here (me).

Quote Unquote

From legendary investor Seth Klarman: “While others attempt to win every lap around the track, it is crucial to remember that to succeed at investing, you have to be around at the finish.”

To support this point, take a look at the returns Bear Stearns provided, right up until the firm blew up in March of 2008:

1991: 14.9%
1992: 28.1%
1993: 27.7%
1994: 22.3%
1995: 11.3%
1996: 21.2%
1997: 22.1%
1998: 19.2%
1999: 16.1%
2000: 15.9%
2001: 11.7%
2002: 15.7%
2003: 17.7%
2004: 17.0%
2005: 15.2%
2006: 18.3%
2007: 1.8%

It’s worth repeating.

“While others attempt to win every lap around the track, it is crucial to remember that to succeed at investing, you have to be around at the finish.”

Here’s another gem: “We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said, ‘I would rather lose half our shareholders…than lose half our shareholder’s money….'”

Yet another: “We continue to adhere to a common-sense view of risk – how much we can lose and the probability of losing it. While this perspective may seem over[ly] simplistic or even hopelessly outdated, we believe it provides a vital clarity about the true risks in investing.”