Evidence is Not Enough

Note: I will be attending the terrific Evidence-Based Investing Conference on November 15, 2016 in New York. You should too.There is a new and growing movement in our industry toward so-called evidence-based investing (which has much in common with evidence-based medicine). As Robin Powell puts the problem, “[a]ll too often we base our investment decisions on industry marketing and advertising or on what we read and hear in the media.” Evidence-based investing is the idea that no investment advice should be given unless and until it is adequately supported by good evidence. Thus evidence-based financial advice involves life-long, self-directed learning and faithfully caring for client needs. It requires good information and solutions that are well supported by good research as well as the demonstrated ability of the proffered solutions actually to work in the real world over the long haul (which is why I would prefer to describe this approach as science-based  investing, but I digress).

The obvious response to the question about whether one’s financial advice ought to be evidence-based is, “Duh!” Then again, investors of every sort – those with a good process, a bad process, a questionable process, an iffy process, an ad hoc process, a debatable process, a speculative process, a delusional process, or no process at all – all think that they are evidence-based investors already. They may not describe it that way specifically. But they all tend to think that their process is a good one based upon good reasons. Nothing to see here. Move right along.

Nearly as problematic is the nature of evidence itself. The legal profession has been dealing with what good and relevant evidence is for centuries. According to the Federal Rules of Evidence (Rule 401): “Evidence is relevant if: (a) it has any tendency to make a fact more or less probable than it would be without the evidence; and (b) the fact is of consequence in determining the action.” That’s a really low bar, which explains why so much more than merely evidence is implicit within the rubric of evidence-based investing.

And therein lies the problem. Committing to an evidence-based approach is a great start, a necessary start even, to sound investing over the long-term. But it’s not enough…not by a longshot. As philosophers would say, it’s necessary but not sufficient. Most fundamentally, that’s because:

• The evidence almost always cuts in multiple directions;
• We don’t see the evidence clearly; and
• We look for the wrong sorts of evidence.

I’ll examine each of these related issues in turn. 

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Financial Gaslighting

Note: This is my 1,000^th post at Above the Market, which began publication nearly five years ago, in August of 2011.  I remain as astonished as ever at the attention it has received. I am grateful to each and every reader. Thank you.

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In 1821, a man named William Hart dug the first natural gas well in the United States on the banks of Canadaway Creek in my home town of Fredonia, New York. The well was 27 feet deep, was excavated by hand using shovels, and its gas pipeline consisted of hollowed out logs sealed with tar and rags. Natural gas was soon transported to businesses and street lights in town. These lights frequently attracted travelers, often causing them to make a significant detour to see this new “wonder.” Expanding on Hart’s work, the Fredonia Gas Light Company was formed in 1858, becoming the first American natural gas company.

Gas lighting is thus an inexorable part of my personal history. But I’m even more interested in gaslighting.

In the 1938 play Gaslight, a murderous husband is intent on inducing instability in his wife in order to accommodate his venality. When she notices that he has dimmed the gaslights in their house, he tells her she is imagining things—that they are as bright as ever – as a way to get her to question her senses and her sanity. The British play became a classic 1944 American film from George Cukor, starring Ingrid Bergman as the heroine and Charles Boyer as her abusive spouse, out to convince her that reality is not what she perceives. In this sort of story, our most dangerous enemies are always those closest to us, masquerading as lovers and friends. Gaslight reminds us how uniquely terrifying it can be to mistrust the evidence of our senses and of what we know to be true.

Taking off from the film, “gaslighting“ in contemporary usage means a form of intimidation or psychological abuse whereby false information is systematically presented to the victim, causing him to doubt his own memory, perception or even his sanity. As in the movie, gaslighting is a hallmark of domestic abuse, but one can see its use and impact almost everywhere. I wrote much of this while in Washington, D.C., perhaps the world’s gaslighting capital.

In the investment management world, the overarching priority for the vast majority of money managers is to gather assets and revenues and only peripherally to provide quality performance for investors. Gaslighting is routinely used to try to obscure those priorities and to convince investors that, despite the reality of what they see, investing in product X or with firm y is a smashing good idea. 

Here We Go Again: Forecasting Follies 2016

Image from xkcd

In a great scene from the classic film, The Wizard of Oz, Dorothy and her friends have — after some difficulty and fanfare — obtained an audience with “the great and powerful Oz.” When, during that audience, Dorothy’s dog Toto pulls back a curtain to reveal that Oz is nothing like what he purports to be, Oz bellows, “Pay no attention to that man behind the curtain,” in an unsuccessful effort to get his guests to focus their attention elsewhere.

Like the Wizard, the great and powerful on Wall Street would have us pay no attention what is really there — “behind the curtain.”  Yet once in a great while the Street rats itself out so that we get to find out, beyond a shadow of doubt (if you still had any), what the big investment houses really think about what they do and who they do it to.

The now-defunct Bear Stearns won a noteworthy 2002 legal decision involving former Fed Governor and then-Bear Chief Economist Wayne Angell over advice he and the firm gave to a Bear Stearns client named Count Henryk de Kwiatkowski (really) after the Count lost hundreds of millions of dollars in a just a few weeks (really) following that advice by trading currency futures on margin (really). The Count had been born in Poland, escaped invading Nazis, been banished to Siberia by the Soviets, escaped and travelled across Asia on foot to Tehran, talked his way into the British Embassy, became a renowned RAF pilot, moved to Canada, became an engineer, and made a fortune trading used airliners, most famously selling nine 747s to the Shah of Iran over a game of backgammon in the royal palace (really). He also became the owner of the famous thoroughbred racing institution, Calumet Farm (really).

Bear offered the Count “a level of service and investment timing comparable to that which [Bear] offer[ed its] largest institutional clients” (which is not to say that they were any good at it). The key trade was a huge and ultimately disastrous bet that the U.S. dollar would rise in late 1994 and early 1995. At one point, the Count’s positions totaled $6.5 billion nominally and accounted for 30 percent of the total open interest in certain currencies on the Chicago Mercantile Exchange. The jury awarded a huge verdict to the Count but the appellate court reversed. The appellate judges determined, quite conventionally, that brokers may not be held liable for honest opinions that turn out to be wrong when providing advice on non-discretionary accounts.

But I’m not primarily interested in the main story. Instead, I’m struck by a line of testimony offered at trial by then-Bear CEO Jimmy Cayne that does not even show up in subsequent court opinions, despite extensive recitals of the facts of the case. The generally “cocksure” Cayne apparently thought that his firm could be in trouble so he took a creative and disarmingly honest position given how aggressive Bear was in promoting Angell’s alleged expertise to its customers. Cayne brazenly asserted that Angell was merely an “entertainer” whose advice should never give rise to liability.

Pants on Fire: 10 Big Lies in the Financial Services Industry

We all lie, especially to and about ourselves. Sometimes the lies are overt. Sometimes they are unintentional. Sometimes they are sales puffery. And sometimes they are devious. What follows are ten great lies in the financial services industry. The first three are propagated primarily by academic finance. The fourth is within the province of the academics but is a bigger problem amongst the professionals – advisors and money managers alike. The next three are predominantly professional lies. Number eight is asserted most often by the professional class and believed by consumers while the last two are universal but play out most unfortunately amongst consumer investors. I’m sure there are more. Do you have others to suggest?

Here goes….

You Can’t Outrun the Boulder

The idea behind tactical asset management is to make tactical shifts in asset allocation in order to take advantage of what is doing well and to escape what is doing poorly. The standard benchmark is a classic 60:40 allocation, of which VBINX is an excellent proxy. Had the whole concept of market-timing not been so utterly discredited (the latest data is here), it would probably still be called that. Such funds have broad discretion to move among stocks, bonds and cash and to move in and out of various sectors of the equity and fixed income markets in order (allegedly) to take advantage of market opportunities and to avoid market pitfalls.

From a marketing standpoint, the thrust of tactical management is to avoid market downturns (at least the significant ones) and to provide a lower volatility experience. That’s why, after almost disappearing, tactical managers returned with a vengeance after the 2008-2009 financial crisis. Visually, the idea is essentially that, like Indiana Jones, tactical managers can outrun the onrushing boulder of negative returns.

In reality, we can’t outrun the boulder, as the following video (using a plastic “boulder” – it looks like a blast) demonstrates clearly.

A Morningstar study from 2010, updated in 2012 and updated again in 2014 should put the matter to rest. During the pre-2010 period, tactical management underperformance averaged 2.6 percent per year. And over the three years through July of 2014, tactically managed funds underperformed a classic 60:40 portfolio by 3.8 percentage points per year.

The great William Bernstein states the key to that underperformance well as follows.

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”

Another reason for the underperformance is fees, which are the best indicator we have of performance success. Tactical funds on average charge an annual management fee of 1.48 percent as of 2014, according to Morningstar. That’s nearly double the mutual fund industry average of 0.77 percent, according to ICI.

Tactical management is yet another sort of “cargo cult” investing “solution” (thank you, Dr. Feynman) — an approach, model or system that is said to work somehow without adequate analysis, testing and safeguards. A data-mined but insufficiently authenticated “solution” will almost surely be a disaster for everyone but those collecting fees for it. Some of these “solutions” seem like a joke. Most are deadly serious. But there’s no reason to expect them to work.

You aren’t Indiana Jones. You’re not going to outrun the boulder.

It’s the waiting part that’s hard

CalPERS, the highly influential California public employee pension agency, announced in September that it would no longer invest its dollars via hedge funds. That decision is not altogether surprising in that the annualized rate of return of the hedge funds in the CalPERS portfolio over the past decade was only 4.8 percent. The behemoth pension plan sponsor was careful to note that not all hedge funds are bad, but that “at the end of the day, judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size,” the hedge fund investment program “is no longer warranted.”

In essence, CalPERS recognized and acted upon what should be apparent to everyone: hedge fund returns have simply not lived up to their hype. As Victor Fleischer famously put it, “hedge funds are a compensation scheme masquerading as an asset class.” 

Doing Too Much

It was the worst moment in San Diego Chargers history, even worse than drafting Ryan Leaf (who, coincidentally, was released from prison this week).

On January 14, 2007 I was in the stands with my younger son watching as the Chargers (14-2 in the regular season and widely regarded as the league’s nest team) hosted the New England Patriots in the divisional round of the playoffs. The Chargers had been 8-0 at home, had five All-Pro players and had nine players elected to the Pro Bowl. The day before I had received a certified letter from the Bolts, advising me that I had won a lottery among season tickets holders and would thus be allowed to purchase Super Bowl tickets if (when!) the Chargers advanced there.

But the day didn’t turn out the way I had envisioned.

Marty Schottenheimer foolishly attempted to convert a 4^th and 11 at the New England 30 early in the game. The sure-handed Eric Parker muffed a punt, one of four turnovers in all. Drayton Florence head-butted a Patriots player and drew an unsportsmanlike conduct penalty to negate a fumble recovery for the home team. Lots went wrong, but the Chargers still had the lead late. The great LaDainian Tomlinson, who had rushed for 1,815 yards and 31 touchdowns that season, ran for 123 yards and two scores that afternoon and extended the lead to 21-13 via a touchdown run with 8:35 left in the 4^th quarter.

On the very next series, Tom Brady threw his third pick of the day. The game should have been over, but Marlon McCree tried to return the interception rather than falling to the ground while cradling the football. McCree was stripped of the ball (right); the Patriots recovered and went on to win. When the Pats proceeded to do the silly Shawne Merriman sack dance on the Chargers logo in the middle of the field after the game, it instigated a brawl.

After the game, McCree was unrepentant. “I was trying to make a play,” he said, “and anytime I get the ball I am going to try and score. …[In] hindsight I don’t regret it because I would never try and just go down on the [ground]. I want to score.”

It’s a football cliché, of course, but Marlon McCree simply tried to do too much. It happens in investing all the time too.

Crash Ahead!!!

Anybody who has spent more than a few minutes on the web has seen some amazing doomsday predictions. Among my favorites are those relating to the great Yellowstone Caldera volcano, which is often described as about ready to blow and destined to create terror and mayhem even though Yellowstone is pretty calm as giant caldera systems go. For example, check out the following headline from the Toronto Sun on March 9, 2014, which provides a good representative sample of the genre.

Failing to Remember

It was 51 years ago, on August 28, 1963, that Rev. Dr. Martin Luther King, Jr. delivered his famous “I Have a Dream” speech on the steps of the Lincoln Memorial in our nation’s capital as part of the March on Washington for Jobs and Freedom.

Even with the easy availability of the full video of the speech, we readily misremember both the speech and its context.

Robin Williams: In Memoriam

The great comedian and actor Robin Williams was found dead on Monday afternoon of an apparent suicide. The loss is an enormous one. The tributes have been many and appropriately so. I’d like mine to be relevant to the usual objects of discussion here. I trust you’ll not find it forced.

In the film Dead Poets Society, Williams brilliantly plays John Keating, an unorthodox teacher who rejects the strictures of the elite Welton Academy and implores his students to search for meaning in their lives. In a crucial scene, Williams tells his students that “we don’t read and write poetry because it’s cute, we read and write poetry because we are members of the human race.” He goes on to quote Walt Whitman’s “O Me! O Life!,” a poem that ends by speaking directly to its readers: “the powerful play goes on and you may contribute a verse.” Williams repeats that great line again and then turns to his students to ask the telling question: “What will your verse be?”

But this powerful climax matters more when considered in context with what happens just prior. Take a look.