Math is Different

Outlook 15Recently I wrote a piece on financial services lies here at Above the Market. Lie #10 was “I don’t need help.” Here’s what I wrote about it.

American virologist David Baltimore, who won the Nobel Prize for Medicine in 1975 for his work on the genetic mechanisms of viruses, once told me that over the years (and especially while he was president of CalTech) he received many manuscripts claiming to have solved some great scientific problem. Most prominent scientists have drawers full of similar submissions, almost always from people who work alone and outside of the scientific community. Unfortunately, none of these offerings has done anything remotely close to what was claimed, and Dr. Baltimore offered some fascinating insight into why he thinks that’s so. At its best, he noted, good science (like good investing and good thinking) is a collaborative, community effort. On the other hand, “crackpots work alone.” Good collaboration among professionals and with good professionals by consumers improves investment outcomes, usually by a lot. A good professional can offer help with goals and plans, an Investment Policy Statement, asset allocation, risk management, behavioral management, protection from fraud (especially for seniors), and tax, estate and financial planning. We all need more help than we think.

A commenter calling himself (herself?) “pott” responded to that post as follows.

“Crackpots work alone” — a crackpot. https://www.quantamagazine.org/20150402-prime-proof-zhang-interview/ Damn right, mister.

Continue reading

The Maleficent 7

Maleficent 7The Magnificent Seven is a terrific 1960 movie “western” about seven gunfighters hired to protect a small Mexican village from marauding bandits. A re-make is currently in the works and the “original is itself a re-make of Akira Kurosawa’s Japanese classic, Seven Samurai. Meanwhile, Maleficent is the “Mistress of All Evil” in Sleeping Beauty who curses the infant princess to prick her finger on the spindle of a spinning wheel and die before the sun sets on her sixteenth birthday. Today I’m offering up a mash-up from these movies to outline what I’m calling the Maleficent 7 – seven inherent human problems and limitations that impede our ability to make good decisions generally and especially about money. Continue reading

Fixing the Math Suckage

DanicaI have repeatedly raged against our human failings with respect to all things mathematical and probabilistic (examples are here, here, here, here, here and here).  Therefore, I was delighted to see Danica McKellar (best known for playing Winnie Cooper on The Wonder Years, but also featured on favorite shows such as The West Wing and The Big Bang Theory as well as being a math whiz from UCLA) at this past week-end’s Los Angeles Times Festival of Books to promote various methods to help us (and particularly young women) to improve at math.  She was encouraging, engaging and even frequently insightful.  Danica (or at least Winnie Cooper) is also featured in The New Yorker today.  You can check out her books here. I encourage you to do so, especially if you are a young woman or have any young women in your life.  The odds are very good that you will be glad you did.

Loser’s Math

On Tuesday, the excellent Josh Brown wrote a post called Math isn’t an Edge.  In it he argued that math isn’t an investing edge, important though it is.  I countered with Math is a Major Edge, in which I asserted that since math is so often misinterpreted and ignored, it does indeed provide a major edge. Josh clarified his point in Math is a Foundation, Not an Edge to be clear that while nearly everyone in the field knows the math — it’s an important and necessary foundation — it’s the analysis that sets people apart.  I replied  to note that while I agree that good analysis can provide a major edge, there is a foundational problem too. 

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. 

I concluded by stating the obvious:  “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.”

I thought Josh and I had a healthy exchange and don’t think we disagree all that much overall.  That was that, in other words.  But then my final post in the series received this comment by “Matt”:

Can you provide any specific examples as to how your math edge has generated sustained alpha? Thanks.

Just about the right blend of self-satisfied smug and snark, don’t you think?  But more to the point, the predicate to Matt’s question demonstrates why and how simply using math (and not ignoring it) provides a major investing edge.

Investing is a loser’s game much of the time (as Charley Ellis first noted and as I have also noted before) – with outcomes dominated by luck rather than skill and high transaction costs.  To illustrate, for most of us tennis is a loser’s game. We do not possess the skills to play well consistently.  Trying harder to make great shots only makes matters worse.  Most of us are far better off simply trying to keep the ball in play rather than trying to outclass an opponent.  If we keep the ball in play we give the opponent the opportunity to make errors.  That’s a loser’s game — the results are dominated by what the loser does.  On the other hand, professional tennis is a winner’s game, with the outcome based predominately upon the winner’s better shots.  A pro generally needs to do more than just keep the ball in play to succeed.  In other words, if I avoid mistakes I can win a lot of matches at my local club.  But I can’t win Wimbledon that way.

Sadly, unlike professional tennis, even professional investing is predominantly a loser’s game.  Those who avoid mistakes will generally win (as the statistics above amply demonstrate).

Therefore, Matt, I don’t need to generate sustained alpha to gain and maintain an edge.  Hedge funds have underperformed T-bills for over a decade — by a lot.  Roughly 90 percent of investment managers fail by any reasonable standard.  Simply not screwing up (based upon the math) means that I will have a major edge.

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).