Superior investment results are usually attributed to some combination of better information, better analysis, and better emotion management. The first of these, information, is central to any investing endeavour. Analysis is the synthesis of information; information is its foundation. Similarly, no amount of emotion management can overcome deficiencies in the original analysis. It's no wonder, then, that investors go to great extremes (occasionally crossing ethical lines) to obtain information that can provide them with a competitive advantage. In this age of continuous, real-time data, many investors satisfy their information cravings with a steady diet of business news on TV and the Internet. But this unceasing flow of news rarely provides the advantage that some investors think it does. If anything, it's probably harmful to the investment process.
T.S. Eliot had something to say on this subject, famously writing, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?" We are confronted today with a surfeit of information, but significantly less knowledge and wisdom. The financial press is always quick to construct facile narratives for market movements. "The market fell today on fears of a hard landing in China," we hear, or, "The market rallied today in anticipation of a more dovish Fed." It's much harder to admit that markets are both random and complex.
Chalk it up to the power of "because." Harvard social psychologist Ellen Langer demonstrated this in a series of experiments asking a small favor of people waiting in line for a library copying machine. The first request was, "Excuse me, I have five pages. May I use the Xerox machine because I'm in a rush?" An impressive 94% of those in line allowed her to skip ahead. This fell to just 64% when participants were confronted with the request, "Excuse me, I have five pages. May I use the Xerox machine?" But the real kicker was the final experiment, where participants were asked, "Excuse me, I have five pages. May I use the Xerox machine because I have to make some copies?" Amazingly, 93% of those asked agreed, even though the request contained no new information. Some justification, no matter how flimsy, was enough to secure compliance.
In the world of investing, we see this when investors get locked into a prevailing narrative. In his book "Common Stocks and Common Sense," value investor Edgar Wachenheim recounts a winning investment in Southwest Airlines. Other investors failed to realize that a tightening in airline capacity would lead to higher pricing for airline seats. But Wachenheim is most critical of sell-side analysts, who had become so focused on short-term developments that they ended up missing the bigger picture. The so-called experts, he writes, "had become reporters of recent news, not analysts."
I prefer to leave the reporting to reporters. Intelligent contrarianism, which Philip Fisher described as "correctly zigging when the financial community is zagging", is at the heart of fundamental investing. But this is hard to do when we confuse the news with information or knowledge. We all need to stop and think a little bit harder, especially when the news offers that most seductive of words: "Because."
Tuesday, June 28, 2016
Saturday, June 18, 2016
Triumph of the Optimists
When interviewing people, the venture capitalist and entrepreneur Peter Thiel has a go-to question: "Tell me something that's true that nobody else agrees with." As it turns out, this is a stunningly hard question. But one of my answers would be simply, "That the world is getting much better."
We are bombarded daily with news coverage of threats like terrorism, global pandemic and economic mayhem. It's hard to follow the news without getting depressed about the future of humanity and the planet we inhabit. And yet, the truth is, the world is getting much better. This is true broadly in human health, economic well-being and safety, as documented by writers like Matt Ridley, Charles Kenny and Steven Pinker. On Twitter, I'm constantly impressed by the data visualizations compiled by Max Roser and HumanProgress.org, which highlight remarkable improvements in our world. This is not to deny that major suffering still exists, or that pockets of society in the US have seen only modest progress over the last 50 years. But looking at the big picture, I find it hard not to be awed by the strides we have made over several generations, and to therefore be optimistic about future developments.
Still, this appears to be a relatively unusual opinion. Even if it is something people agree with on an intellectual level, they often cannot help but feel differently at the visceral level. Why exactly this is the case is the cause of much debate. Personally, I'm always interested in trying to figure out how to apply contrarian opinions for practical purposes. It struck me that I use this particular unpopular stance all the time: I invest in equities for the long term.
Contrarian optimism is hardly an unusual strategy when it comes to investing. There are two quotes that every investing aficionado knows: (1) "Be fearful when others are greedy, and be greedy when others are fearful" (Warren Buffett), and (2) "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." (John Templeton). But I'm thinking here of a longer term phenomenon instead of a cyclical one. Equity investors are generally rewarded for tolerating short-term volatility and long-term uncertainty. In fact, this is one of the many findings of Dimson, Marsh and Staunton's book that produced the title of this post. I wrote a few months ago that the point of a bear market is to return risky assets to their rightful owners. Most people seem ill-equipped for a combination of volatility and uncertainty, but this prevents them from enjoying the benefits of compounding, which only accumulate over time. Looking back at long periods of history is helpful for grasping the gigantic advantage available to those who can truly invest for the long term.
Obviously, it's possible to take this optimism too far. Investors often overestimate a company's long-term prospects. And the great bubbles in history have been the unfortunate byproduct of excessive optimism, greed and a pernicious fear of missing out. There's no doubt that we all need a healthy dose of skepticism to counter the inherent bullishness of the Wall Street machine. So an optimistic outlook needs to be combined with a finely-tuned malarkey detector. But while the pessimists sit on their hands, predicting the next financial collapse or outbreak of hyperinflation, positive change continues to happen all around us. As Ben Carlson notes, "Investors now spend 90% of their time planning for events that happen 5% of the time." This hardly seems like the best way to plan for the future. Instead, the best financial strategies focus on the powerful improvements unfolding over the long term while acknowledging the short-term challenges that always exist.
Of course, only time will tell if I'm right. But I'm relatively confident in betting that the next 50 years will prove to be yet another triumph of the optimists.
We are bombarded daily with news coverage of threats like terrorism, global pandemic and economic mayhem. It's hard to follow the news without getting depressed about the future of humanity and the planet we inhabit. And yet, the truth is, the world is getting much better. This is true broadly in human health, economic well-being and safety, as documented by writers like Matt Ridley, Charles Kenny and Steven Pinker. On Twitter, I'm constantly impressed by the data visualizations compiled by Max Roser and HumanProgress.org, which highlight remarkable improvements in our world. This is not to deny that major suffering still exists, or that pockets of society in the US have seen only modest progress over the last 50 years. But looking at the big picture, I find it hard not to be awed by the strides we have made over several generations, and to therefore be optimistic about future developments.
Still, this appears to be a relatively unusual opinion. Even if it is something people agree with on an intellectual level, they often cannot help but feel differently at the visceral level. Why exactly this is the case is the cause of much debate. Personally, I'm always interested in trying to figure out how to apply contrarian opinions for practical purposes. It struck me that I use this particular unpopular stance all the time: I invest in equities for the long term.
Contrarian optimism is hardly an unusual strategy when it comes to investing. There are two quotes that every investing aficionado knows: (1) "Be fearful when others are greedy, and be greedy when others are fearful" (Warren Buffett), and (2) "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." (John Templeton). But I'm thinking here of a longer term phenomenon instead of a cyclical one. Equity investors are generally rewarded for tolerating short-term volatility and long-term uncertainty. In fact, this is one of the many findings of Dimson, Marsh and Staunton's book that produced the title of this post. I wrote a few months ago that the point of a bear market is to return risky assets to their rightful owners. Most people seem ill-equipped for a combination of volatility and uncertainty, but this prevents them from enjoying the benefits of compounding, which only accumulate over time. Looking back at long periods of history is helpful for grasping the gigantic advantage available to those who can truly invest for the long term.
Obviously, it's possible to take this optimism too far. Investors often overestimate a company's long-term prospects. And the great bubbles in history have been the unfortunate byproduct of excessive optimism, greed and a pernicious fear of missing out. There's no doubt that we all need a healthy dose of skepticism to counter the inherent bullishness of the Wall Street machine. So an optimistic outlook needs to be combined with a finely-tuned malarkey detector. But while the pessimists sit on their hands, predicting the next financial collapse or outbreak of hyperinflation, positive change continues to happen all around us. As Ben Carlson notes, "Investors now spend 90% of their time planning for events that happen 5% of the time." This hardly seems like the best way to plan for the future. Instead, the best financial strategies focus on the powerful improvements unfolding over the long term while acknowledging the short-term challenges that always exist.
Of course, only time will tell if I'm right. But I'm relatively confident in betting that the next 50 years will prove to be yet another triumph of the optimists.
Tuesday, June 7, 2016
Four Goals Good, Five Goals Bad
In my last post, I argued that despite talk of the Fed's dual mandate, it is targeting at least four goals:
1) Price stability
2) Full employment
3) International stability, seeking to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes the Fed's influence on global economic, monetary and financial conditions
4) Financial stability, avoiding both unwarranted booms and busts in asset prices.
Tim Duy has two theories (again, see previous post) for why the Fed seems surprisingly keen on raising rates. I think the Fed's recent actions appear much more understandable in light of their unstated financial stability goal.
One narrative of the cause of the financial crisis is that the Fed was directly responsible for the financial crisis of 2007-2009 by keeping interest rates too low for too long. A more generous view is that, as Hyman Minsky warned, stability breeds instability, and the success of "the Great Moderation" unfortunately encouraged high leverage and complex financial instruments at fragile institutions.
Despite the Fed's best efforts to insulate itself from political pressure, it's unthinkable that it can have remained impervious to the two views above. In this sense, "normalization" can be seen as an attempt to head off any reprise of the financial crisis. Two more concerns are extant:
1) The notion that market participants have somehow become "addicted" to monetary stimulus. (Side note: If there's one thing that automatically sets my teeth on edge, it's references to the economy or financial markets as an alcoholic or drug addict, and to the Fed as a shameless enabler.) The problem is that this bias leads observers to see the 2013 taper tantrum and the 2016 Jan/Feb sell-off as evidence that financial markets are relying on low rates indefinitely.
2) The notion that Fed actions have pushed all asset markets to overvalued levels.
Part of the financial stability goal is clearly aimed at keeping unbridled speculation at bay. In Paul Blustein's "The Chastening", he recounts how Larry Summers famously told his bailout negotiating team, "We want to keep markets calm and the Russians scared." The Fed is playing an even more difficult game where it wants to keep markets calm and the speculators scared. This is already attempting to thread the needle, but even more difficult given the Fed's other three goals.
I've been endlessly critical of hard money types, but it's worth acknowledging that they're not the only ones who may find this expanded array of goals troubling. Those who advocate different types of rules-based monetary policy, such as nominal GDP level targeting, may also consider the monetary policy Apocrypha too hard to achieve. Their concerns are understandable. In its attempt to fulfil its Apocryphal financial stability mandate, the Fed is failing to meet its Canonical dual mandate. Furthermore, in doing so, as Narayana Kocherlakota points out, the Fed is jeopardizing its credibility to meet the Canonical Mandates. I was stunned to read the well-known economist (and former Fed vice-chair!) Alan Blinder lament the limits of monetary policy. "If there is a cyclical downturn in a year or in the next several months, there would be nothing in that shotgun," Blinder warns. If a former Fed vice-chair believes that the Fed is out of ammo (another image I don't care for), it's unlikely economic and financial markets fully believe the Fed can stabilize economy in future downturns.
As unwieldy as the quadruple mandate may be, it seems to be the right approach to central banking in the US. There's no doubt that it's incredibly challenging to manage these four goals, but I don't see any other way. If, for example, we're aware that our diet will affect our teeth, skin, weight and ability to build muscle, it's challenging to choose the right food - but we have no choice but to constantly manage the trade-offs between these effects. Why, you may argue, should the Fed restrict itself to four mandates? Why not five? Why not six? I don't have a great answer to that, and recognize the danger of over-reach: in fact, one of the problems here is that policy-makers do indeed seem to have taken on a fifth mandate, "Normalization", which is at odds with many of its more worthwhile goals.
One of my favourite books is John Kay's "Obliquity." In it, he writes, "Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple or single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity." Yellen's Fed has presumably used a dashboard of indicators to guide its policy-making thus far. It would be a huge mistake to fixate on one or two of those, despite the political appeal and intellectual comfort of doing so. While financial stability is a perfectly valid goal for the Fed to consider, the balance of risks does not appear to require a hasty set of rate hikes. If anything, it is that new mandate, "Normalization", that should be abandoned in favour of the four mandates that have historically served the Fed.
1) Price stability
2) Full employment
3) International stability, seeking to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes the Fed's influence on global economic, monetary and financial conditions
4) Financial stability, avoiding both unwarranted booms and busts in asset prices.
Tim Duy has two theories (again, see previous post) for why the Fed seems surprisingly keen on raising rates. I think the Fed's recent actions appear much more understandable in light of their unstated financial stability goal.
One narrative of the cause of the financial crisis is that the Fed was directly responsible for the financial crisis of 2007-2009 by keeping interest rates too low for too long. A more generous view is that, as Hyman Minsky warned, stability breeds instability, and the success of "the Great Moderation" unfortunately encouraged high leverage and complex financial instruments at fragile institutions.
Despite the Fed's best efforts to insulate itself from political pressure, it's unthinkable that it can have remained impervious to the two views above. In this sense, "normalization" can be seen as an attempt to head off any reprise of the financial crisis. Two more concerns are extant:
1) The notion that market participants have somehow become "addicted" to monetary stimulus. (Side note: If there's one thing that automatically sets my teeth on edge, it's references to the economy or financial markets as an alcoholic or drug addict, and to the Fed as a shameless enabler.) The problem is that this bias leads observers to see the 2013 taper tantrum and the 2016 Jan/Feb sell-off as evidence that financial markets are relying on low rates indefinitely.
2) The notion that Fed actions have pushed all asset markets to overvalued levels.
Part of the financial stability goal is clearly aimed at keeping unbridled speculation at bay. In Paul Blustein's "The Chastening", he recounts how Larry Summers famously told his bailout negotiating team, "We want to keep markets calm and the Russians scared." The Fed is playing an even more difficult game where it wants to keep markets calm and the speculators scared. This is already attempting to thread the needle, but even more difficult given the Fed's other three goals.
I've been endlessly critical of hard money types, but it's worth acknowledging that they're not the only ones who may find this expanded array of goals troubling. Those who advocate different types of rules-based monetary policy, such as nominal GDP level targeting, may also consider the monetary policy Apocrypha too hard to achieve. Their concerns are understandable. In its attempt to fulfil its Apocryphal financial stability mandate, the Fed is failing to meet its Canonical dual mandate. Furthermore, in doing so, as Narayana Kocherlakota points out, the Fed is jeopardizing its credibility to meet the Canonical Mandates. I was stunned to read the well-known economist (and former Fed vice-chair!) Alan Blinder lament the limits of monetary policy. "If there is a cyclical downturn in a year or in the next several months, there would be nothing in that shotgun," Blinder warns. If a former Fed vice-chair believes that the Fed is out of ammo (another image I don't care for), it's unlikely economic and financial markets fully believe the Fed can stabilize economy in future downturns.
As unwieldy as the quadruple mandate may be, it seems to be the right approach to central banking in the US. There's no doubt that it's incredibly challenging to manage these four goals, but I don't see any other way. If, for example, we're aware that our diet will affect our teeth, skin, weight and ability to build muscle, it's challenging to choose the right food - but we have no choice but to constantly manage the trade-offs between these effects. Why, you may argue, should the Fed restrict itself to four mandates? Why not five? Why not six? I don't have a great answer to that, and recognize the danger of over-reach: in fact, one of the problems here is that policy-makers do indeed seem to have taken on a fifth mandate, "Normalization", which is at odds with many of its more worthwhile goals.
One of my favourite books is John Kay's "Obliquity." In it, he writes, "Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple or single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity." Yellen's Fed has presumably used a dashboard of indicators to guide its policy-making thus far. It would be a huge mistake to fixate on one or two of those, despite the political appeal and intellectual comfort of doing so. While financial stability is a perfectly valid goal for the Fed to consider, the balance of risks does not appear to require a hasty set of rate hikes. If anything, it is that new mandate, "Normalization", that should be abandoned in favour of the four mandates that have historically served the Fed.
The Fed's Monetary Policy Apocrypha
In a blog post simply titled "Curious", Tim Duy ponders why so many FOMC participants seem eager to raise rates despite failing to meet either of its official mandates (price stability and full employment). Duy has two theories: (a) the FOMC does not view the removal of QE as tightening, and therefore believes it has yet to remove accommodative policy, and (b) the FOMC views a much higher level of interest rates as "normal" and is eager to reach these higher rates.
I find the second argument more convincing (by which I mean, I find it convincing as explaining Fed policy. As I will try to argue, it is a problematic stance for the Fed to take, since giving too great a weight to "normalizing policy" makes it ever hard to reach those levels). The Fed's desire for "normalization" may also reflect some view of the "normal" size of its balance sheet. But really, this argument is a sub-set of a much broader argument - one which makes the Fed's action far less curious. Simply put, the Fed is trying to meet not two, but (at least) four mandates.
No doubt this is already raising the ire of hard money types in particular, who think central banks should be focused solely on price stability, and to whom a full employment mandate is already venturing into dangerous territory. Many of these folks are likely to lionize Paul Volcker for successfully driving inflation down, even at the expense of causing a recession. But here's the funny thing: if you listen to Volcker himself, he was focused on at least three mandates throughout his lauded career. Yes, price stability was incredibly important to him. No, he didn't think the full employment mandate was particularly helpful. But he was also focused on mandates no. 3 and 4, namely international considerations and financial stability. This is strongly apparent in an excellent two-part interview he recently gave the FT's Cardiff Garcia.
Broadly speaking, I would define the extra mandates as follows:
Mandate 3: The Fed seeks to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes its influence on global economic, monetary and financial conditions.
Mandate 4: The Fed seeks to implement monetary policy in a way that maintains financial stability, avoiding both unwarranted booms AND busts in asset prices.
These mandates are hidden from the public eye. The Greek phrase for "hidden things" is Apocrypha - a phrase most commonly used in reference to a group of non-canonical writings only included in some Christian Bibles. These books are called Apocrypha "because of the belief that the men who wrote them were not addressing their contemporaries but were writing for the benefit of future generations; the meaning of those books would be hidden until their interpretation would be disclosed at some future date by persons qualified to do so." In a similar vein, the Fed's monetary policy Apocrypha are implemented for the benefit of future generations, but are largely shielded from the eyes of current observers (presumably because they lie outside the Fed's official purview).
I mainly want to talk about Mandate 4 (financial stability), but let me make some brief comments on Mandate 3. Mandate 3a is something every central bank must grapple with, particularly if it has pegged its exchange rate. Mandate 3b, however, only applies to major central banks, like the Fed, the ECB, the PBoC, and the BoJ. David Beckworth coined this the "monetary superpower" phenomenon, which I covered in a prior post.
The hidden financial stability mandate appears to be the biggest source of controversy at this point, and I cover this in my next post.
I find the second argument more convincing (by which I mean, I find it convincing as explaining Fed policy. As I will try to argue, it is a problematic stance for the Fed to take, since giving too great a weight to "normalizing policy" makes it ever hard to reach those levels). The Fed's desire for "normalization" may also reflect some view of the "normal" size of its balance sheet. But really, this argument is a sub-set of a much broader argument - one which makes the Fed's action far less curious. Simply put, the Fed is trying to meet not two, but (at least) four mandates.
No doubt this is already raising the ire of hard money types in particular, who think central banks should be focused solely on price stability, and to whom a full employment mandate is already venturing into dangerous territory. Many of these folks are likely to lionize Paul Volcker for successfully driving inflation down, even at the expense of causing a recession. But here's the funny thing: if you listen to Volcker himself, he was focused on at least three mandates throughout his lauded career. Yes, price stability was incredibly important to him. No, he didn't think the full employment mandate was particularly helpful. But he was also focused on mandates no. 3 and 4, namely international considerations and financial stability. This is strongly apparent in an excellent two-part interview he recently gave the FT's Cardiff Garcia.
Broadly speaking, I would define the extra mandates as follows:
Mandate 3: The Fed seeks to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes its influence on global economic, monetary and financial conditions.
Mandate 4: The Fed seeks to implement monetary policy in a way that maintains financial stability, avoiding both unwarranted booms AND busts in asset prices.
These mandates are hidden from the public eye. The Greek phrase for "hidden things" is Apocrypha - a phrase most commonly used in reference to a group of non-canonical writings only included in some Christian Bibles. These books are called Apocrypha "because of the belief that the men who wrote them were not addressing their contemporaries but were writing for the benefit of future generations; the meaning of those books would be hidden until their interpretation would be disclosed at some future date by persons qualified to do so." In a similar vein, the Fed's monetary policy Apocrypha are implemented for the benefit of future generations, but are largely shielded from the eyes of current observers (presumably because they lie outside the Fed's official purview).
I mainly want to talk about Mandate 4 (financial stability), but let me make some brief comments on Mandate 3. Mandate 3a is something every central bank must grapple with, particularly if it has pegged its exchange rate. Mandate 3b, however, only applies to major central banks, like the Fed, the ECB, the PBoC, and the BoJ. David Beckworth coined this the "monetary superpower" phenomenon, which I covered in a prior post.
The hidden financial stability mandate appears to be the biggest source of controversy at this point, and I cover this in my next post.
Saturday, May 28, 2016
What Do Investing FOMO and Over-Eating Have In Common?
There's nothing more frustrating than seeing an asset that you had on your watchlist go up by 50% before you've had time to do work on it, or before you manage to pull the trigger. If you're anything like me, this experience causes profound feelings of regret.
Why do we have these feelings? I see at least four possible reasons:
1) Greed. This seems like an obvious one. But I don't think it's the main driver, at least for myself. It's interesting that I usually think "I can't believe I missed that 50% move", rather than "I could have made $X! And bought so much with it!"
2) The missed opportunity to seem smart to colleagues and other investors. I confess to this one. It's totally understandable - we're social creatures and desire the approval of our peers. But dulling those urges for peer approval is necessary for actually earning outstanding returns. As I argued in a recent post, the exceptional investor will at times appear imprudent, and possibly deviant.
3) Professional pride. I see this one as related to (2), if slightly different. The feelings of regret are magnified if the recently appreciated asset is in the sectors I follow, or a company I used to own. Again, it's a natural emotion, and one which can be a positive spur to performance - in moderation.
4) The fear of missing out. This is the one I really want to focus on. There's a fine line between greed and the fear of missing out (FOMO), but the two often appear identical to outsider observers.
First, a quick digression on over-eating. I hate wasting food, and if someone in my family offers me the last bit of something delicious, my instinct is always to say yes. It's not just simple greed. The more I've become aware of this, the more I think it has deep underpinnings in evolutionary psychology. At some level, I believe, there is part of me that fears that if I don't use the resources at my disposal and consume the food, I will face hunger and possible threats to my survival. That might sound a bit nutty, but there is certainly some evidence for it in psychology. So despite the knowledge that I am (mercifully) unlikely to go without food for long, these pangs occasionally drive me to eat more than I need to.
Back to investing. I think, at some level, we fear missing out on investments because we fear we will never have similar opportunities again, and that we will be forever denied those scarce resources. We seem to be particularly susceptible to FOMO when we know people who have profited from the move (seeing the resources "consumed" just seems to chafe more). Investing FOMO also seems to be heightened in asset classes like real estate, where there appears to be a deep psychological fear of being denied shelter. In fact, there's academic work that backs this up. (The analogy between chasing returns and over-eating isn't perfect. Over-eating delivers an excess of calories. Chasing returns usually results in negative performance. But both of those are unhealthy outcomes!)
I take two things from this realization:
a) Be aware you are subject to investing FOMO. It happens sometimes. But it probably happens less if we restrict our investing to areas where we can build up a deep wealth of experience and information. A former boss used to sagely remind me, "You can't dance with all the pretty girls" if I was frustrated at missing out on something. (I may have taken his words to heart much more than he intended. I got married while working for him.)
Furthermore, markets are cyclical, and hard as it is to believe in the moment, it's quite likely that we'll get other shots. Rather than fixating on the opportunities we've missed, there are other things waiting to be discovered. As Irving Kahn reminded Peter Cundill, "There's always something to do."
(As an aside, when someone offers me delicious food, I try to take it home, rather than eating it on the spot. This seems to convince me that I will in fact enjoy those resources at some point, just at a later time. Psychological tricks seem to work in eating as well as in investing!)
b) Try and recognize when other investors have been swept up in FOMO. Buffett's dictum to be "fearful when others are greedy" is generally wise. But we also need to be fearful when others are fearful (of missing out). My guess is that a great many people who got caught up in the US real estate boom prior to 2007 weren't greedy, but just misguided. Sadly, it seems a cruel truth that it's those who attempt some discipline who usually capitulate right at a market top.
Investing FOMO is a powerful emotion. But being aware of it in ourselves and others is the first step to weakening its hold on us - and our investing decisions.
Why do we have these feelings? I see at least four possible reasons:
1) Greed. This seems like an obvious one. But I don't think it's the main driver, at least for myself. It's interesting that I usually think "I can't believe I missed that 50% move", rather than "I could have made $X! And bought so much with it!"
2) The missed opportunity to seem smart to colleagues and other investors. I confess to this one. It's totally understandable - we're social creatures and desire the approval of our peers. But dulling those urges for peer approval is necessary for actually earning outstanding returns. As I argued in a recent post, the exceptional investor will at times appear imprudent, and possibly deviant.
3) Professional pride. I see this one as related to (2), if slightly different. The feelings of regret are magnified if the recently appreciated asset is in the sectors I follow, or a company I used to own. Again, it's a natural emotion, and one which can be a positive spur to performance - in moderation.
4) The fear of missing out. This is the one I really want to focus on. There's a fine line between greed and the fear of missing out (FOMO), but the two often appear identical to outsider observers.
First, a quick digression on over-eating. I hate wasting food, and if someone in my family offers me the last bit of something delicious, my instinct is always to say yes. It's not just simple greed. The more I've become aware of this, the more I think it has deep underpinnings in evolutionary psychology. At some level, I believe, there is part of me that fears that if I don't use the resources at my disposal and consume the food, I will face hunger and possible threats to my survival. That might sound a bit nutty, but there is certainly some evidence for it in psychology. So despite the knowledge that I am (mercifully) unlikely to go without food for long, these pangs occasionally drive me to eat more than I need to.
Back to investing. I think, at some level, we fear missing out on investments because we fear we will never have similar opportunities again, and that we will be forever denied those scarce resources. We seem to be particularly susceptible to FOMO when we know people who have profited from the move (seeing the resources "consumed" just seems to chafe more). Investing FOMO also seems to be heightened in asset classes like real estate, where there appears to be a deep psychological fear of being denied shelter. In fact, there's academic work that backs this up. (The analogy between chasing returns and over-eating isn't perfect. Over-eating delivers an excess of calories. Chasing returns usually results in negative performance. But both of those are unhealthy outcomes!)
I take two things from this realization:
a) Be aware you are subject to investing FOMO. It happens sometimes. But it probably happens less if we restrict our investing to areas where we can build up a deep wealth of experience and information. A former boss used to sagely remind me, "You can't dance with all the pretty girls" if I was frustrated at missing out on something. (I may have taken his words to heart much more than he intended. I got married while working for him.)
Furthermore, markets are cyclical, and hard as it is to believe in the moment, it's quite likely that we'll get other shots. Rather than fixating on the opportunities we've missed, there are other things waiting to be discovered. As Irving Kahn reminded Peter Cundill, "There's always something to do."
(As an aside, when someone offers me delicious food, I try to take it home, rather than eating it on the spot. This seems to convince me that I will in fact enjoy those resources at some point, just at a later time. Psychological tricks seem to work in eating as well as in investing!)
b) Try and recognize when other investors have been swept up in FOMO. Buffett's dictum to be "fearful when others are greedy" is generally wise. But we also need to be fearful when others are fearful (of missing out). My guess is that a great many people who got caught up in the US real estate boom prior to 2007 weren't greedy, but just misguided. Sadly, it seems a cruel truth that it's those who attempt some discipline who usually capitulate right at a market top.
Investing FOMO is a powerful emotion. But being aware of it in ourselves and others is the first step to weakening its hold on us - and our investing decisions.
Saturday, April 9, 2016
Uncool, Imprudent & Deviant Investors
I've been reading the work of sociologist Howard Becker this past week, in which he makes an argument for reasoning from cases. By this, he means using detailed knowledge of one specific case to uncover more general ideas about how society works. Becker writes, "I want to avoid the fate of researchers who relied too heavily on a relatively few easily observed facts to do their explanatory work... that insistence doesn't fit well with much contemporary thinking about how social facts or events occur and develop, which instead works by measuring the connections between measured things rather than explaining how those connections produce the results we want to understand."
Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past.
A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."
Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms.
To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."
A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.
There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past."
Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."
Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.
Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past.
A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."
Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms.
To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."
A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.
There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past."
Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."
Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.
Saturday, April 2, 2016
The Point Of A Bear Market
In his classic book Supermoney, the writer Jerry Goodman (aka “Adam Smith”) tells a story of an investment group therapy session gone wrong. After a vicious bear market in 1969, he convened a group of investment professionals to discuss mistakes they had made in the "Go-Go Years". For a while it appears to be going well, with participants sharing the pain collectively. The meeting, however, takes an unexpected turn when Goodman asks David Babson to speak. Babson, described as “a crusty, amiable New Englander who heads the sixth biggest investment-counseling firm in the country”, proceeds to criticize professionals who got sucked into speculation. Looking out at the crowd, Babson tells them, “Some of you should leave this business.” He then pulls out a list of former speculative high-fliers that had declined dramatically or gone bankrupt. Goodman attempts to intervene several times:
“David,” I said gently into the microphone. The audience was beginning to rustle. You can tell something has happened to the good feelings when the water pitchers start to clink nervously against the water glasses in a rising cacophony.
Babson continues reading the names of former stock market darlings.
Goodman tries to interject again:
“Don’t read the list,” I said. The audience was beginning to scrape its chairs. My massive group therapy session had taken a sour turn. Nobody was going to confess if they were being accused.
Unrelenting, Babson continues to read names. Finally, Goodman cuts in:
“David,” I said, “you have passed the pain threshold of the audience.”
Phew. I attended a much milder version of a group therapy session gone awry in 2009. At a well-attended investment conference in New York, one panelist repeated a Wall Street aphorism I had never heard before. “The point of a bear market”, he said smugly, “is to return capital to its rightful owners.” There was an uncomfortable silence, as a noticeable tension filled the air. While the speaker had obviously avoided the worst of 2008, there were many in the room to whom financial markets had been less forgiving.
That adage has stayed with me all these years. But I don’t think our self-satisfied friend was quite right. The point of a bear market, I think, is to return risky assets to their rightful owners.
Put simply, assets exist on a continuum of safety. US Treasury notes are one extreme, while equities are another. As anyone familiar with the risk/reward trade-off knows, equities usually offer the possibility of high returns, but these returns face great variability. High returns compensate the investor for bearing risk.
In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets.
David Babson, I am sure, would never have made that mistake.
In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets.
David Babson, I am sure, would never have made that mistake.
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