Logic Test Solution

Spoiler —

This is the solution to yesterday’s Logic Test.  Readers should check out the test before reading the solution.  The source of the problem (which we obviously modified) is poker expert Steve Zolotow.


We sympathize with several respondents who said, "I don’t get kings that often and I am going to play them!"  That is a real-life solution, but this is a logic problem.

The key element is to evaluate what the first player might have said.  Here is a clear explanation from one respondent.  Nice going, Nemo!

The small blind is telling the truth.  Fold.

A bear would honestly claim to be a bear.  A bull would lie and claim to be a bear.  It is unknown whether the player to your left is a bull or a bear, but either way, he must have said "I am a bear."

Therefore the button was lying and the small blind was telling the truth.

Among respondent answers, David Lehman, a veteran CBOE trader solved the problem most quickly, in 45 seconds.  Other correct solutions came from regular readers RB and Eric B., with somewhat longer times.

In our earlier testing, there were two faster times.

Ralph Katz,  a top options trader and clearing firm owner, is currently competing in the finals of the Bermuda Bowl, the world bridge championship.  (In a future post we will take up the question of why so many top investors are also involved with bridge.  Hint:  Those thinking tea and crumpets do not understand the game).  Ralph asked one clarifying question and then announced his answer, taking less than twenty seconds.

The overall prize goes to young Ryan, Financial Analyst and Trader in our office.  He reviewed the conditions out loud and announced the answer.  Time:  About ten seconds.  (Note to hiring employers: You cannot coach speed!)

The Lesson

We suspect that many more would have solved the problem, or gotten it faster, without all of the poker trappings.  Suppose, for example, we had just posited three people making statements….

Something about presenting an actual poker hand throws people off track.

We suspect that similar things happen to those invested in a specific trading position.  There is a focus on one’s holdings rather than the logic of the situation.  Discipline is lost.  We would love to see the problem presented to two different groups — with and without the poker background.

This is a question for Dr. Brett!

Continue reading…

A Logic Test

At "A Dash" we are seeking ways to help investors and traders fight the traps described in the literature of behavioral finance.  One method, which we used successfully in the classroom many years ago, is to present problems wildly different from the main theme.  Later, we try to show the connection.

This problem came from two different sources. We will credit the poker source tomorrow, but the inspiration to present it came from The Trading Goddess.  Like many thousands of others we read her blog every day as a source of information and ideas.  What sets the blog apart is the originality and style of presentation — educational and always …..entertaining.  (We congratulate two of the bloggers we also read daily, the inimitable Muckdog and Bullish Jim, on their selection by the Trading Goddess as contributors.  Nice recognition!)

Here is what caught our attention. 

This  image reminded us of the problem, which we have already tested on a strong group of very smart people.  It may seem familiar to you.  If so, you may be able to solve it quickly.  Keep track of your time.  Even if you do not play poker, you can solve this problem.  It has a clear answer.

Here is the situation:

You find yourself visiting Chicago and the Old Prof answers your request to find a poker game.  To help you play, you are reliably informed that the players — all options and futures traders from the Merc and the CBOE– are either bulls or bears.

The bears ( spoofed last week,  and the good guys now) are completely honest.  They always tell the truth in their statements, and they never bluff.  The bulls always lie and frequently bluff, although they might fold a worthless hand.

You are playing with three others, but you do not know whether they are bulls or bears.  You are the big blind, and when you look at your hand you are delighted to see two kings.

Trying to get a read on the table, you ask the next player whether he is a bull or a bear.  He answers, but you cannot make out what he says.  He folds.

The next player, the button, looks at you.  He says, "He told you that he was a bull."  The button now folds.  The last player, the small blind, looks at the player on the button and says,"You are a liar!  You are a lying bull."  She now looks at you and says, "I have pocket rockets (two aces, for the non-poker players) and I am going all in."

Does she have the hand in the picture?  Who is telling the truth and who is lying?  What should you do with your kings?

Please do not post your solution in the comments.  You can email me for recognition in tomorrow’s post, where we will reveal the solution.  The range of answers — all from very intelligent people, many of whom play poker — include complete failure and rapid solution.  Keep track of your time to solve.

Avoiding Confirmation Bias

Sometimes an answer is easier to see if one steps away from the immediate problem, instead looking at an analogous situation.  This is a common teaching method, and one that we use frequently at "A Dash."


Getting away from the immediate question helps to avoid what behavioral psychologists call the confirmation bias.  This tendency to see evidence as supporting one’s preconceptions is very powerful.  We believe that even the leading market pundits, who are well aware of the phenomenon, fall victim to its power.

There is another important advantage:  Clarifying our objective.  So many prominent market commentaries claim not to make specific forecasts.  Frequently the authors criticize those who make specific and quantifiable predictions, pouncing on their errors.

We find this position quite remarkable.  If a market pundit is not trying to make some prediction, what is the value to readers?  Those claiming to have a "variant view" are making predictions.  The "variant view" idea involves even more complex predictions.  The author must make his own prediction, and then also prove that the market has not already discounted his widely-publicized idea.

The critical reader should ask whether these predictions are specific, quantifiable, and falsifiable.  If not, the argument is not useful for trading.

Bill Rempel’s strongly-stated article on this subject deserves a wide readership:

There are some who would have it both ways. These people actively
manage money! Perhaps for client accounts, where they buy or sell based
on their technical models. Perhaps in mutual funds, where they decide
whether to hedge with index puts, and how much hedging to put on.
However, they try to have it both ways by saying “it’s not a
prediction” or authoring articles about the fallacies of making

Please read Bill’s entire analysis.  As we attempt to guide readers to the best sources on the Internet — especially informing the explosion of new readers who have not joined us yet — Bill’s criteria should have a prominent place.

A Test of Confirmation Bias

Let us pretend that we live in Chicago — something that means living and dying with "Da Bears."  [Giant fans and others can substitute their own team.]  We are interested in whether the Bears will win each game, each week.  We have many sources of information about Bears players, injuries, strategies, coaching, and most importantly, whether "good Rex" or "bad Rex" will be at the helm this week.  There are also many predictions from a community of experts.  Since we are fans, we have a lot of information and plenty of opinions.

This information can be our undoing.  We think that we know more and can parse information better than the real experts.  Everything that we see on TV, hear on talk radio, or read in the paper feeds our confirmation bias.  This is reflected not just in our interpretation of what we read, but also in what we choose to read.

An Alternative

Now let us suppose that we wished to predict the weekly result of the  Phoenix Cardinals, a team in which we have little interest.  Our  search for information  would be much more objective, including  a more open mind about expert predictions, sources, and data.

[It would be an interesting experiment for those like Scott Rothbort and Brett Steenbarger who have a ready audience, the appropriate intellectual interest, and the skill to conduct such tests.]

The Market Application

Let us imagine that a group of potential investors, abandoning the business of condo-flipping, decided to look at stocks with a long-term view.  These investors did not have any preconceived notions.  They had no market theory.  Their only question was whether to invest in stocks, and whether this was the right time.

In doing their research, they discovered that there was a community of experts.  These commentators had no allegiance to a particular viewpoint.  Their earnings were strictly based upon their results.  Poor performance, poor revenue.

The group of new investors might discover Mark Hulbert, who monitors the long-term performance of market advisory letters.  He identified the best and worst performers over the last ten years.  These groups of experts, unlike bloggers or pundits, cannot "fake it."  Revenues flow from performance.

The rookie investors discover the following from Hulbert (Barron’s subscription required) — a truly remarkable result:

The bottom line? None of
these nine top timers are bearish. The average equity allocation among
all nine is 92%. This is higher than where this average stood a year
ago, as well as where it was in early May.

This 92% average is good news for the stock market
in its own right, of course. But it’s particularly bullish relative to
the average forecast of the 10 stock-market timing newsletters with the
very worst risk-adjusted performances over the last decade. The average
recommended equity exposure among these worst performers right now is

In other words, the worst market timers are quite
bearish right now, while the best timers are quite bullish. Rarely are
we presented with a contrast this stark.

There are no guarantees. But to bet on a new bear
market right now, you have to bet against the timers with the best
long-term records and with those whose records have been awful.


There are many issues surrounding the prospects for stocks.  One needs to understand the worries, the probabilities, and how much current prices already reflect these concerns.

The intelligent investor reads a lot of information and has opinions on everything.  It is an easy question:

Do you think you are smarter and better informed than the consensus of all of the investment newsletter writers?

Or might  you be falling victim to the confirmation bias, spending a little too much time at your favorite bearish blog?

The Outcome Bias

Readers of "A Dash" know that we are not attempting to describe or explain every zig and zag of the market.  It is not that we lack opinions; it is just not our purpose.  By way of contrast, each day we write a market commentary for our clients on our private blog.  For our investors, we discuss what is currently happening with special attention to the positions we own.

Background:  Explaining the Daily Market

This daily exercise puts us in the position of the journalist, looking at the blank page and needing to write something intelligent to describe market action.  The journalist has no choice.  Something must be written.  Tomorrow’s readers need an definitive explanation.

We have a choice.  We frequently observe that market moves were basically random noise.  Often we disagree with what we know will be the headline story in the next day’s papers.  [For today — Oil prices went up, despite OPEC supply increases.  There was a lot of
futures buying driving a low-volume rally.  Some big player(s) wanted
more exposure.  There is no real explanation.  Others will cite a "rethinking" of Fed moves.  Yada, yada.]

The Outcome Bias

One of the many useful contributions of the study of cognitive biases is the outcome bias.  When one starts with knowledge of the result, it is easy to find explanations and easier to conclude that one’s own decisions would have been perfect.  There are strong psychological studies of this effect.

My non-trader friends often observe, after a volatile market day, how wonderful it must have been for traders.  It shows how little they understand.  The volatile day provides potential for a wide variation in results.  It all depends on how one was positioned going in.  For those with each position there will be successes and failures.

Long Premium.  This means that you own options which gain deltas (your favorable position gets bigger) as the underlying stocks move higher and lose deltas as the stocks move lower.  The trader takes "scalps" by selling short stock on the rally and buying it on the decline.  Even this trader may kick himself for "selling too soon" or not guessing the trading range correctly.  The actual traders with this position will do many different things, some getting the optimum result by selling at the top.  Others might wind up losers if they do not trade at all, expecting a big run rather than a trading range.

Long the Underlying.  Your stock (or index) rallies.  You get a big upward move.  Did you sell anything?  If you did, you can buy back lower.  If not, you have some explaining to do, since experienced traders always sell something into rallies.

Short the Underlying.  Your stock (or index) rallies in your face.  Your losses are mounting.  Do you throw in the towel?  Do you add to positions?  Either could be correct, but today, only one decision was right.  As in the other cases, some of those with this position make each decision.  There are many different stories, including those selling at the top.  Every trade has two sides.

Short the Premium. This is the toughest.  Suppose that a trader decided after last Friday’s employment report to sell some index calls, expecting them to expire worthless.  A big rally like today’s can cause calls to explode in value, making the position much larger than the  original planned size.  Should the trader bail out?  We know from experience that every trader has a price where he gives up.  If the trader does not have this price, his backer or clearing firm does.  Brett Steenbarger has a great discussion of trader fear, and this is one of the causes.  [searching for Adam Warner’s recent great article on this topic.  UPDATE: Link added.]  Our experience with traders is that original position size is often too large, based upon what the trader hopes to gain, rather than the risk of loss.

An Experiment

In tournament bridge circles (a group including many leading traders and investors) we often give a problem "on a napkin."  It is called this because it involves card play, and is written down at dinner on a handy piece of paper.  Sometimes there is an obvious way to play the hand — clearly best via expert analysis.  The person posing the problem hopes to get confirmation for his (losing) decision or admiration for his brilliancy from his fellow experts.  The problem is that some of those getting the problem may try (consciously or subconsciously) to gain acclaim from dinner companions by finding the winning answer on the particular deal.  That respondent may choose an anti-percentage action, just because of the problem setting.

This would be an interesting trader experiment.  We are not going to summarize the factors leading to today’s trading, since the information is readily available.  Instead, let us imagine an experiment.  Perhaps Brett Steenbarger, who works daily with traders, or Scott Rothbort, who uses innovative methods in his classes, will give this experiment some thought and find an implementation.

Take a day like today, and some other big market moves.  Provide whatever information might seem to be relevant — charts, economic fundamentals, earnings stories, breaking news — to everyone in the test panel.

Tell them the news —  in advance!

Each participant gets to predict the market outcome knowing the news in advance.  The experiment could include a variety of situational examples with different facts.

The key point is one of our recurring themes — the difficulty in predicting unlikely events.

We would expect a range of outcomes with very few coming close to maximizing the result.  We suspect that those with the "wrong" positions would do the worst, reacting to fear.  Those with the "right" positions would not come close to optimizing the result.  This expectation is based upon experience.  We have been there.

Individual investors who understand the advantage of staying with the normal odds — and not trying to predict extreme outcomes — can gain a significant advantage.  For the individual investor it comes down to understanding the difference in time frames and not being frightened by volatility.

More Homework: Interpreting What You Read about Market Action

One of the biggest traps for the smart investor or trader is the often persuasive commentary about recent market action.

When the Dow had a decline of over 1% last June, we highlighted this problem, calling it the biggest mistake of the individual investor.  As background, readers should go back and look at that article, written when the Dow was under 11,000.  The road was a little rocky for another month, but we all know how it turned out.

What about now?

Today’s Barron’s had a number of interesting insights into current sentiment.  Let us first look at this comment from The Trader column:

"We’re at the point in the mature cycle
where we all know excesses have been built up, and everyone is watching
for signs that point to the end of the cycle [emphasis added]
," says Jeffrey Kleintop,
chief-market strategist at LPL Financial. "The market’s perspective
will get even more short-term from here, and the bull will be a rougher

Our sense is that this is an accurate reflection of many hot-money managers, trying to time the end of  "the cycle."  Timing this cycle has been going on for three years, spurred by skepticism about Fed policy.  It began with the gradual increase in interest rates from an abnormally low rate.  These guys are shorter than they want to be and reacting to every data point.  Readers might wish to compare  this behavior with that described in our Blackjack article.

Contrast this with Warren Buffett’s advice:  "You can’t get rich with a weather vane."

Barron’s also has an excellent article by Michael Santoli called The Missing Man.  Santoli provides a lot of information about how individual investors have not yet participated in a rising market. Readers should check out the entire article, but here are some key quotes:

Net inflows into stock mutual funds have
been a trickle for most of the past few years, in many months turning
into outflows. This is true even if one includes the money added to
hugely popular exchange-traded funds. The Bank Credit Analyst, a
research firm, points out that household-equity positions as a
percentage of broad money-supply measures have been stagnant since
2004, and are on par with levels from 1995 or 1996, despite today’s
significantly lower interest rates.

That is actual data about the individual investor, not speculation about sentiment.

Richard Russell, the longtime market
commentator and editor of Dow Theory Forecasts, described this
situation in a note to his newsletter subscribers last week. "True, the
little guy may be skeptical, he may be wringing his hands over the
housing situation or the price of a dinner at his favorite restaurant
or the cost of gasoline," he said. "But somehow the big picture, the
stock-market boom, has eluded him. That will not last. The little guy
will not forever resist the lure of the bull market. It’s a question of

Scott Rothbort, writing for RealMoney, the paid service of TheStreet.com and worth it, (full disclosure:  We now write for RealMoney, although regular readers know we have consistently endorsed this source) has an excellent article where he cites a new interest in the market within his circle of contacts.

We are very far from a top as measured by individual investor participation.  Check it out by looking at a typical CNBC commercial from the bubble era, Stuart teaching his boss to trade online.

Also from the anecdotal-evidence file, in
the week when the Dow first touched 14,000, the prominent ad space on
the back cover of Barron’s shouted, "Short. And Simple," in highlighting the ProShares ETFs that let investors bet against the market.

So we also have individual investors now empowered to short the market based upon "feel" and what they read in the continual pounding from bearish Internet sources.  In another Barron’s article Michael Santoli writes about bullish market predictions at the year’s start as follows:

Those were consensus calls among the
standard sell-side and long-only investment pros at the start of the
year — not, mind you, among the many wised-up, blog-scraping,
doom-inviting macro bears out there who can tell you how many
homeowners defaulted on their mortgages in DeKalb County, Ga. last
week, but not why the Dow hasn’t collapsed.


It is another case where the "smart investor" reading a lot of Internet information could make a big mistake.  The question is where to look and how to interpret what one reads.  Our next installment in this series will cover investment blogs and how to interpret them.

Misusing the Most Powerful Computer – Part 2

Those who do not understand research  methods have been empowered to make mistakes.  Computers permit backtesting and curve-fitting.  The system developer who takes ALL of the past data develops a perfect model — perfect for "post-diction."


Using data to develop predictive models is much more challenging.  The process involves — minimally — holding out-of-sample data for testing.  Better yet is extensive testing on different stocks and time periods.  Anyone who does the systematic  development of models understands this or quickly fails as a trader.

Misuse of the Most Powerful Computer

The most powerful computer is the human mind.  It can be easily abused.  The mistaken process is a simple one.

Start with the conclusion one seeks.  Then find the pattern.

A few months ago we described how many pundits were using this method by finding charts.  If one starts with the conclusion, it is easy to find charts that support it.

An objective, scientific approach would be to find all chart patterns describing a particular "setup" and then look at what happens.  The best analysts do this.  One often finds that there are not enough cases for reliable inference.

Making Comparisons with Words

We now see many analysts who use words to accomplish the same objective as the chart abusers.  Pundits see the current market as similar to that of 1929, or 1937, or 1974, or 1987, or 2000.  The debate rages among bearish pundits about which disaster scenario is most comparable to the current market.

Here is a useful "sniff test."  Remember back to your college days when you had an essay question that asked you to "compare and contrast."  If the writer makes no effort to do both sides of the analysis, just move on.  That writer is not making a serious effort  to analyze.

The Case of 1987

Helene Meisler, an excellent technical analyst who writes for RealMoney (paid site at the.street.com and worth it for serious investors) was asked to put up a chart comparing 1987 to the current market.  She did so.   The chart  did indeed show a pattern similar to the current market, but her conclusion was that it is not really a similar case.  She cited a number of technical factors.

The Real Story

I posted a comment on RealMoney that provided the "contrast".  This is pretty easy to do in any of the proposed comparisons, but an analyst with an agenda will not provide this for the reader.  Here is the contrasting 1987 analysis, as I wrote it:

Meanwhile, I am also getting questions about the 1987 comparison. It
has been written about enough to worry some of my clients. I see (at
least) four important differences:

1) Any valuation method that uses both earnings and interest
rates shows stocks very overvalued in 1987 and very undervalued now.

2) Individual investors were "all in" on mutual funds and then
they headed for the exits all weekend before the Monday crash. The
process of handling redemptions was clumsy. The individual investor of
today does not have the same equity exposure.

3) The system of ‘portfolio insurance’ gave institutions an
unfounded sense of complacency. Managers believed that they could sell
futures contracts to hedge positions after a big decline started, so
they were also "all-in." This is akin to buying insurance after your
house is on fire. The post-crash discussions (and there are many fine
ones) all emphasize this dependence on prospective selling of futures.
There were also no circuit breakers. Today’s managers have learned this
lesson, and put premiums are low.

4) The complacency was so great that individual investors
regularly sold naked puts as a means of generating monthly income. You
can see the ads for such "systems" in the issue of Barron’s that came
out the day of the crash. Aggressive put-selling, especially by naive
investors, is a good measure of complacency, and something you do not
see now.


This is not 1987, but it is easy to be misled by facile comparisons and charts.  If the writer does not seem to be providing a balanced analysis,  just say "no" and move on.

Misusing the Most Powerful Computer

There is a perfect storm tempting many traders and investors.  The increased power of computers, the easy availability of data, and the user-friendliness of software have made it possible for nearly anyone to backtest trading systems.  The result is that people with no background or training in research methods are using the most powerful tools, but not knowing how to do it.

The sad result is the story of the system trader we covered in an earlier post, and the need for a scientific method for using the tools.  One of the comments to that post did a nice job of summarizing the best approach — saving lots of out-of-sample data, making sure the method works in different eras and markets, testing equity curves during the relevant periods, etc.

Here we introduce a new idea, one that I have never seen before.  Perhaps readers will alert me to some other mention of this notion, so that I can cite it (since this is a blog about a book).

Suppose I told you that my computer discovered a certain technical "set-up".  Let us say that it was a double bottom, followed by a five-month rally in the stock or index.  The wise system tester might ask how many such instances there were, the comparative results, and expect an out-of-sample test after discovering an apparent relationship.  Such are the methods used by system gurus like James Altucher (whose book on trading systems we recommend in our reading list) and our own Vince Castelli.

Computer systems are evaluated with scientific skepticism and rigorous demands on testing — and rightly so.  That is the world of the system trader.

Most market participants do not have the requisite skill set to evaluate systems.  They do, however, have another "skill" that is exceedingly dangerous — looking at charts.  Everyone believes in his own ability to look at a chart, see trends, see breakouts, and see correlations.

They use the most powerful computer — the human mind — to follow a process vaguely similar to the development of a trading system.  The human analyst takes the current market situation and seeks out some past situation that seems similar.  Instead of using a computer technique, the human comes up with an old chart and compares it to the new one.

There are multiple problems:

  • No one asks how many such "set-ups" there were, or what happened in all of the cases.
  • There is no question about whether there are enough cases to form a conclusion.
  • There is no out-of-sample testing.

The effect on the average reader, including market professionals, is very powerful.  The charts seem quite similar.  It is very much like the behavioral finance concept of anchoring, where a totally irrelevant fact predisposes humans to accept the fact as a base point for reality.  In the behavioral science literature a random number is often used as the base point.  Even though people know that it is random, it still has a powerful effect.

In the case of the old chart, the human parses through history to find the desired example.  Since almost no one understands how to test this, but all think they know how to read charts, the effect is powerful.  There is often little effort to compare the fundamental similarities and differences between the two time periods.

Sometimes the chartist offers several different stocks or indices from the same period.  Since the indices are all highly correlated, this actually provides no additional information, but it seems to make the argument more powerful.

While on vacation last week I read an analysis of this type at Barry Ritholtz’s site, The Big Picture.  Barry, who is more skilled than most on behavioral finance traps, thinks that this is relevant to the current market.  In fact, Barry cites similar work in Barron’s.

At "A Dash" we believe that such comparisons lack the requisite testing, the sort that we would routinely perform on technical predictions.  Barry is doing what everyone does, and he does it well.  Our objection is that the method is unsound.

Expert humans, even the most astute fund managers, are unduly influenced when someone does what we call human data dredging.

Since the influence of this is powerful, it provides an opportunity for those who reject the approach.  Let us be completely clear.  We are not saying that the conclusion is false.  Our position is that the analysis provides no useful additional information, yet it influences many in a specific direction.

One of the major themes at "A Dash" is that astute Wall Street professionals are subject to the same behavioral finance problems as individual investors.  Knowledge of the literature does not necessarily inoculate one against the effects.

The lessons for investors and traders alike is to view such comparisons with the same skepticism they would have for computer models.  If many others are influenced by the questionable information, the contrary trade is indicated.

Warren Buffett and the “Soft Landing” Quotation: A Prediction

Warren Buffett’s annual letter to the  shareholders of Berkshire Hathaway is widely read both for its wide-ranging wisdom and as a source of new ideas.  The 2006 edition, released this week, is already attracting attention and media commentary.

Since most investors are not going to read the entire letter themselves (although they should), they will rely on media reports to learn Mr. Buffett’s thoughts.  We predict that one aspect of the letter will be cited in a way that seriously misleads investors, the statement where he uses the term "soft landing."

Look first at the relevant paragraph in the letter, a section where Mr. Buffett is discussing U.S. trade deficits and debt problems:

I want to emphasize that even though our course is unwise, Americans will live better ten or twenty years from now than they do today. Per-capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual “tribute” so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a “soft landing” seems like wishful thinking.

As usual, Mr. Buffett’s point is strongly stated and clearly put.  Trade and budget deficits are decades-old problems, and, as the statement suggests, may take decades to resolve.  Unless our policy direction is changed, there will be an unpleasant ending.  This is an issue that requires the use of the ballot box, particularly by young people.

Now consider the lead from a Reuters story on the letter:

Warren Buffett said on
Thursday the U.S. economy may not enjoy a "soft landing"
because Americans are taking on too much debt as the U.S. trade
deficit worsens.

Because of the multi-year debate about the Fed tightening cycle, the "soft landing" phrase probably brings that association to mind for nearly all investors and most other readers as well.  While most people are worried about what stocks will do next year — or even next week — that is certainly not the topic of Mr. Buffett’s comment.

He is also not commenting on the Fed or the economy or current economic prospects.  Consulting my autographed copy of the wonderful book of his quotations, I find (P.97) the following:

We spend essentially no time thinking about macroeconomic factors.  In other words, if someone handed us a prediction by the most revered intellectual on the subject, with figures for unemployment or interest rates or whatever it might be for the next two years, we would not pay attention to it.

The Reuters story provides the entire quotation for someone who reads it carefully, and the article is not technically incorrect.  It is however, very misleading.  The all-important lead sentence will be interpreted by many as a short-term prediction about the success of current Fed policy.  It is nothing of the sort.

Our prediction is that there will be more egregious stories, far worse than the Reuters example.  During the next few days you will hear statements like "Buffett says there will be no soft landing."  These will be tossed around as fact — the accepted conventional wisdom.

It is very similar to the manner in which Alan Greenspan’s recent general comments about business cycles morphed into a forecast of imminent recession.

Most people do not do complete and careful reading.  The media summaries both very important and potentially dangerous.

Can You Find the Real Expert? A Microsoft Example

Recognizing relevant expertise is vital for investment research.  Here is a good example using Microsoft and Vista.


I was listening to a podcast interview with a well-known finance professor at a top institution, someone who is also a noted expert on investing.  The interviewer asked him questions on three topics:

  1. The current economy and likely Fed policy;
  2. The likely outcome of the race for the Democratic Presidential nomination in ’08;
  3. The market impact of a Democratic victory.

The professor handled questions on all three topics with equal assurance and aplomb.  Do you see the problem?

There is an entertaining weekly radio program on NPR called Wait, Wait… Don’t Tell Me!  It is a combination news quiz show and trivia contest with a lively panel, a great format, and plenty of laughs.  One of the segments is called, "Not My Job."  They bring in a celebrity guest and ask questions about something where the guest knows nothing at all.  Here is a good example.  Former Secretary of State Madeleine Albright (a brilliant woman, and great speaker whom I had the pleasure of hearing in person one time) was questioned about Playboy Magazine and Hugh Hefner.

What we need is a warning signal that comes with investment discussion, something that will tell us that the speaker is really playing the "Not My Job" game.


With this idea in mind, today’s Barron’s provides a first-rate chance to use the principle.  One of the big investment themes of the year is Microsoft’s new Vista operating system.  It is relevant not only for Microsoft, but for PC makers and equipment suppliers.  Barron’s has two relevant stories.

The first, Microsoft’s Game to Lose,  carries the summary splash:

Hopes for Vista boosted Microsoft’s shares sharply last year.  Now, amid signs consumers may be disappointed, there’s a real risk the stock will fall.

Author Jay Palmer, the "chief gadget reviewer" for Barron’s, is ambivalent about Vista.  His article combines an informed review of the software, with speculation about Microsoft stock (where he mentions a possible 20% decline) and the implications for a general upgrade cycle.  On this latter point, Palmer quotes a couple of sell-side analysts who share his negative view.  He concludes that many users will not upgrade because Vista is not cheap and older PC’s "lack the horsepower" to use it effectively.

A second Barron’s article, Cycling into a Big Year for Tech Stocks, is a Sandra Ward interview with Michael Cahill of Chilton Investment Co.  Cahill has a multi-year record of trouncing both the market averages and technology sector averages, despite a difficult market for tech.  He makes a number of stock suggestions related to the growth of wireless.  (His picks will all pop on Monday — wait for the pullback, if interested).  Our focus here is on Vista and the potential effect on other stocks.

Here is Cahill’s observation:

But what will drive this year is Vista ….  It is late, but from a timing perspective, they are hitting the PC refresh cycle almost perfectly.  The last PC refresh cycle peaked around ’03.  So here we are in ’07 and there are 411 million PC’s that are 3 1/2 years old or older that are natural candidates for the Vista upgrade.

Cahill also notes that last year was not strong for PC upgrades.

Both writers are experts, but on different subjects.  Do you believe that Cahill does not know the strengths and limitations of Vista, a topic getting saturation coverage for the last few weeks?  Who would you expect to have the better read on the upgrade cycle?

Investors and traders share a problem — so much information and so little time.  Even those who actively seek varied information get much of it in the form of sound bites.

Those journalists hoping to present a balanced story do so by looking for a representative of any relevant viewpoint.  CNBC reports many segments this way.  Viewers must be very careful, since those interviewed are frequently asked questions on subjects where they have no special expertise.

No one puts up a sign saying that this is a segment of "Not My Job!"

The Two Biggest Mistakes of the Individual Investor

Part of our business is advising individual investors.  When we talk with them, we try to get them to focus on two big mistakes.

  • Chasing performance.  This applies to those who are active investors and traders.  We have written about this on several occasions, and encourage readers to review these posts.  There is a new piece of evidence from Mark Hulbert.  We admire Hulbert as an entrepreneur.  He saw a market — the analysis of investment newsletters — and built a business based upon analyzing the recommendations of investment gurus.

Most investors start with the question "How have you done this year (or last year, since we are just starting 2007).  If they are looking at investment newsletters, they look for the hot hand.  Mark Hulbert’s recent article on this subject shows the fallacy of this approach.

  • Asset allocation.  Many investors gave up on U.S. equities after 2001 and plunged into real estate.  It is time to re-examine the balance of portfolios.  Our series on stock valuation (especially here and here) highlights this choice.

We believe that the best opportunities in stocks are in those that have lagged in performance due to the Misguided Gloom
about earnings, the economy, and the Fed.  Some of the key stocks have
built better businesses, better balance sheets, and better earnings for
several years — yet the stock price has not reflected the true

Seizing opportunity means looking forward.  The best opportunities come when sentiment is excessive, as it is now.