Investors and Hedge Fund Risk

Everyone should read Barry Ritholtz’s the honest and forthright description of how small hedge funds must interview for investors.  He is exactly right about how the interviews go.  I have many similar stories, but he has told it so well already, I will not try to add any more examples.  (Yes, I know my readers will find that unusual!!)

The impact of investor behavior is a major theme at "A Dash."  We are developing the thesis that much of what happens in markets is an extension of the principles studied in Behavioral Finance.  Even if individual managers hope to reject the short-term pressure for performance, the market may push them to ever riskier strategies.  Investors may have trouble finding funds that control risk, because most of them have been starved out of existence.

There are always plenty of successful funds with great records.  What one does not know is how the record was compiled.  Were these the lucky survivors of the process described so well in "Fooled by Randomness" or was there an underlying process with intellectual rigor and integrity?

Barry is right.  Investors get what they seek and deserve.

But there is more.  Investors who push for short-term performance, without understanding risk,  determine the menu of choices available to everyone else.

The Three Stooges and the Seven Dwarfs

A recent poll by Zogby International showed that 75% of the people can name the Three Stooges, but only 42% can name the three branches of government.  80% could accurately name two of the seven dwarfs but only 30% could name two Supreme Court justices — and Clarence Thomas was the most frequently named.  There is more fun:  Harry Potter or Tony Blair, Krypton or Mercury.  The inescapable result is that the people polled lacked relevant knowledge of a pretty basic sort, while possessing knowledge from television and other entertainment.

This is nothing new, of course.  I used to give a basic knowledge quiz to Poli Sci 101 students.  About half of them (based upon a multiple choice question) thought that the Electoral College was "a small liberal arts school in Minnesota."  Many polls have shown that about half of U.S. citizens cannot name their own Congressperson.

The Zogby survey reflects all of U.S. society.  The people questioned are not stupid and many of them have college degrees.

In upcoming posts we will pursue this theme a bit, since it provides a tremendous opportunity for investors. It is one that has been explored at some length in non-economic social science studies and more recently in the study of behavioral finance.  Two major themes of our work here at "A Dash" are as follows:

  1. Investors, like voters, are poorly informed and subject to various psychological influences.
  2. Investment managers and pundits are subject to the same influences.  Reading a book about behavioral finance does not innoculate one from the effects.

In the political world, there are mechanisms that allow us to have a great democracy despite widespread voter ignorance and apathy.  In the investment world, the mechanisms that might accomplish this are seriously flawed.

In democracy, you and I cannot take advantage of a poorly informed electorate.  In a poker game, poorly informed opponents make it much more attractive to play.

Trading or investing provides a similar opportunity.  While investing is not gambling, the poker game is a good analogy when it comes to knowledge.  You cannot profit from people not knowing who is on the Supreme Court, but you can profit when the the market does not accurately reflect information about investments.

The Message of the Market(ing)

The big operations can always afford to do market research and initiate slick campaigns.  For those of us who do not have a big research budget, we can observe what they have discovered.  As usual, these are probably contrarian indicators.  Simply put, they are playing to the worst instincts of the weakest investors and traders.

A summary from TV and my email offers:

  • CNBC ads continue to suggest that you can do technical analysis at home through advanced trading software.  You can plot retracements that no one else can see, spot trends, backtest your strategies (as if anyone watching had a clue about how to do this correctly!), and use your innate "feel" for sector movement in order to trade ETF’s.  At least they no longer have the guy buying stock based upon his daughter’s brand of jeans.
  • A prominent economist informs me (via mass email) that this looks a lot like 1987.  We have a rookie Fed chair and we have deficits and the dollar is falling.  I should sign up for his service so that I will understand more clearly what he already told me — we are headed for a complete collapse.  Like every "this reminds me of …" discussion that I see, the careful historical analysis is lacking.  I admit that the OldProf is not a historian, but I had many good colleagues who were.  I know what good historical work looks like, and this is not the real deal.  I remember well the crash of ’87, since I had just left the academic world for a new business.  I watched it and then read countless books and articles.  I analyzed data. It had a lot to do with valuation, the flawed idea of "portfolio insurance," and a few other factors.  There is also a difference with the new Treasury Secretary, Hank Paulson, who is saying all of the right things about the dollar.  Let’s give the guy a chance.  We may have another Rubin, who did a great job.
  • A warning from a prominent technical analyst, researcher, and newsletter writer who warns me that a recession is coming.  The yield curve indicates an 88% chance of recession!!!  As our readers know, the best research on the yield curve, which we have analyzed carefully, does not support this at all.  The economic consensus on recession in the next twelve months is about 25%, which is not far from the long term average at any time period.  If you are trying to hit the glide path, there is always some chance of missing in the next twelve months.
  • Another popular firm wants to sell me their best stock picks, beginning with one that (they imply) is loved by Bill Gates.

Part of the reason that individual investors underperform market averages is that they fall for these marketing ploys.  They are calculated to play upon the worst instincts of the individual investor and the rookie trader.

At ‘A Dash’ we are eclectic.  We do not have the answers to everything, but we are pretty good at spotting who the real experts are.  We prefer to get our economic forecasts from consensus economic picks, not pundits.  We prefer to get history from historians, not economists or pundits.  We prefer to get market research from those who know who to frame a hypothesis and test it rather than backfit data.

Here is a refreshing idea.  The big firms should hire some real historians, those who look at both the similarities and differences between eras, rather than just trying to sell something.

Earnings Season–Fighting the Last War

The financial media has the effect of reinforcing some of the most counter-productive tendencies identified by the behavioral finance literature, described in prior posts.  On a day like today, with the market down big time, CNBC brings in those who can "explain" what has happened.  The selection bias gives the illusion that there are all of these wise heads who are figuring this stuff out in advance.

Here is the edge for the savvy investor.  Most people are dramatically influenced by early occurrences in their lives or careers.  Most hedge fund managers are pretty young, and perhaps unduly influenced by the "internet and tech bubble."  They also have in their (brief) careers some experience with corporate accounting issues, deception, lying by sell-side research analysts to foster investment banking business, a myriad of one-time charges, and other elements that exaggerate earnings.

Like  the Nobel Prize winning Pavlov‘s dogs, they have learned to be suspicious of any earnings forecast.

The problem?  They are fighting the last war!

This one is over.  The world has changed.  (There is this child’s game played by pundits, where if you dare to say that "thing’s are different" you lose.)  Well it is different to anyone who is not wearing blinders.  At "A Dash" we read hundreds of analyst reports on the stocks we follow and the changes are apparent.  Here is what has taken place:

  • Companies are much cleaner in their earnings reports.
  • Options expensing has been mandated by FASB.
  • Companies are extremely careful in their forward- looking statements.  This is not even close to the cheeleading days of 1999 and 2000.  I followed interviews in 2003 very carefully, and CEO’s were all conservative in front of the Iraq war.  Companies do not give encouraging guidance unless they can really see it.
  • Sell-side analysts are more conservative — much more conservative.  They have a higher number of "hold" and "sell" ratings, even though the coverage universe is smaller.
  • Analysts try to guess the economoy to find some sell ratings.  When the specific information from the company does not justify lowering earnings, they produce some authentic Wall Street Gibberish about how this is the peak of the cycle.  That means that they have decided to predict the economy, instead of following their stock.

Pundits who are stretching the mileage from their "bubble era" analysis, continue to say that analyst estimates are exaggerated and "must come down" even though these estimates have already been normalized, discounted, and discounted again.

There are many pundits and hedge fund managers who harbor this view.  For some time now, when the prediction has been incorrect, the PE multiple for stocks has just gone lower.  Since "everyone" knows that earnings will move lower, it makes sense to "bake in" a lower multiple.

The next segment will see how that approach has worked…..

The Big Mistake: A Compelling Example

Take a look at this interesting example:

that you had encountered Warren Buffett at the end of 1975. Impressed
with his intellect and investment approach, you would have naturally
examined his track record — and almost certainly, to your everlasting
regret, not invested. Why? Because his results, as measured by the
stock price of Berkshire Hathaway, were truly dreadful over a four-year period. The stock not only declined and trailed the market during the 1973-74 downturn, but also in the 1975 rebound. Consider this data:

Yr    S&P 500  Berkshire
    18.9%      14.3%
1973   -14.8%     -11.3%
1974   -26.6%     -43.7%
1975    37.2%      -5.0%
TOTAL    2.0%     -45.8%


The rest is, of course, history. From $38/share at the end of 1975, Berkshire Hathaway has risen nearly 2,000 times to yesterday’s closing
price of $73,900. [For more information about the track records of
these investors (and many others), plus some of the wisest words ever
spoken about investing, see Buffett’s famous 1984 speech, The Superinvestors of Graham-and-Doddsville.]"

A complete account of this is available from Whitney Tilson on the Motley Fool Site.

The point is not that one should ignore performance.  That would be silly.  Performance is the ultimate test.  The problem is that the investor’s concept of the time frame necessary to gauge performance is far shorter than what occurs in reality.  I will elaborate on this in coming posts.  For now, it is important to understand that there can be muti-year eras of strange market behavior, like the Internet bubble.

Determining investment potential involves understanding the methods used, and whether these methods are sound on a long-term basis.  It takes both developing the method and the discipline to follow it even when there are painful setbacks.

Successful investing depends on profiting from the mistakes of other market participants.  It may not be possible to "time the market" by predicting when value will be recognized.

There will always be those that call a particular market turn, but the question is the method used.  Since many thousands of managers are always trying to do this, there will always be some who succeed.  How does one avoid being "Fooled by Randomness?"

This intriguing topic will be the subject of future posts.

The Biggest Investor Mistake

For most people, the information in today’s post is probably more important than any other single fact they can learn about investing.  Understanding and following this advice could make a million-dollar difference for a middle-class family thinking about college and retirement.

The problem is that the advice is extremely difficult to follow.  Since very few individuals will follow this advice, it is yet another source of market inefficiency.  It explains why Warren Buffett and other managers can maintain a positive expectancy in gains over the market.

Ready?  Here goes —

Don’t sell the bottom!

Don’t do it with stocks.  Don’t do it with mutual funds.

Let me explain the psychology first, and then show you some persuasive evidence of the effects.

They psychology comes from our desire to control, and the feeling that we can control our investments.  There is a strong marketing interest in persuading investors that they can and should make their own decisions.  It is profitable for brokerages, and they run many ads to that effect.

They show the "Power Guy" with his fancy trading tools telling a broker (as if he would really be talking to a broker in these days of online trading).  The Power Guy says "OK, I’ll buy a thousand shares, but if it goes down, I’m going to dump it!"  Firm, decisive, and wrong!  The market creates all sorts of movements in stocks.  If your fundamental reasons are intact, you should be prepared to buy more.  But it certainly sounds good.  The TV commercial plays upon our desire to show that we are in control, and that this sort of decisiveness makes sense.

Another commercial theme for Diamonds (the ETF that is a Dow 30 equivalent) highlighted a woman who did not have the time to study individual stocks, but who had a "feel for the market."  Just what people need — not!  Encouragement to try market timing based upon casual knowledge.  I wonder how much people have lost following that commercial.

And then there is the guy who spots a good investment because he is buying jeans for his daughter.  This is a perversion of some great advice from Peter Lynch.  It is fine to try to spot trends early. This provides a nice starting point, not the reason for an immediate investment.

The sad result is that individual investors make 1/3 to 1/2 of the market returns in every study I have seen on the subject.  Here is one such study, and there are many more.

Warren Buffett says the following:

"You can’t get rich with a weather vane."

"The market is there only as a reference point to see if anybody is offering to do anything foolish.  When we invest in stocks, we invest in businesses."

If you are not studying the individual companies, the financials, the trends, you are not analyzing the business.

In many stocks right now the market is offering an opportunity.  There is an extremely high level of concern, not about current conditions, but about an expectation that the Fed or oil prices or budget deficits, or something, will ruin the economy.  Before concluding that the market (which has predicted seven out of the last two recessions) has some great message, the investor should get some evidence.

The studies also show that the average investor applies the same criteria to investment managers, selling funds that did poorly recently to buy those that did well.  The investor is not making a careful decision because this strategy has been proven to work.  In fact, it has been proven to be a loser.  Investors behave this way because they want a simple rule, called a heuristic in behavioral finance, and this is the only information they have.  It gives the illusion of control, and costs them many thousands of dollars.

Heuristics — Edge Comes from the Exceptions

People making decisions under uncertainty in complex situations employ simple rules of thumb or heuristics.  Stock market analysts have taken note of this literature.  Their summaries of it seem to suggest that average investors make mistakes.  What they seem not to realize is that reading the books does not innoculate one from these same human tendencies.  I expect to show that much of Wall Street lore follows these simple rules.  I further hope to show that investors who understand how the rules work, and when there are exceptions, can profit from a contrarian stance.

First, the literature —

There has been tremendous research progress in psychology and decision-making, and much of it has made its way into the literature on Behavioral Finance.  I applaud the work of Daniel Kahneman and others.  It has been an interest of mine since my early college days and I studied much of the early literature in my dissertation research.

I have especially appreciated many of the recent works that have applied the findings to topics of my daily interest.  At some point I’ll figure out how to list the books on this site, but they include books like How We Know What Isn’t So, Why Smart People Make Big Money Mistakes, Inevitable Illusions, and a number of others.  I’ll try to put up a more complete list of what I have studied.  A favorite, related more to the entire research process, is Fooled by Randomness, which I sent to many of my favorite clients.

Now why is this important?

It is a widely accepted notion that markets discount information quite effectively.  Some believe in various levels of the efficient market hypothesis.   If markets were in fact completely efficient, most of us in the investment business would be charlatans!

Experts in fields requiring decision-making know all of the heuristics, but they also know the underlying causal models.  They know when to make exceptions.  They know when to say "Things are different this time."

In one of my worlds, high-level tournament bridge, many of the competitors are experts at stocks, options, and other derivatives.  They are highly skilled at analyzing risk and reward, doing so quickly,  and acting under pressure.  Bridge has a large number of heuristics that help beginning players learn how to play at an adequate level, avoiding serious error.  There is a point count system for evaluating hands.  There are rules of play like "second hand low,"  "third hand high," lead up to weakness," and "cover an honor with an honor."

Blindly following these rules might help a player achieve average in a Flight C game, but that is about it.  Experts understand that these rules usually work, but each case is tested to see if "this time is different."  When  you see a hand in a bridge column, the expert player popped an honor second hand, or ducked as third hand, or whatever.

Perhaps readers can suggest similar concepts from other intellectual activities requiring heuristics.

The point is that knowing the basic rules of the stock market like The Presidential Cycle, Don’t Fight the Fed, Three Steps and a Stumble, or other similar slogans is only enough to make you average in the Flight C game.  These are universally known market concepts that should be fully discounted by current market prices.

If one wants to find edge, one needs to know, for example,  why the Presidential Cycle seems to be relevant.  What is behind it?  What is the cause?  Should we expect it to be in force right now, in 2006?

Is the Fed tightening just like those from history?  Is the Eisenhower experience relevant?  Does it matter what the starting and ending rates of the tightening cycle are?

These are questions that I will explore in the upcoming weeks.

This time it really was different

A couple of weeks ago I was driving around town through a familiar intersection.  Having lived in for fifteen years in  Naperville, a kid-friendly Chicago burb of about 140,000 people, I have driven through this intersection thousands of times.  The light was green, a simple indicator that I could proceed.  On this particular occasion, however, someone was blasting through the intersection, against the light, at a high rate of speed.  As a cautious old guy I have learned not to depend on the simple heuristic of the green light.  The younger Jeff (and a lot of cell-phone gabbing teenagers in my neighborhood) might have had a serious accident.  But since I understood the underlying mechanism of the traffic signal I know that it is only an indicator of probable safety.

Earlier this month I heard the DuPage County sirens go off, indicating a tornado or disaster of some sort.  This is an important warning system, since there have been major tornado disasters a few miles from my home.  We take the warning seriously.  I glanced at the clock and noticed that it was 10:00 AM on the first Tuesday of the month, and remembered that this was the normal monthly siren-testing time.  By understanding the underlying mechanism, I realized that the indicator did not have its normal message.  (Some day there will be a tornado or disaster at exactly that time, but that is another problem).

The point for stock market observers is that there is danger in blindly following heuristics.  By paying attention to the underlying mechanism, called a causal model in social science research, one can avoid mistakes.

I understand that many of my readers behave just as I do in many real-life situations.  The question is whether they take that experience and apply it when they have a question related to the market.  I will provide examples where many Wall Street types show blind adherence to simplistic rules.  In fact, the example occur daily on CNBC faster than I can record them!

Please note the point.  I am not saying that those following the "rule" are wrong.  I am saying that without knowing the causal model, they do not know whether they are wise or blind.

Real Estate Sucker Bet

The major problem facing investment advisors is helping clients with
asset allocation.  Your client is intelligent and engaged.  The problem
is that they are focused on what worked last year, and your job is to
help them with what will work next year.

Our company has an internal ranking of pundits and advisors.  John Rutledge is one of our good sources.

Link:  Real Estate Sucker Bet

I was on CNBC’s Closing Bell with fellow guest and old friend Brian
Westbury to discuss the housing market on Monday, July 5. Brian and I
have known each other since the Reagan White House. He’s a great guy
and first class economist–one of the most …

I’ll expand on the housing theme in future posts, but we believe Dr.
Rutledge has it right on one of the major questions.  People have the
idea that real estate cannot decline in value — a dangerous notion.