Investors have an inherent need to make sense of the world around them, and for that they need stories. Stories that engage and explain. “The initial point I’d make is that our minds work very hard to make sure there’s a cause for every effect. If we see an outcome that we can’t explain, it’s like an itch that’s demanding to be scratched,” says Michael J Mauboussin, the chief investment strategist at Legg Mason Capital Management, the ninth-largest asset management firm in the world, with $703 billion under management as on September 30, 2009. (That is a little over four times the current size of the Indian mutual fund industry).
OK, business news channels and newspapers try and fulfill this investor need for stories. But are they really effective? No, if one is to believe Mauboussin. As he writes in his best selling book More Than You Know - Finding Financial Wisdom in Unconventional Places, “The press sounds a lot like a split-brain patient making up a cause for an effect, and we investors lap it up because the link satisfies a very basic need (of stories)... Read the morning paper explaining yesterday’s action for entertainment, not education.” Mauboussin’s latest book Think Twice - Harnessing the Power of Counterintuition is just out. In this interview he speaks to DNA's Vivek Kaul on the art and the science of investing. Excerpts:
Fund managers regularly find it difficult to beat the market rate of return. Why is that?
There are a number of reasons it is so difficult to earn a return in excess of the market. To start, markets tend to be quite competitive: information tends to be rapidly incorporated into prices and, in normal times, arbitrageurs cruise the market to find pricing anomalies. Competition alone makes it tough.
Next are costs. Active managers charge a fee for their service, and incur other expenses as well, including transaction and market impact costs. These costs can add up to 100 basis points or more for an average mutual fund, and are typically higher for a hedge fund. Given that the inflation-adjusted return for the market has been in the 6-7% range, those costs are not inconsequential.
Incentives are also important. Some investment firms have been more motivated by gathering assets than by delivering high excess returns for their fund holders. As a consequence, they tend to build portfolios that don’t differ meaningfully from their benchmarks. If your fund looks and acts like its benchmark but has higher costs, you’ll lose over time.
Finally, I’d mention the role of psychology. As Warren Buffett says, the goal is to be fearful when others are greedy, and greedy when others are fearful. This is easy to say but is very taxing psychologically. Great investors seem to have a natural temperament that lets them go against the grain. That is a rare attribute.
Even with that, investors keep handing money to active fund managers. Wouldn’t it be better to just invest money in an index fund?
I think investing via index funds makes a lot of sense. For individuals who do not have the time or inclination to study the details of managers or funds, this is a very sensible way to go.
But I would add two points. First, investors have differing ability, just as you see in other human endeavours. Some investors are more skillful than others. Identifying that skill is not easy, but it’s also not impossible. For example, Martin Cremers and Antii Petajisto, professors of finance at Yale University, have developed what they call “active share,” which measures how much portfolios differ from their benchmarks. The premise is that to really beat the market, you have to be different. Their analysis suggests that funds with high active share deliver better risk-adjusted returns than those funds that resemble the market. Streaks are another great way to observe skill.
Second, we have done some work to show that there are some regimes where active managers do relatively well and others where they struggle. The simplest way to say it is when markets reach extremes and people’s beliefs are correlated, active managers can add value. When markets exhibit lots of diversity of opinion and perspectives, active managers have a harder time.
Motivated investors can consider carefully investor skill and environments conducive to active management. But it’s not easy. So, for many investors, index funds are appropriate.
In effect, most people see and hear what they want and tune out everything else, you write in your new book Think Twice. How does that affect the process of investing?
This is a big challenge in investing. Once we’ve committed to something, whether it’s a stock in the portfolio or a macro view, we tend to fall for the confirmation trap. That means we seek confirming information and discount or even disavow disconfirming information. Consistency allows us to avoid thinking and acting.
As an example of this, I mention the story of the former US vice-president Dick Cheney. A memo was released that revealed his requirements when he travelled to hotels. These included a pot of decaf coffee, four Diet Sprites, a room temperature of 68 degrees, and all televisions on and turned to Fox News, the channel that most closely reflects his political views.
If you are only spending time reaffirming what you already believe, you’ll miss important changes. So the best investors welcome diverse views, even if they run counter to their current beliefs. And when they are proven wrong, which happens to everyone, the best investors have the mental flexibility to act on the updated information.
Your current boss Bill Miller has had a 15-year winning streak of generating more returns than the market in his value fund. Would you attribute it to sheer luck?
I wouldn’t attribute that streak to sheer luck. The point of that chapter is that streaks, by definition, are a combination of good luck and good skill. Stephen Jay Gould, a prominent paleontologist at Harvard University and an avid baseball fan, said it well: “Long streaks are, and must be, a matter of extraordinary luck imposed on great skill.”
Here’s the way to think about it. Suppose you have two jars, one for “skill” and the other for “luck.” And let’s say each jar has three cards: -10, 0, and +10. You get to select one “skill” card, and then for each trial you’ll take one “luck” card, record your number, return it to the jar, and repeat the process over and over.
Even using armchair logic you can see that the people with the best results will be those who have a +10 skill card and who repeatedly pull +10 luck cards. Streaks are a combination of skill and luck.
Over time, about 40-45% of funds beat their benchmarks on average, but the standard deviation is somewhere around 15-20%. That means there are years where only 10% of active managers beat the benchmark. Both 1995 and 1997 were such years. So the probability of Bill’s streak, which included 1995 and 1997, occurring by luck alone is infinitesimal.
Would you say that likes of Warren Buffett, George Soros, the guys investors all across the world worship, have been plain lucky?
You would be hard pressed to find anyone who has been extremely successful who has not benefited greatly from luck. But that does not take away the fact that they also had tremendous skill. It’s the combination that provides the exceptional results.
Consider a continuum of pure skill on one side and pure luck on the other, and reflect on where you might put various activities.
Swimming races, or chess, might be very close to the pure skill side. And the roulette wheel, or slot machines, might be close to the pure luck side. Investing, I believe, is closer to the luck side than the skill side.
That said, the value of skill over time is very significant. Investors who can beat the market by 100 or 200 or 300 basis points annually over time add an enormous amount of value because of compounding. So while luck is prominent in investing, skill makes a big difference over time.
Incidentally, it is my experience that great investors are the first to recognise the role of luck in their success. You have to worry about the successful people who don’t realise how lucky they have been.
Fortune eventually frowns on everyone, and those who are unprepared suffer the most.
Why do most investors excel at buying high and selling low?
It relates to what we were discussing before—the relative contributions of skill and luck. In any activity where the outcomes combine skill and luck, you will see reversion to the mean. Reversion to the mean says that for any outcome that’s far from average, the expected value of the next observation is closer to average.
Let me make this a little more concrete but talking about human heights. If two tall parents have a child, the expectation is that the child will be tall, but not as tall as his or her parents. Likewise, children of short parents will be shorter than average, but not as short as their parents. Reversion to the mean is everywhere, including sports, corporate performance, and of course the results of investment managers.
This is where the investors come in. Investors have a very strong tendency to buy what has done well, and to sell what has done poorly. For example, a study of 3,400 plan sponsors—the investors who are supposed to be sophisticated—found that the sponsors tended to hire fund managers who had recently beat their benchmark and fire those who had fared poorly. But in subsequent periods, the managers they fired did as well or better on average than the managers they hired.
For individuals, the results are even more depressing. Over the 20 years ended 2008, the S&P 500 returned about 8.4% annually and the average mutual fund returned about 7.5%. The largest part of the difference is, of course, fees. But the average investor earned only about 5%. The reason is timing—bad timing. Investors tend to put money into hot stocks or funds right before they revert toward the mean, and neglect poor performing sectors or stocks before they improve.
One of the things that you have pointed out is that investors should be wary of explanations for market activity. Why do you say that?
The initial point I’d make is that our minds work very hard to make sure there’s a cause for every effect. If we see an outcome that we can’t explain, it’s like an itch that’s demanding to be scratched. In fact, neuroscientists have dubbed the left hemisphere of the brain “the interpreter” because it is the part of the brain that makes up causes.
Understanding links between cause and effect is very useful in natural settings, and hence conferred our ancestors with some advantage. The problem is that many systems we face today are complex, and hence defy simple cause-and-effect explanations. When people seeking cause and effect links meet systems that hide them, mistakes will happen.
The most prominent example is confusing correlation with causation. In other words, when two events happen at the same time—they are correlated—people naturally assume that one of them caused the other. For example, one researcher found there was an over 70% correlation between butter production in Bangladesh and the performance of the S&P 500. This is a silly example to make a serious point. Investors who confuse correlation for causation will make poor decisions.
So every day the financial newspapers will dutifully report what happened the day before based on market experts. Investors should use the explanations for entertainment, not education.
What are the dangers of investors relying on experts trying to tell them what to do with their money?
A point that has been quite clearly established through studies and analysis is that people, even so-called experts, are really poor at predicting the outcomes related to complex systems. The best work that I know of on this topic is by Phil Tetlock, a professor of psychology at the University of California, Berkeley. A few years ago, he published a book called Expert Political Judgment that tracked the specific economic and political predictions of hundreds of experts over time. He found that their performance was dismal and that they offered the same excuses for their poor outcomes as the rest of us do.
I believe in what I call the “expert squeeze.” That is, the value of experts is being reduced from two sides. On the one hand there are computers and algorithms. These are typically stable systems where cause and effect are pretty clear. Experts do fine with these problems, but computers are faster, cheaper, and more reliable.
Think of a purchase recommendation from an e-commerce site like amazon.com versus the advice of a local shopkeeper.
Amazon.com’s massive database simply allows for better tailored recommendations.
But one big challenge remains: most people feel fundamentally uncomfortable not relying on experts. We prefer to defer to the expert in the room, even if he or she is likely to predict poorly.
Human beings are very good at seeing patterns. We see patterns even when none exist. How does this affect the process of investing?
Jason Zweig, a very thoughtful journalist, relates an experiment where people were shown random sequences of squares and circles while in a functional magnetic resonance machine, allowing scientists to peer into their brains. It turns out that after only two consecutive symbols—for example, two squares—your mind will strongly anticipate a third.
The implications for investors should be quite clear. These little patterns, even if dictated by chance, will tug at your mind and encourage faulty decisions. Understanding randomness is crucial, and we as humans are not at all good at it.
How does stress affect the process of investing?
I will mention the brilliant work of Robert Sapolsky, a neurobiologist at Stanford University. Sapolsky starts by asking what stresses an animal. The answer is often a physical stressor. For example, you’re a zebra on the savannah and a lion decides you look like a delicious meal. Well, if that happens your stress response kicks in—you increase your heart rate and blood pressure, adrenaline is released, your acuity improves, and you run like crazy. If you elude the lion, you settle back to normal. You go back to homeostasis.
Humans today rarely have physical stressors, most of our stressors are psychological. Things like worries about money, relationships, or our jobs. But the key is that the stress response is the same whether it comes from a physical or psychological source. And the problem with psychological stressors is once they are turned on, they often are not turned off.
But here’s the main point: when we are stressed, we turn off our long-term systems including digestion, reproduction, and immune system and focus on the here and now. That strategy makes enormous sense for the minute or so that you’re being chased by a lion, but is very deleterious if you never turn off your stress response. As a result, stressed people have a really hard time making good decisions about the long term.
You can imagine a highly stressed portfolio manager who is worried about his job. Let’s say an analyst recommends to him a stock she’s confident will double or triple over the next 3-5 years. The manager doesn’t want to hear it. He wants to know what will work now. As a consequence, investors start dealing much more with speculation than enterprise.
You have made a connect between mazes and ants have to do with the challenging job of managing money…
I think the connection is the importance of thinking differently. Here’s a story about the ants. If you put a food source some distance from the nest and offer the ants paths of various lengths to the source, they are highly efficient at identifying the shortest path. In other words, they are really good at exploiting resources efficiently.
But when the researchers studied the ants, they realised that some of them wandered off the trail from time to time. That didn’t seem to make sense, especially if there was a good food source.
As they studied it in more depth, they realised there was a mathematical probability an ant would leave the trail, and that the probability was somewhat related to how likely it was that another food source would appear. So the colonies were adept at exploiting and exploring. And the point of exploring is that it might be where the next great idea comes from. It’s like corporate research and development.
The lesson for investors is that you should be allocating some percentage of your time to non-traditional information because if you’re doing what everybody else is doing you’re unlikely to have results much different from them.
Your books stress on the importance of diverse thinking to profit in constantly changing financial markets...
My inspiration here is Charlie Munger, the vice chairman of Berkshire Hathaway and Warren Buffett’s partner. Munger talks a lot about the mental models approach. The basic point is that you should strive to understand the big ideas from many different disciplines, because those ideas will come in handy when you’re solving problems. He’s fond of the saying, “To a person with a hammer, every problem looks like a nail.” If you don’t have many tools in your mental toolbox, you won’t be effective.
So how do you develop your mental models? The main way I know is to read. Most of the great investors I have known read constantly—hours and hours a day. They are reading plenty of traditional material, but also carve out time to learn about ideas that are off the beaten path. The problem with the mental models approach is that it is hard, time consuming, and leads you down many intellectual cul-de-sacs. The benefit is that flash of insight that comes with recognising how to solve a seemingly difficult problem in a way that others have not thought of.
What are the four-five points which investors should keep in mind while investing in stocks?
First, it is essential to always differentiate between fundamentals and expectations. Perhaps the biggest and most consistent mistake in the investment world is a failure to separate those two factors. For the stock market, fundamentals are the future financial performance of the business—it’s sales growth, cash flows, and return on invested capital. The expectations are the stock price. It is possible to reverse engineer the expectations in the stock to understand what is implied about future financial performance. It is a vital task, and few investors do it with discipline.
Next, I’d say stay steadfastly focused on process. Because investing is probabilistic, outcomes can be very noisy, especially in the short-term. Process includes finding securities that are mispriced and constructing a portfolio that takes advantage of that edge via position sizing while being mindful of risk.
I’d also echo another Buffett and Munger theme and say to identify and stay within your circle of competence. It’s a big world out there and it is unlikely that you’ll be able to find investment edge everywhere you go. So recognise what you’re good at and stick to it. This means there will be times when other people seem to be making much more money or having much more fun. You have to have persistence and stay the course.
Finally, I’d recommend that investors keep track of their decisions. Create an investment journal. Write down what you decide, what you expect to happen, and why. Perhaps make note of how you feel physically and emotionally. A journal is one of the few ways you can provide yourself with honest and clear feedback.