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.
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