Monthly Archives: January 2011

Don’t You Ever Get Tired of Always Being Wrong?

I once worked at a Wall Street shop which employed a very interesting capital markets strategist.  Like most other Wall Street strategists, he had his estimates, charts and thoughtful opinions.  He was well educated and quite articulate.  His views always seemed reasonable, logical and probable.  His unique claim to fame was this – he was always wrong.  In fact, one client of the firm loved him very much exactly for this trait.  They would listen to him very carefully and then do the exact opposite.  This client paid the firm very well for his “guidance.” They said that he made them lots of money doing this.

Like many bizarre stories, this one doesn’t have a happy ending.  One year, this strategist was uncannily accurate in nearly all of his calls for the year.  Interest rates, currencies, the stock market, and so forth all moved exactly as he had predicted.  As he was basking in the warm glow that comes with being right about complex functions such as the capital markets, the sales person covering that one big client who liked him as a contra-indicator called with bad news.  They were cutting off the firm because he had disappointed them by being so right!

There is another group of investors whose claim to fame is always being wrong – the individual investor.  Now, before I suffer the wrath of millions of smart, outperforming individual investors, please let me explain what’s behind this reputation.

In theory, stock prices are supposed to discount (that is already account for) all things known and expected by all investors.  This is why we sometimes see the “buy on the rumor, sell on the news” phenomenon.  So-called “smart money” (people like Warren Buffet, the best hedge fund and portfolio managers, big bank prop traders, etc.) will usually buy something well before the good news becomes obvious.  It’s not that they have insider information or really “know” something is going to happen, it’s that they do this full time, have enormous resources at their disposal and are backed by many years of experience.  They understand the distribution of probabilities, are often able to measure which outcomes are more likely, and consequently deploy capital in an effort to profit from those expectations.

Let’s contrast this approach to that often used by the individual or “retail” investor.  The “average” investor in this group likely does not invest as a full-time job.  He or she may get investment ideas from a relative or a friend.  Maybe the source of investment inspiration comes from a magazine, newspaper or TV show.  Often the idea is “sold” to the investor by a well-intended (perhaps) person who may or may not have an ulterior motive.  Most of the time, this “great” investment idea sounds logical, plausible and compelling.  The problem with this approach is that more often than not, the potential of this great story stock is already priced in.  “Smart money” bought the stock a while back and has already made the bulk of return (notice how most “great” investment ideas involve stocks that are up a bunch?).  Retail investors are left with the scraps and often the losses.

As a group (clearly there are retail investors who invest well and achieve above-market returns), retail investors are very good at one thing:  investing heavily in the thing that just worked well.  We can see this when we look at the sum of all retail portfolios and measure the aggregate asset allocation.  Retail investors held a record amount of stocks (as a percentage of the total) in 2000, just before the tech bubble burst and the market collapsed.  Their largest cash holding ever came in early 2009 as the stock market was bottoming and fear was peaking.  Bonds peaked as a percentage of the total sometime last year. We shall see how that works out for them…

In the Wall Street Journal over the weekend, Jason Zweig (one of my favorite market commentators) asked the question “Will Small Investors Ever Warm Up to Stocks Again?”  In his piece, he notes that retail investors, acting precisely as expected, have shunned stocks even after the huge run the market has had.  If they began to aggressively embrace stocks, he notes (and I concur), it may be a yellow flag for the market.

I have my own theory about this.  I think the retail investor is sick and tired of always being wrong and will shun stocks for the entire cycle!  That way they won’t be wrong this time.  How they all got together to decide this is still a bit of mystery to me.  Maybe they are all using Facebook or something.  If I’m right, we may have to measure the next peak in the market without the help (?) of the resilient retail investor, who despite this bad rap, continues to invest in risk assets.  If I’m wrong, we will likely see a resurgence of retail investor interest in stocks, no doubt peaking just as the market does.  Time will tell.

If I Had a Hammer…

HammerI love the old saying “If all you have is a hammer, everything looks like a nail.”  This is a common tendency I see in many walks of life.  To the military officer, solutions tend to look like battle plans, and the discussion about them are peppered with war analogies.  To the athlete, solutions may come packaged in notions about winning or losing; again sprinkled with metaphors and phrases common to sports and physical activity.  From time to time, we all may wield our own kind of hammer.

In the investment world, we sometimes see this behavior as well.  To some investment professionals, their hammer is monetary policy.  They believe all other investment considerations pale in the comparison to monetary policy.  For others, it may be broad, top-down macro factors. If we can predict various countries’ economic growth rates, they reason, then all else falls into place.  For some, measuring an asset’s intrinsic value is the critical factor.

I must admit the biggest hammer in my tool box is probably the valuation one.  Yet, I feel that to make the best decisions I can, I need to use other tools.  I will use technical analysis to help me understand money flows and sentiment about a stock.  Sometimes, insider transactions will give me insight about how a company’s management feels about the company’s prospects (independent of what they might be saying).  Having some sense about the big picture clearly is important in that it can tell me where we are in the business cycle and where to look for potential macro concerns.

In many ways, I wish my work were simpler. How nice would it be to have one tool that would get the job done perfectly every time.  Alas, the complexity of the capital markets makes this impossible.  I know this, and I suspect that most people would agree.  And yet, I see examples nearly every day of some “guru” in the media telling us that the solution to problem “X” is simply “Y.”  We may understand that this simple answer is wrong and yet we crave this kind of solution.

So, the conclusion must be that something that sounds simple and logical may not be a workable solution.  Bringing multiple disciplines and different layers of solutions is probably much better than just one thing.  (For a more in-depth discussion of this topic, please refer to our latest client letter, which can be found here).

…And This is Your Brain on Uncertainty

Brain On Uncertainty

Brain On Uncertainty

Perhaps no one really likes uncertainty.  We all deal in uncertainty.  But how we deal with uncertainty seems to be a critical part of life.  Our brains are clearly affected by this lack in clarity in so much of what we do.

American author Jonah Lehrer penned a short piece in The Washington Post last weekend which dealt with how our brains react to uncertainty.  He cited a study done by the California Institute of Technology that used a simple game to measure how our brains respond to uncertainty.  In the first run of the test, participants were asked to bet on whether the next card drawn from a deck of 20 cards would be red or black.  They were told how many cards of each color were in the deck.  This allowed them to figure out the likelihood of the next card being red or black.  The scientists measured the brain activity of the participants and found increased activity in area associated with the expectation of rewards.  We seem to like to play a game where outcomes are somewhat predictable.

In the next phase of the experiment, the subjects were asked to do the same thing, but were not told the number of black and red cards in the deck.  Thus, they really had to guess which color was coming next.  Lo and behold, the scientists found that a different part of the brain saw increased activity in this experiment – the part associated with scary memories and emotional arousal.

This makes a lot of sense to me.  It’s why when we put money into a vending machine we calmly expect our treat to pop out when we push the button.  We have learned to expect this.  Our brain tells us that something good will follow our putting money in the machine.  Even when the machine is broken and all we can do is retrieve the money, we will continue to put it back in, more than once and maybe with a bit of extra force or some spin, because we “know” it must work.  We have learned to expect this.  In those times when the machine “eats” our money, how do we react?  All of a sudden our calm expectations have been shattered and our treat has turned to a mean trick.  We may think, “Oh no, it’s happened again!” (scary memories).  We may actually get physical with the machine – banging on it, tilting it or in extreme cases, punching it (emotional arousal).

We see this behavior in the investment world as well.  It explains why smart people will put good money on a highly speculative, but well-marketed investment idea.  The quality of the marketing will actually make the risk of the investment appear to be much smaller than it really is (the fine print notwithstanding).  The investor may be using the “expectation of rewards” part of the brain because he or she is only focused on the upside of the investment.  And inevitably, when the deal goes sour, the investor’s brain starts churning out all kinds of scary, negative and highly emotional thoughts which stand in stark contrast with the warm, happy ones he or she felt during the marketing presentation.

I deal with uncertainty every day.  I have all kinds of expectations and scenarios that I measure and adjust on a regular basis.  Some days are diamonds and some days are stones.  But even on my worst days, I try to assess why I am feeling the way I do.  I try to calm down those scary and emotional parts of my brain, so that the analytical, clear-thinking parts can resume control.  I still ride the roller coaster with y’all, but I think I’ve sort of figured out a way to better enjoy the ride.