Tag: behavioral-finance

Stock Market ≠ Economy

Economic statistics hit your inbox almost on a daily basis. Markit has its “flash” numbers ready 15 days before the “final” numbers. Government/RBI press releases about the GDP, CAD, etc come out once a month. And then there are expert forecasts about how the numbers are going to look on an annual basis, etc. And then there are bloggers and commentators who slice-and-dice the data to read the tea leaves. But should equity market investors care?

“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.” – Evan Esar

If you are not trading interest-rate or currency derivatives, and if you truly are a long-term equity market investor, then growth rates hardly matter. Data show that there is very little correlation between GDP growth and stock market returns. In a 2012 paper titled “Is Economic Growth Good for Investors?”, Jay R. Ritter from the University of Florida actually found a negative correlation between GDP growth per capita and inflation-adjusted stock returns. From the abstract:

Economic growth comes partly from increased inputs of capital and labor, which don’t necessarily benefit the stockholders of existing companies. Economic growth also comes from technological change, which does not necessarily lead to higher profits if competition between firms results in the benefits being passed to consumers and workers. Realized growth has both an expected and unexpected component. Apparently investors overpay for expected growth, and this over-payment more than offsets the benefits of unexpected growth.

“If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” – Peter Lynch

In fact, seasoned investors have time and again advised us to keep economists away from the trading floor. Here’s a gem from TRB:

Stocks trade based on three things: sentiment, valuation and trend. Yes, economic data feeds into these things, but it is up to the trader or investor to determine their combined favorability, an economist does not do that sort of work. The reality is that there is no such positive correlation over various periods of time between economic data and stocks in any given country.

And recently from AWOC:

The economy and the stock market are two different animals. The economy matters much less to stock market returns than most professional investors would have you believe. Economic data lags, gets revised, has seasonality and is just generally hard to use when making investment decisions for all but a very small percentage of investment professionals.

I am all on board to keeping a 36,000 foot view on growth trends, credit cycles, bank balance-sheets etc. It allows you to develop an understanding of sector rotations and position your portfolio beta. But knowing the minutiae might actually be of negative value to your investment process.

Sources:

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The Seersucker Theory

We have always been skeptical about forecasting experts. However, skepticism about forecasts is nothing new. Lao Tzu, a 6th century poet is quoted as saying: “Those who have knowledge don’t predict. Those who predict don’t have knowledge.” The Little Book of Behavioral Investing has an entire chapter dedicated to explaining why Forecasting is a Sham. And yet, people are willing to pay heavily for expert advice. They generally ignore available evidence and continue paying for forecasts.

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As J. Scott Armstrong so eloquently put it: “No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.” This is the Seersucker Theory.

Its not that experts are useless. But expertise beyond a minimal level is of little value in forecasting change. This conclusion is both surprising and useful, and its implication is clear: Don’t hire the best expert, hire the cheapest expert.

However, we often fool ourselves into believing that the more we pay for advice, the better it is. Armstrong goes on to say: One explanation is that the client is not interested in accuracy, but only in avoiding responsibility. A client who calls in the best wizard available avoids blame if the forecasts are inaccurate. The evasion of responsibility is one possible explanation for why stock market investors continue to purchase expert advice in spite of overwhelming evidence that such advice is worthless.

The whole paper is worth a read and raises some important questions about our own beliefs.

Source: The seer-sucker theory: the value of experts inforecasting

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Overcoming the 5 common mistakes that investors make

We are big fans of emotion control when it comes to investing. Most of us know this famous Jesse Livermore quote: “Money is made by sitting, not trading.” And yet, we can’t help ourselves.

Michael J. Mauboussin of Credit Suisse has an interesting report out on how to make better decisions:

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Know the outside view

The outside view imposes a fundamental question: “What happened when others were in this position before?” Research shows that the inside view often yields predictions that are too optimistic, revealing a form of overconfidence. The outside view generally tempers that overconfidence and provides a much stronger foundation for thinking about how the future might unfold.

Conduct a pre-mortem

Rather than using the past as a guide for the present, the pr-emortem goes from the future to the present. Before you actually make a decision, launch yourself into the future, say one year from now, and pretend that you made the decision. Now assume the decision turned out poorly, and you must document the reasons for the failure.

Seek out naysayers

It is common for investment firms to position their portfolios to reflect a particular point of view or theme. Mind-sets can be good, of course, when they get everyone on the same page. But mind-sets are a problem if the world changes. So seek out naysayers, or “red-teams.” Red-teaming is a technique to offset the rigidity of mind-sets.

A red team attacks and a blue team defends. In this case, the blue team would be assigned to defend the mind-set that underpins the portfolio. The red team would be a small number of people who would be charged with contesting the mind-set. Red-teaming allows for an explicit challenge to the prevailing mind-set, and at a minimum forces the team members to seriously consider an alternative point of view.

Maintain a decision-making journal

Sometimes good decisions turn out poorly and bad decisions turn out well. Since our minds are biased to assume that the outcome reflects the level of skill, keeping track of the quality of our decisions is difficult. The primary way to focus attention on the decision-making process is to keep a journal that documents your thinking. This is how you impose accountability on yourself.

Be mindful of your surroundings and work to improve them

When we observe the behavior of others, we attribute that behavior to the individual’s disposition and not to the situation. But there is substantial evidence that shows that the situation exerts a very powerful influence on the decisions that people make.

For example, some investors that claim to have a long-term orientation focus disproportionately on the short term following a spell of poor results. Others claim to use a fundamental approach yet use charts to time trades. The divergence between what you say and what you do might be result of the environmental cues around you.

And remember this awesome quote from Phil Birnbaum:

“You gain more by not being stupid than you do by being smart. Smart gets neutralized by other smart people. Stupid does not.”

Source: Methods to Improve Decisions

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More Information ≠ Better Information

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We live in an era of information overload – the 18 hour business channel, endlessly refreshing twitter streams and news feeds. Our brains just haven’t evolved fast enough to keep pace with the bombardment of information. Add the typical uncertainties of investing into the mix and our brains just can’t cope. However, that doesn’t prevent us from seeking incremental information. We tend to believe that if we just had a “bit more” information, we may arrive at “better” decisions. But this is not necessarily true.

Consider the experiment outlined in “On the Pursuit and Misuse of Useless Information,” by Bastardi and Shafir (pdf).

Group I

Question:

You are considering registering for a course in your major that has very interesting subject matter and will not be offered again before you graduate. While the course is reputed to be taught by an excellent professor, you have just discovered that he will be on leave, and that a less popular professor will be teaching the course.
Do you:

  1. Decide to register for the course? [82%]
  2. Decide not to register for the course? [18%]

(the percentage of participants who chose each option appears in brackets)

So a large majority (82%) of respondents effectively doesn’t care about the teacher, and cares only about the course.

Group II

Another set of students were asked the uncertain version of the question:

You are considering registering for a course in your major that has very interesting subject matter and will not be offered again before you graduate. While the course is reputed to be taught by an excellent professor, you have just discovered that he may be on leave. It will not be known until tomorrow if the regular professor will teach the course or if a less popular professor will.

Do you:

  1. Decide to register for the course? [42%]
  2. Decide not to register for the course? [2%]
  3. Wait until tomorrow? [56%]

Here, 56% of the respondents believe that if they just had that incremental piece of information, they’ll make a better decision.

Group II Followup

Here’s the follow up question to the same set of (Group II) students who chose (3) in the question above:

It is the next day, and you find out that the less popular professor will be teaching the course.

Do you:

  1. Decide to register for the course? [29%]
  2. Decide not to register for the course? [27%]

Therefore, the new distribution of overall preferences under the “uncertain version”:

  1. Decide to register for the course [42% + 29% = 71%]
  2. Decide not to register for the course [2% + 27% = 29%]

Whereas before, under the “simple version,” 82% chose to take the course, in the “uncertain version,” after the introduction of a piece of information that we know to be useless, only 71% chose to take the course.

So not only do we lust after incremental information that is useless, but once we get them, we assign too much value to them.

h/t TurnkeyAnalyst

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Investing: Man vs Monkey

A must read article at Priceonomics:

In 2010, a Russian circus monkey named Lusha picked an investment portfolio that “outperformed 94% of the country’s investment funds” to great acclaim. Given 30 blocks, each representing a different company, and asked “Where would you like to invest your money this year?”, the chimp picked out 8 blocks. An editor from a Russian finance magazine commented that Lusha “bought successfully and her portfolio grew almost three times.” He suggested that “financial whizz-kids” be “sent to the circus” instead of rewarded with large bonuses.

 

Can your portfolio beat a blind-folded monkey, when adjusted by risk?

Source: How Well Do Blindfolded Monkeys Play the Stock Market?

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