Active Investing Archives - Page 3 of 3

October 27, 2013

Saving Investors From Themselves | WSJ

Jason Zweig, in his 250th Intelligent Investor column for The Wall Street Journal, writes:

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance…….My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors’ own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.

While I agree with Jason that investors are often their own worst enemy, I would hesitate to advise anyone to invest in under-performing stocks (anticipating reversion to the mean) or to adopt a buy-and-hold strategy. Our research shows that investing in top-performing stocks (buying momentum) delivers significant outperformance over a buy-and-hold strategy in the long-term.

The risk to momentum investing is not of reversion to the mean, but of significant draw-downs when there is a broad market down-turn. Most stocks fall in a bear market, but top-performing (momentum) stocks tend to fall further. Value stocks are also likely to fall during a market down-turn and the best defense is often to move to cash or counter-cyclical investments such as bonds.

The difficulty is to identify these broad market swings with enough certainty to confidently switch your investment allocation. Common mistakes are to continually jump in and out of the market at the slightest hint of bad news, leading to expensive whipsaws, or to get caught up in the intoxicating sentiment of a bull market, blinding you to warning signs of a reversal.

I believe investors should allocate half their time to deciding what stocks to buy/sell and the other half to identifying when to be in/out of the market. Too often I see them focusing on one half while neglecting the other — usually with disastrous consequences.

July 9, 2013

BBC News: Could one man have shortened the Vietnam War?

Malcolm Gladwell tells the story of story of Konrad Kellen, a “truly great listener”:

Everyone believed what [Leon Goure, US expert who believed the Vietcong were demoralised and about to give up] said, with one exception – Konrad Kellen. He read the same interviews and reached the exact opposite conclusion.

Years later, he would say that his rethinking began with one memorable interview with a senior Vietcong captain. He was asked very early in the interview if he thought the Vietcong could win the war, and he said no.

But pages later, he was asked if he thought that the US could win the war, and he said no.

The second answer profoundly changes the meaning of the first. He didn’t think in terms of winning or losing at all, which is a very different proposition. An enemy who is indifferent to the outcome of a battle is the most dangerous enemy of all.

Goure’s analysis is a classic case of confirmation bias: he sought evidence to support his preconceived ideas, rather than gathering and evaluating evidence objectively. This applies as much to investing as it does to war.

June 4, 2013

Are You Trying to Get Rich — Or Stay Rich? | The Big Picture

Excellent post by Barry Ritholz discusses the traps awaiting rich investors or what he calls The Fallacy of Competency Transference:

Last week, Bloomberg caused a minor stir with their story on C/NET founder Halsey Minor (How Halsey Minor Blew Tech Fortune on Way to Bankruptcy):

“How do you sell the technology company you founded for $1.8 billion and five years later file for personal bankruptcy? For Halsey Minor, it may have been a fascination with houses, hotels, horses and art.”

This tale of foolishness and excess is worth discussing, if for no other reason it is strewn with lessons for others. Not just for dot com millionaires, but for anyone else who suddenly finds themselves with much more money [than] they had the prior year. This goes for professional athletes, entrepreneurs, actors, rock stars and lottery winners. Even those kids of baby boomers who find themselves with a minor inheritance can find lessons to learn from Halsey’s follies.

The key is recognizing that your new found wealth is not an ongoing revenue stream, but more typically reflects a one time (or short term) windfall.

Why is that? Because you never know what the future holds. Post IPO stock prices can falter, athletes suffer from career ending injuries, artists may be one hit wonders. An old Yiddish proverb states “Man plans and God laughs.”

How do you plan and not tickle the funny bone of major deities? Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.

I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).

The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).

What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.

Which brings us back to Halsey Minor: Without the expertise, without putting the time in, without much more than capital, he jumped into 3 different fields he had little or no knowledge of:

1. He became an Angel Investor, pouring money into early-stage startups and incubators and other such technology investments that eventually cost him a huge chunk of capital;

2. He went on a mad shopping spree for real estate, high-end art and contemporary designer furniture, “investing” tens of millions of dollars;

3. He purchased an immense Virginia Plantation where he planned to raise racehorses;

All of these purchases were eventually unwound at a fraction of their original purchase price in order to pay off creditors.

Which leads us directly to a few rules about dealing with sudden wealth:

1. You must avoid the hubris and arrogance that often accompanies sudden wealth. (Becoming wealthier does not = acquiring more expertise);

2. Debt is a dangerous tool, especially in the hands of the naive;

3. Assets are not the same as income; wealth is not the same as cash flow; Spending is not the same as investing;

4. You best understand your own strengths and weaknesses; this includes emotional, intellectual as well as behavioral.

5. Experience teaches us that the belief “I’m rich, therefore I must be very smart” is a recipe for disaster when not backed up with actual knowledge in relevant fields.

There are many more rules we can derive from this tale of woe, but perhaps the single most important one is the importance of living within your means. This is true whether you have $500 in the bank or $500 million.

Insolvency occurs when your liabilities exceed your assets and cash flow, regardless of how many zeros are on either side of the balance sheet . . .

In investment banking the joke was: “How to make a small fortune? Start with a big one.”

I have witnessed numerous examples of this Fallacy of Competence over the years. In fact I would go so far as to say it is the single biggest factor in the destruction of capital. Just because you are a competent eye-surgeon, for example, doesn’t make you a good investor. You are likely to exhibit the same level of competence as an investor as you would if asked to perform eye-surgery in your freshman year at university.

And just because you are wealthy doesn’t make you competent. The ancient Greeks believed that hubris is followed by nemesis.

As Will Rogers said: “We are all ignorant — just on different subjects.”

June 3, 2013

Smart and Stupid Arguments for Active Management | The Reformed Broker

Are active or passive investment strategies best? Josh Brown at The Reformed Broker writes there are both smart and stupid arguments to be made for active management:

Marketocracy’s Ken Kam, who has spent a career studying and vetting active managers, touches on one of each type in an interview with Covestor the other day.

First, his smart argument, the thing about all strategies that is always true:

“My experience has taught me two important lessons. One, there is no sector or investment style that works all the time. And two: a great manager gets that way by honing his skill in a single sector or style. The combination of these two lessons is that if you want good performance over time, you can’t get it by using the same managers year after year.

My approach is to look among the managers who have proven themselves over the long term to find those whose style is performing well now. If there are a lot of proven managers who are all performing well now, then I choose managers whose styles are different from one another, to reduce the impact of any single manager’s style falling out of favor.”

This is absolutely correct, there is no strategy – be it active, passive, value, growth, long-short, arbitrage, mean reversion, trend-following, stock picking etc – that will always work in all environments. Kam gets this correct. The trouble is, most passive guys say they don’t care about this or that style being out of favor, they will wait ’til the cycle swings back around – “Forget the needle, buy the haystack” Jack Bogle exhorts us. Most active guys, on the other hand, will be the last to recognize (or admit) that their expertise is not beneficial in a particular market moment.

Kam’s other argument is of the “stupid” variety. Please understand that this is a very smart man making it, so no insult intended:

“Owning an index fund is like being a passenger on a jet on automatic pilot. Today’s automatic pilots are so good that one might argue that having a human pilot on board is an unnecessary expense. But would you be willing to fly on jet without a human pilot on board? Perhaps if the sky is clear you might consider it. But certainly not if you thought you might be flying into a storm.

I think index funds make sense for those who see clear skies ahead for the stock market. For those who see a storm coming, having a human pilot at the helm makes a lot more sense.”

Okay, I’m gonna stop you right there.

The passive investor absolutely does not see “clear skies ahead” at all times. Rather, this investor recognizes that most managers will not be able to detect and react to the thunderclouds in a timely, consistent way. In addition, many of them will be so hyperactive that every gray cloud will appear to be a hurricane, and so a lot of buying and selling (churn) will be the result – leading to higher taxes, trading costs and potential for missed opportunities.

While Josh does not take sides, professing that he is ambivalent about whether active or passive management is preferable, he says in the past five years passive has outperformed active investing.

I agree with Kam and Brown that no investment style works all the time. But I disagree that index funds out-perform in a bull market, when there are “clear skies ahead”. Active investors using momentum or trend-following strategies will comfortably out-perform the index. But, as Brown points out, most active investors fail to react to an approaching “thunderstorm” and will get caught in the ensuing bear market. Holding fast-moving stocks, they then under-perform the index, with sharp falls and severe capital draw-downs. And in the uncertainty that follows, like 2010 to 2012, active investors will also under-perform: with no strong trend there are too many false starts.

My conclusion is that active strategies out-perform in a bull market, while passive strategies are more resilient when there is no strong trend. Neither do well in a bear market, but passive strategies incur relatively less damage. Using technical indicators to identify the start and end of bull markets may seem the obvious solution, but can lead to false signals and expensive “churn”. A thorough understanding of macroeconomic indicators is essential to confirm market signals, but this can take years of study and is not for the faint-hearted. At all costs, do not try to make forecasts; even professional economists seldom get this right. Simply use the indicators to identify market risk and adjust your strategy accordingly.