Tuesday, January 1, 2013

How to Be a Better Investor

It’s Christmas shopping time: No doubt us obsessive investors will be thinking about gifts and contemplating buying the latest book designed to convince us that a certain investor or other has the panacea to investment or management problems. Whether it is a book on ‘master investors,’ the latest Buffett biography, ‘Business Secrets of the Pharaohs,’  ‘Why Mayan Civilization Collapsed: A Technical Analysis’ or other such nonsense, you can be sure they will be out in book shops near you. Well, in the spirit of Christmas, it’s time to throw my opinions over for free.

Fooled by Topiary

Any discourse on this subject can’t avoid a reference to Nassim Taleb. In truth, most investors owe a debt to him for his popularization of the idea that most of these tomes are merely selling observations of ‘certainty’ on events which are in fact random in nature. I’m greatly sympathetic to this view. For example, if you want to analyze what makes great investors do you only analyze the traits of ‘the greats’ or do you analyze a huge cross sample and see which traits appear to lead to some of them being great?

Let me put it this way. Assume Buffett, Soros and Chanos love doing topiary on the weekends. Conclusion: doing topiary makes you a great investor! However, you can analyze 1,000 investors (including plenty of losing investors) and discover that doing topiary on the weekends actually causes negative overall performance.

In other words, I don’t think a narrow analysis of a few great investors’ traits is a legitimate pursuit.  It’s a bit like looking at say Exxon Mobil or Chevron and the huge run up they both had from 2003 to 2008 and then concluding that the management was fantastic because they may have all favored topiary when in fact it was largely due to the price of oil. If you buy these stocks, you are de facto taking a position in oil.

And don’t get me started on hindsight or survivorship bias!

Stop Analyzing the Pro’s

The other problem that private investors (and authors for that matter) have is that most of the track record is in the professional arena.  This is an issue because professional investors are necessarily solely focused on generating risk adjusted returns.  I’ll explain.

Private investors can take no solace in the track record of professionals.  Essentially the investment industry works on a couple of working principles which it has learned empirically over the years. It took the work of behavioral psychologists Kahneman & Tversky to rationally express these principles or heuristics, but the investment industry has always lived by them.

  • A loss is psychologically weighted double that of a gain
  • Investors overweight near term performance

The first point plays out because asset managers are terrified to deviate from industry benchmarks on the downside because they will lose their blessed assets under management (AUM), and there is little benefit to be gained in trying to beat their peers because upside is not as strongly rewarded.

The second point is that investors tend to overweight short term performance, and the industry knows this so there is nothing wrong (for the industry) in chasing myriad risky strategies which produce short term outperformance but then blow up when conditions change. After all, the important thing is to get AUM and tie it up.  This is why asset managers tend to have a stable of different types of funds. When one is hot they market it more and then investors duly reward them with AUM. Of course the problem is that that manager may have taken on excess risk to get the numbers. But who cares? Asset managers make money by managing assets after all.

In this sense it is exactly the same principle with what went wrong with the financials. Risk went out the window in many cases and if it wasn’t for the largess of the Government and taxpayers money, the likes of Goldman Sachs (NYSE: GS), JP Morgan (NYSE: JPM) and AIG (NYSE: AIG) wouldn’t be around today. It’s tough to blame them for the whole crisis because so few saw it coming, but then again if conditions collapse for a topiary supply company then they go bust.  Who ever heard of a bank going, errr, bankrupt?  My point here is that these organizations don’t appear to be run with a cognizance that they might fail, therefore the only game in town is (still) to go for profits irrespective of the risk.

I would urge great caution in following professional investors too closely unless they have demonstrable track records of making money over the long term. I would also suggest investors avoid tomes in technical analysis which in fact turn out to be capturing some facet of market conditions that worked for a while only to then fall apart as they changed.

So What to Do?

My only suggestion if you want to be a better investor is to look at your internal thought processes. You will find no end of information, views and data on stocks. In my humble opinion what makes a good investor is the ability to disseminate this mass of information into something coherent and then pick out the salient drivers that are going to guide the stock price. In the end all you want is the stock price to go up while not taking on too much risk. The latter stipulation usually requires a level of humility (diversifying to accept that fact that you might be wrong) that is often missing in professional investors touting for AUM.

No matter, it shouldn’t detract private investors from trying to define clearly what they think is the key driver of the stock price and then analyzing whether they are good at doing this or not over the long term.

As for the Christmas book shopping, I would advise Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. Any lingering doubt that investing requires humility and the need to avoid selective reasoning should be eradicated after reading that marvelous book.

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