learning the art of value investing
TRANSCRIPT
"Learning the Art of Value Investing" - A new thread
22 posts by 11 authors in Intelligent Investor Forum
Wise Investor Post reply
May 2
Hi IIfians,
I and saurabh have thought upon to start this new thread on " Learning the Art of
Value Investing" to share articles and information for our members to improve on
our Investment Process. I request all members to actively participate in this Thread
and share views and articles and information from various sources in this thread so
as into improve our knowledge. More Hands if join together can help us dig into
lot of available investment insights ,for us to improve in future. The Focus is to
Improve our INVESTMENT PROCESS.
regards,
Wise Investor
Seth Klarman On Preventing Mental Mistakes
Seth Klarman, in his 2011 letter to Baupost investors, wrote: “Understanding how
our brains work—our limitations, endless mental shortcuts, and deeply ingrained
biases—is one of the keys to successful investing.” He stressed a few key mental
errors made by both individual and institutional investors. Here are some mental
errors that we should all watch out for:
Overreacting to the latest news
Klarman had this to say about overreacting: “Investors emotionally pile in on good
news and rush for the exits on bad news, causing prices to overshoot.” We tend to
act in the heat of the moment and make quick buy and sell decisions without any
significant thought. The average investor’s mindset, according to Klarman, is this:
“Most of us like a stock more when it has risen in price and less when it has
fallen.” If a company reports an increase in earnings, our brains might feel
something golden and jump on the bandwagon. Tech giant Intel (INTC) recently
reported increased earnings for the 1st quarter of 2012. Does that mean we should
buy it right away?
What we should do is to reverse our thinking about the latest hot news and look for
reasons why a company like Intel may not be a good investment. As Sir John
Templeton once noted, “The time of maximum pessimism is the best time to buy
and the time of maximum optimism is the best time to sell”. So when the stock
market is down, it is time to look for opportunities, not to sit back and do nothing.
Klarman suggests a common error when searching for investment opportunities:
“The herd can irrationally lose sight of the underlying assets and long-term
prospects of a business when it focuses on price movements.”
Looking in the rearview mirror
As Klarman states, “Our expectations about future events are distorted by past
experience.” When we think too much about the past, we become more hesitant to
take risks. And Klarman further states: “Actions that seemed prudent in foresight
can look horribly negligent in hindsight.” We likely fail to overcome the extreme
fear that prevented smart decision-making. Fear, particularly upon suffering a loss,
causes people to ignore bargains in the market. Banking businesses like Citigroup
(C) were a bargain following the low point of the economic recession. But did
anyone bother to look at Citigroup’s future outlook?
People in the market today are scared due to their memories of the recent financial
crisis. However, “Protective actions, whether by individuals or governments, tend
to be designed to prevent a recurrence of the worst such disaster previously
experienced, ” wrote Klarman. We tend to become too cautious in trying to prevent
the worst of such disasters. We tend to look back at the worst scenario that may not
happen again. In Montier’s words, we become afraid of the big, bad market.
Focusing on results rather than processes
Klarman makes the ultimate point about focusing less on results: “A good result
says nothing about whether the process involved was a good one and whether or
not the success might be replicable.” Montier takes this a step further: “You could
have a good process but a bad outcome. Or you could have a bad process but a
lucky outcome. The bad process/lucky outcome combination is worse because it
sets investors up for a higher likelihood of failure in the future.” Klarman
explained: “The focus on benefits lessens our concern about what could go
wrong.” The biggest mistake we make is not remembering our past mistakes. With
a good outcome, we are less likely to remember and analyze our weaknesses.
Klarman notes: “Those who have been lucky are almost never punished for having
taken too much risk.” With good results that may turn out to be pure luck, we are
quick to praise the positive outcome on genuine skill that we don’t really have.
Letting intuitive hunches take over rationality
Klarman stressed the importance of being a rational thinker: “It is good to buy
investment bargains, but it is far better if you know why they are bargain-priced.”
In essence, it is important to focus on logic and rationality. Look no further
than Warren Buffett, whose investment logic is to buy businesses with good-to-
superb underlying economics run by reliable people.
Investor irrationality comes from the two systems in his or her brain: an intuitive
brain, System One, and an analytical brain, System Two. Our intuitive brain makes
quick, unconscious decisions on the spot. Our analytical brain takes more time to
process the information and formulate solutions. This is how our brains tend to
work, according to Klarman: “When System One substitutes an easier question for
a harder one, it is easy to make mistakes.” The best investors are the ones with a
strong analytical brain.
We, by human nature, think we know the difference between right and wrong
without extensive analysis, if we have been around the business for a long time. So
we come to believe that our decisions are always rational no matter what. We need
to always be conscious of whether we are making rational decisions or not.
Klarman wrote: “No one should be confident that they are immune from irrational
behavior from time to time.”
Regards,
Wise Investor.
Guru Post reply
May 2
Re: [IIF:20045] "Learning the Art of Value Investing" - A new thread
Great Idea. I will be able to learn a lot because of this. Will share few details from
my side too.
- show quoted text -
- show quoted text -
Wise Investor.
--
DISCLAIMER
IIF members recommending/discussing any stock/stock idea shall without
prejudice, be deemed to be construed that, he/she may have vested interest in doing
so. Fellow IIF members are requested to complete their own research /due dligence
in addition to the stock idea and \ or consult a qualified financial advisor before
taking any action.IIF, its members and managers do not take any responsibility for
any consequences (financial, legal or otherwise) resulting from action based on
views discussed in the forum.
Only make investments that suit your particular goals and capital constraints.
https://groups.google.com/group/intelligent-investor-forum?hl=en
Anuj Anandwala Post reply
May 2
Re: [IIF:20046] "Learning the Art of Value Investing" - A new thread
PFA some articles I found interesting & helpful.
Cheers !
- show quoted text -
--
Warm Regards,
~ monkk ~
Attachments (2)
Stumbling on value investing.pdf
131 KB View Download
Charlie Munger - Art of Stock Picking.pdf
297 KB View Download
Constant Seeker Post reply
May 2
Re: [IIF:20052] "Learning the Art of Value Investing" - A new thread
Hi All,
I would like to start by focusing on the various biases we have in investing and we
can discuss each bias for a week or 3-4 days.
BIAS 1:- AVAILABILITY BIAS
The availability bias is a mental shortcut that operates on the notion that "if you
can think of it, it must be important". In investing terms it is our tendency to make
a judgment on whether to buy/sell a stock on basis of
How easy is information available on the
price of stock so that you "feel" u have
enough knowledge to buy that stock
Remembering instances when how easily
yourself or others have made money doing
such trades.
As Prof. Bakshi puts it lightly " If the girl I like is not near me , i like the girl near
me" :)
Example:
Just have a look at any business channel to
see this in action. Whenever any event
happens like a rate cut or elections the price
rises and falls of impacted stocks are shown
in a very vivid and easy to absorb fashion.
Due to the availability of this data in we
tend to form an opinion on such events and
start to base our buy sell decision on such
instances rather than fundamentals.
Similarly most of the times focus is on high
volume stocks where even a small gain or
loss is highlighted. So if someone has ideal
cash his usual bias will be to enter these
stocks for quick gains rather than looking at
it on a fundamental level.
Ways to counter this ( i am still trying to follow them :P)
Underweight the extra, more attention
grabbing news and focus more on silent
undercurrents.
An idea or a fact is not worth more because
it is readily available to you- Munger. In
other words initially be skeptical to any
idea you generate
Views invited.
Regards,
Saurabh
- show quoted text -
Wise Investor Post reply
May 3
Re: [IIF:20063] "Learning the Art of Value Investing" - A new thread
Hi IiFians,
Good Morning.....
The file attached is a snapshot from Daniel Kahneman Book - Thinking Fast and
Slow, It addresses the way our minds are designed to think and how r we forced to
think in that pattern. The point which Saurabh has raised on Availability Bias
could be addressed partially through Daniel work and research.
Interesting Reading ...
regards,
Wise Investor.
DISCLAIMER
IIF members recommending/discussing any stock/stock idea shall without
prejudice, be deemed to be construed that, he/she may have vested interest in doing
so. Fellow IIF members are requested to complete their own research /due dligence
in addition to the stock idea and \ or consult a qualified financial advisor before
taking any action.IIF, its members and managers do not take any responsibility for
any consequences (financial, legal or otherwise) resulting from action based on
views discussed in the forum.
Only make investments that suit your particular goals and capital constraints.
https://groups.google.com/group/intelligent-investor-forum?hl=en
Attachments (1)
Bias, Blindness and How We Think- Daniel Kahnenam.pdf
129 KB View Download
Guru Post reply
May 4
Re: [IIF:20080] "Learning the Art of Value Investing" - A new thread
The mental habit of thinking backward forces objectivity. One of the ways you
think a thing through backward is you take your initial assumption and say, Let’s
try and disprove it. For example, if you were hired by the World Bank to
help India, it would be very helpful to determine the three best ways to increase
man-years of misery in India—and, then, turn around and avoid those ways. So
think it backward as well as forward. It’s a trick that works in algebra and it’s a
trick that works in life. If you don’t, you’ll never be a really good thinker.---Charlie
Munger
- show quoted text -
- show quoted text -
--
DISCLAIMER
IIF members recommending/discussing any stock/stock idea shall without
prejudice, be deemed to be construed that, he/she may have vested interest in doing
so. Fellow IIF members are requested to complete their own research /due dligence
in addition to the stock idea and \ or consult a qualified financial advisor before
taking any action.IIF, its members and managers do not take any responsibility for
any consequences (financial, legal or otherwise) resulting from action based on
views discussed in the forum.
Only make investments that suit your particular goals and capital constraints.
https://groups.google.com/group/intelligent-investor-forum?hl=en
Guru Post reply
May 4
Re: [IIF:20080] "Learning the Art of Value Investing" - A new thread
"A lot of opportunities in life tend to last a short while, due to some temporary
inefficiency... For each of us, reallygood investment opportunities aren't going to
come along too often and won't last too long, so you've got to beready to act and
have a prepared mind”---Charlie Munger
- show quoted text -
Guru Post reply
May 4
Re: [IIF:20080] "Learning the Art of Value Investing" - A new thread
"In many corporations, there is an obsession with meeting quarterly earnings
targets. To do so, they'd fudge a little,sell stock at a capital gain, sell a building or
two... Then, if that was not enough, they would engage in channel stuffing — if
you were selling through a middleman, you could unload your product at the end
of the quarter and make the current quarter look better but, of course, the next
quarter would be worse. For many major pharmaceutical, consumer products and
software companies, at the end of quarter, this was very common. That is pretty
well over. A few public hangings will really change behaviour."---Charlie Munger
- show quoted text -
hardik gajra Post reply
May 4
Re: [IIF:20115] "Learning the Art of Value Investing" - A new thread
dear all,
How to control emotion or how one can avoid himself from day trading
,I think almost near stock market doing intraday trade and no one can
make money. there is only looser there
thxxxxxxx
regd,
deepakgajra
On 5/4/12, Guru <[email protected]> wrote:
> *"In many corporations, there is an obsession with meeting quarterly
> earnings targets. To do so, they'd fudge a little,sell stock at a capital
> gain, sell a building or two... Then, if that was not enough, they would
> engage in channel stuffing — if you were selling through a middleman, you
> could unload your product at the end of the quarter and make the current
> quarter look better but, of course, the next quarter would be worse. For
> many major pharmaceutical, consumer products and software companies, at the
> end of quarter, this was very common. That is pretty well over. A few
> public hangings will really change behaviour."---*Charlie Munger
>
> On Fri, May 4, 2012 at 8:36 AM, Guru <[email protected]> wrote:
>
>> *"A lot of opportunities in life tend to last a short while, due to some
>> temporary
>> inefficiency... For each of us, reallygood investment opportunities
>> aren't going to come along too often and won't last too long, so you've
>> got to beready to act and have a prepared mind”---*Charlie Munger
>>
>>
>> On Fri, May 4, 2012 at 8:17 AM, Guru <[email protected]> wrote:
>>
>>> *The mental habit of thinking backward forces objectivity. One of the
>>> ways you think a thing through backward is you take your initial
>>> assumption
>>> and say, Let’s try and disprove it. For example, if you were hired by
>>> the World Bank to help India, it would be very helpful to determine the
>>> three best ways to increase man-years of misery in India—and, then, turn
>>> around and avoid those ways. So think it backward as well as forward.
>>> It’s
>>> a trick that works in algebra and it’s a trick that works in life. If you
>>> don’t, you’ll never be a really good thinker.---*Charlie Munger
- show quoted text -
ANISH POOJARA Post reply
May 8 (13 days ago)
Re: [IIF:20126] "Learning the Art of Value Investing" - A new thread
They say that 10% of the people make 90% of the money in trading.
So far I have come across only one guy who makes money in trading and that also
positional trading in futures. No intraday for him also.
anish poojara
- show quoted text -
agnostic Post reply
May 8 (13 days ago)
When it comes to investing (buy & hold), about 20% make money.
When it comes to trading, barely 2-3% make and retain money.
The above is based on my experience and whatever I have read so far.
Shambo,
Carlos.
On May 8, 3:38 pm, Anish Poojara <[email protected]> wrote:
> They say that 10% of the people make 90% of the money in trading.
> So far I have come across only one guy who makes money in trading and that
> also positional trading in futures. No intraday for him also.
> anish poojara
>
>
>
>
>
>
>
> On Fri, May 4, 2012 at 12:09 PM, deepak Gajra <[email protected]>
wrote:
> > dear all,
> > How to control emotion or how one can avoid himself from day trading
> > ,I think almost near stock market doing intraday trade and no one can
> > make money. there is only looser there
>
> > thxxxxxxx
>
> > regd,
>
> > deepakgajra
>
> > On 5/4/12, Guru <[email protected]> wrote:
> > > *"In many corporations, there is an obsession with meeting quarterly
> > > earnings targets. To do so, they'd fudge a little,sell stock at a capital
> > > gain, sell a building or two... Then, if that was not enough, they would
> > > engage in channel stuffing — if you were selling through a middleman, you
> > > could unload your product at the end of the quarter and make the current
> > > quarter look better but, of course, the next quarter would be worse. For
> > > many major pharmaceutical, consumer products and software companies, at
> > the
> > > end of quarter, this was very common. That is pretty well over. A few
> > > public hangings will really change behaviour."---*Charlie Munger
>
> > > On Fri, May 4, 2012 at 8:36 AM, Guru <[email protected]> wrote:
>
> > >> *"A lot of opportunities in life tend to last a short while, due to some
> > >> temporary
> > >> inefficiency... For each of us, reallygood investment opportunities
> > >> aren't going to come along too often and won't last too long, so you've
> > >> got to beready to act and have a prepared mind”---*Charlie Munger
>
> > >> On Fri, May 4, 2012 at 8:17 AM, Guru <[email protected]> wrote:
>
> > >>> *The mental habit of thinking backward forces objectivity. One of the
> > >>> ways you think a thing through backward is you take your initial
> > >>> assumption
> > >>> and say, Let’s try and disprove it. For example, if you were hired by
> > >>> the World Bank to help India, it would be very helpful to determine the
> > >>> three best ways to increase man-years of misery in India—and, then,
> > turn
> > >>> around and avoid those ways. So think it backward as well as forward.
> > >>> It’s
> > >>> a trick that works in algebra and it’s a trick that works in life. If
> > you
> > >>> don’t, you’ll never be a really good thinker.---*Charlie Munger
>
> > >>> On Thu, May 3, 2012 at 9:56 AM, Wise Investor <
- show quoted text -
Guru Post reply
May 8 (12 days ago)
Re: [IIF:20394] Re: "Learning the Art of Value Investing" - A new thread
Hi Carlos,
Agree 100% with you.
You being one of deep value investor and considering your patience to find gems
at bottom and your vast knowledge, you are the right person to share few good
articles and notes about great investors.
Thanks,
Guru
- show quoted text -
Wise Investor Post reply
May 9 (12 days ago)
Re: [IIF:20399] Re: "Learning the Art of Value Investing" - A new thread
Hi,
Notes on Berkshire Hathways Annual Meeting 2012.
regards,
Wise Investor
--
DISCLAIMER
IIF members recommending/discussing any stock/stock idea shall without
prejudice, be deemed to be construed that, he/she may have vested interest in doing
so. Fellow IIF members are requested to complete their own research /due dligence
in addition to the stock idea and \ or consult a qualified financial advisor before
taking any action.IIF, its members and managers do not take any responsibility for
any consequences (financial, legal or otherwise) resulting from action based on
views discussed in the forum.
Only make investments that suit your particular goals and capital constraints.
https://groups.google.com/group/intelligent-investor-forum?hl=en
Attachments (1)
92763946-Berkshire-Hathaway-Annual-Meeting-2012.pdf
498 KB View Download
Shiv Kumar Post reply
May 9 (12 days ago)
Re: [IIF:20418] Re: "Learning the Art of Value Investing" - A new thread
the guy has neither a cleaning lady nor a cook at home! marrying a
drudge has its own benefits!
shiv kumar
- show quoted text -
paringala Post reply
May 9 (11 days ago)
The Power of Beliefs to Move Markets and Mindsets
by Dominic Barton and Conor Kehoe |
Mindsets matter. For more than two years, we and others have been
talking about the need to shift the prevailing view among managers,
boards of directors and investors from "quarterly capitalism" to what
we call "capitalism for the long term". Together with Harvard Business
Review and the Management Innovation eXchange, we have issued a
challenge calling for the most instructive case studies and
provocative ideas that will help us re-imagine capitalism for the long
term.
Despite promising signs of change, such as a growing turn away from
the standard practice of issuing quarterly earnings guidance, old
attitudes die hard. More and more, we realize, the crucial first step
is to tackle our deeply embedded intellectual frameworks. Beliefs
drive actions and altering our belief systems will ultimately do more
than anything else to amplify and reinforce the kinds of behavioral
changes that, in the end, are the only measure that counts. In this
blog post we'd like to focus on two belief shifts that are critical.
1) Believe in your power to make markets efficient — but abandon the
efficient market dogma
The global financial markets are an extraordinary information
processing engine. Nothing beats the tracking mechanism of stock
prices when it comes to quantifying the constant push-and-pull of
thousands and thousands of investors and managers, pursuing and acting
upon different strategies. And yet . . . it's an extraordinary leap of
faith to go from acknowledging this fact to believing, as orthodox
efficient market theory holds, that markets are so efficient that all
relevant information is always and immediately embedded in prices.
Such a belief implies that any and all decisions that improve a
company's short term share price must logically also be improving its
long term health and vice versa. There can be no contradiction, or so
the theory goes.
In fact, much evidence suggests that the market often gets it very
wrong in the short term — with the most telling example being the 2008
financial crash itself. Beyond such large and violent macro-swings,
our own research at McKinsey suggests businesses that reallocate their
capital more aggressively can generate higher long term returns than
their more passive peers - even if, in the first few years, such
actions initially reduce previously expected earnings (and thus may
prompt a set of investors to sell down the stock, regardless of the
long term value creation). Assuming the market is perfectly efficient,
it appears, merely damns it to inefficiency.
Our suggestion: instead of passively accepting that the market is
always right, investors, managers and boards of directors need to
think in terms of how they can actively make it more efficient. In
short, they need to develop and contribute viewpoints to the market -
not assume the market already contains them - and then be ready to
stick to their guns. This is the way both to achieve higher returns
and make the market more efficient.
2) Believe in the real game — long-term value creation — and stop
acting as if you are meeting your highest calling if you simply play
by the rules
We direct this urgent call less at operating managers, who are out
there getting muddy and trying to score goals every day, than at other
critical corporate players, such as the trustees of pension funds and
sovereign wealth funds or a company's independent directors. Does
anyone honestly think this crowd today are doing all they could to
provide good governance and proper stewardship? Sadly no. Too often
they focus more on checking the boxes and ensuring that they have met
their (not inconsiderable) compliance obligations. But with a crucial
mental reset, they could and should play a much more vital role in
pursuing the real prize, which is long-term value creation.
For big pension fund and SWF managers, that role change starts with
spending the real time required to understand and have a forward-
looking viewpoint on their investments. There are many ways to achieve
this end, once belief systems shift. One path could be to concentrate
one's portfolio. For example, Dutch pension fund PGGM, with over 100
billion euros under management, decided a few years ago to focus one
of its 3 billion euros of its equity portfolio on 15-20 stocks, engage
with those investments as an active long-term owner — and stop
tracking the indexes. Another course might be to take more activity
'in house', especially if contracting investment management out makes
it difficult to achieve alignment with one's chosen asset managers. Or
it may involve keeping a wide portfolio but concentrating governance
efforts on shaping management and strategy at a few stocks at a time -
and doing so either alone or in collaboration with others.
Independent directors confront the same challenge: currently they too
often serve as the box-checking last step in signing-off on a CEO-run
strategic process. If they want to move beyond obeying the letter of
the laws governing their fiduciary duties and delve deeply into the
content of strategy, then they need to increase one critical
investment: their time. This won't be easy, but there are signs the
core belief system may be changing. In a recent survey of some 1600
members of boards of directors, we found that their number one goal is
to spend more time on strategy and the best way to achieve this, they
believe, is to carve out 10 more days a year for their board duties (a
third more time than they are currently spending).
The key step is to foster deeper board engagement. Beyond that, we
have learned, it also helps if an active independent director's
relevant skills match up with the strategy of the company he aims to
steward. Our recent research on 110 large European companies managed
by private equity firms found a strong correlation between successful
value creation and the skill set of the partner serving as lead
director. PE partners with extensive M&A experience delivered better
results when the companies they were overseeing were also embarked on
an aggressive M&A strategy. Similarly companies pursuing organic
growth created more value when the lead directors from their PE owners
had backgrounds with deep management expertise.
Obviously much more needs to be done to foster a capitalism that is
truly patient, principled and socially accountable. The list stretches
from adopting an investor relations policy that concentrates on
fostering a long term investor base and developing better metrics to
tackling, with guidance from active owners, some of the flaws and
inequities in executive compensation. We intend to continue exploring
those issues--and the solutions required to better address them--in
our ongoing research. But the critical first step, we're convinced, is
for more and more institutional investors and independent board
members to abandon old orthodoxies and embrace a new belief: the
belief that through greater engagement and more active ownership/
stewardship they can enhance the market's efficiency while delivering
greater value creation for stakeholders and shareholder alike.
Parin.
On May 8, 8:29 pm, Guru <[email protected]> wrote:
> Hi Carlos,
>
> Agree 100% with you.
>
> You being one of deep value investor and considering your patience to find
> gems at bottom and your vast knowledge, you are the right person to share
> few good articles and notes about great investors.
>
> Thanks,
>
> Guru
>
> On Tue, May 8, 2012 at 5:18 PM, agnostic
<[email protected]>wrote:
- show quoted text -
Wise Investor Post reply
May 11 (10 days ago)
Re: [IIF:20448] Re: "Learning the Art of Value Investing" - A new thread
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HI IIFians
Interesting paper by James Montier on Quants success over human ...., if anyone is
following/ using such quants in its stock picking pls do share with the grp for
everyone learning.
Regards,
Wise Investor.
Global Equity Strategy: Painting by numbers: an ode to quant James Montier discusses the superiority of models over human judgement
What could baseball, wine pricing, medical diagnosis, university admissions,
criminal recidivism and I have in common? They are examples of simple quant
models consist-ently outperforming so-called experts. Why should financial
markets be any different? So why aren't there more quant funds? Hubristic self
belief, self-serving bias and inertia combine to maintain the status quo.
· * There is now an overwhelming amount
of data to suggest that in many environments,
simple quant models significantly outperform
human (expert) judgements. For instance, in
their study of over 130 different papers,
covering decision-making contexts as
wideranging as occupational choice to the
diagnosis of heart attacks, Grove et al located a
mere 8 studies that found in favour of human
judgements over the quant models.
· * All 8 of these studies had one thing in
common. The human participants had access to
information not available to the quant models.
Where quant models and human had the same
information set, the models performed much
better. Across the full range of papers that
Grove et al examined, the average human
participant had a 66.5% accuracy rating,
whereas the quant models had an average hit
ratio of 73.2%.
· * Even when the human participants were
given access to the quant model's results as
aninput for them to use if they chose, they still
managed to underperform the model. This isan
important point. One of the most common
responses to quant superiority is that surelythis
could be a base for qualitative improvements by
skilled users? However, the evidence is clear:
quant models usually provide a ceiling (from
which we detract performance)rather than a
floor (on which we can build performance). We
tend to overweight our ownopinions relative to
those of the models.
· * The good news is that, in some fields,
quant models have become relatively
accepted.For instance, over half the states in the
US use a quant model when considering parole
for convicts. However, in finance a quant
approach is far from common. Those that do
pursue a quant path tend to be rocket scientist
uber-geeks. Once in a while a fairly normal
'quant' fund comes to light. Two explicitly
behavioural based funds stand out in my mind -
LSV and Fuller & Thaler. Both have admirable
track records in terms of outperformance.
Whilst this is far from conclusive proof of the
superiority of quant, it is a step in the right
direction.
· * So why don't we see more quant funds
in the market? The first reason is
overconfidence.We all think we can add
something to a quant model. However, the
quant model has theadvantage of a known error
rate, whilst our own error rate remains
unknown. Secondly,self-serving bias kicks in,
after all what a mess our industry would look if
18 out of every 20 of us were replaced by
computers. Thirdly, inertia plays a part. It is
hard to imagine a large fund management firm
turning around and scrapping most of the
process they have used for the last 20 years.
Finally, quant is often a much harder sell, terms
like 'black box' get bandied around, and
consultants may question why they are
employing you at all, if 'all' you do is turn up
and crank the handle of the model. It is for
reasons like these that quant investing will
remain a fringe activity, no matter how
successful it may be.
Painting by numbers: an ode to quant
Don't worry dear reader, there will be no gratuitous use of poetry in this missive,
despitethe title - I promise. However, pause again for a moment and consider what
baseball, wine,medical diagnosis, university admissions, criminal recidivism and I
might have incommon.
The answer is that they all represent realms where simple statistical models have
outperformed so-called experts. Long-time readers may recall that a few years ago
I designed a tactical asset allocation tool based on a combination of valuation and
momentum. At first this model worked just fine, generating signals in line with my
own bearish disposition. However, after a few months, the model started to output
bullish signals. I chose to override the model, assuming that I knew much better
than it did (despite the fact that I had both designed it and back-tested it to prove it
worked). Of course, much to my chagrin and the amusement of many readers, I
spent about 18 months being thrashed in performance terms by my own model.
This is only anecdotal(and economist George Stigler once opined "The plural of
anecdote is data"), but it setsthe scene for the studies to which I now turn.
Neurosis or psychosis?
The first study I want to discuss is a classic in the field. It centres on the diagnosis
of whether someone is neurotic or psychotic. A patient suffering psychosis has lost
touch with the external world; whereas someone suffering neurosis is in touch with
the external world but suffering from internal emotional distress, which may be
immobilising. The treatments for the two conditions are very different, so the
diagnosis is not one to be taken lightly.
The standard test to distinguish the two is the Minnesota Multiphasic Personality
Inventory (MMPI). This consists of around 600 statements with which the patient
must express either agreement or disagreement. The statements range from "At
times I think I am no good at all" to "I like mechanics magazines". Fairly
obviously, those feeling depressed are much more likely to agree with the first
statement than those in an upbeat mood. More bizarrely, those suffering paranoia
are more likely to enjoy mechanics magazines that the rest of us!
In 1968, Lewis
Goldberg1obtained access to
more than 1000 patients' MMPI
test responses and final
diagnoses as neurotic or
psychotic. He developed a
simple statistical formula, based
on 10 MMPI scores, to predict
the final diagnosis. His model
was roughly 70% accurate when
applied out of sample. Goldberg
then gave MMPI scores to
experienced and inexperienced
clinical psychologists and asked
them to diagnose the patient. As Fig.1 shows, the simple quant rule significantly
outperformed even the best of the psychologists.
Even when the results of the rules' predictions were made available to the
psychologists, they still underperformed the model. This is a very important point:
much as we all like to think we can add something to the quant model output, the
truth is that very often quant models represent a ceiling in performance (from
which we detract) rather than a floor (to which we can add).
Every so often, and
always with the aid of a member of the quant team, I publish a quant note in
Global Equity Strategy. The last one was based on the little book that beats the
market (see Global Equity Strategy, 9 March 2006). Whenever we produce such a
note, the standard response from fund managers is to ask for a list of stocks that the
model would suggest. I can't help but wonder if the findings above apply here as
well. Do the fund managers who receive the lists then pick the ones that they like,
much like the psychologists above selectively using the Goldberg rule as an input?
Brain damage detection
Similar findings were reported by Leli and Filskov2, in the realm of assessing
intellectual deficit due to brain damage. They studied progressive brain
dysfunction and derived a simple rule based on standard tests of intellectual
functioning. This model correctly identified 83% of new (out of sample) cases.
However, groups of inexperienced and experienced professionals working from the
same data underperformed the model with only 63% and 58% accuracy
respectively (that isn't a typo; the inexperienced did better than the experienced!).
When given the output from the model the scores improved to 68% and 75%
respectively - still both significantly below the accuracy rate of the model.
Intriguingly, the improvement appeared to depend upon the extent of the use of the
model.
University admissions
Dawes3 gives a great example of the impotence of interviews (further bolstering
our arguments as to the pointlessness of meeting company managements - The
seven sins of fund management, November 2005). In 1979, the Texas legislature
required the University of Texas to increase its intake of medical students from 150
to 200. The prior 150 had been selected by first examining the academic
credentials of approximately 2200 students, and then selecting the highest 800.
These 800 were called for an interview by the admissions committee and one other
faculty member. At the conclusion of the interview, each member of the committee
ranked the interviewee on a scale of 0 (unacceptable) to 7 (excellent). These
rankings were then averaged to give each applicant a score.
The 150 applicants who ended up going to Texas were all in the top 350, as ranked
by the interview procedure. When the school was told to add another 50 students,
all that were available were those ranked between 700 and 800. 86% of this sample
had failed to get into any medical school at all. No one within the academic staff
was told which students had come from the first selection and which had come
from the second. Robert DeVaul and colleagues4 decided to track the performance
of the two groups at various stages - i.e. the end of the second year, the end of the
clinical rotation (fourth year) and after their first year of residency.
The results they obtained showed no difference between the two groups at any
point in time; they were exactly equal at all stages. For instance, 82% of each
group were granted the M.D. degree, and the proportion granted honours was
constant etc. The obvious conclusion: the interview served absolutely no useful
function at all.
Criminal recidivism
Between October 1977 and May 1987, 1035 convicts became eligible for parole in
Pennsylvania. They were interviewed by a parole specialist who assigned them a
score on a five point scale based on the prognosis for supervision, risk of future
crime, etc. 743 of these cases were then put before a parole board. 85% of those
appearing before the board were granted parole, the decisions (bar one) following
the recommendation of the parole specialist.
25% of the parolees were recommitted to prison, absconded, or arrested for
anothercrime within the year. The parole board predicted none of these. Carroll et
al5 compared the accuracy of prediction from the parole board's ranking, with that
of a prediction based on a three factor model driven by the type of offence, the
number of past convictions andthe number of violations of prison rules. The parole
board's ranking was correlated 6% with recidivism. The three factor model had a
correlation of 22%.
Bordeaux wine
So far we have tackled some pretty heavy areas of social importance. Now for
somethinglighter. In 1995, a classic quant model was revealed to the world: a
pricing equation forBordeaux wine.
Ashenfelter et al6 computed a simple equation based on just four factors; the age
of the vintage, the average temperature over the growing season (April-
September), rain inSeptember and August, and the rain during the months
preceding the vintage (October-March). This model could explain 83% of the
variation of the prices of Bordeaux wines.
Ashenfelter et al also uncovered that young wines are usually overpriced relative to
whatone would expect based on the weather and the price of old wines. As the
wine matures,prices converge to the predictions of the equation. This implies that
"bad" vintages areoverpriced when they are young, and "good" vintages may be
underpriced.
Fig.3 shows the basic pattern. It shows the price of a portfolio of wines fromeach
vintage relative to the (simple average) price of the portfolio of wines from the
1961,62, 64 and 66 vintages. The second column gives the value of the benchmark
portfolio inGBP. The entries for each of the vintages in the remaining columns are
simply the ratios of the prices of the wines in each vintage to the benchmark
portfolio. The predicted price from the equation is also shown. Incidentally, this
data is from a different sample than the original estimation of the equation, so it
amounts to an out of sample test7.
Purchasing managers
Professor Chris Snijders has been examining the behaviour of models versus
purchasing managers8. He has examined purchasing managers at 300 different
organizations. Theresults will not be surprising to those reading this note. Snijders
concludes "We find that (a) judgments of professional managers are meagre at
best, and (b) certainly not betterthan the judgments by less experienced managers
or even amateurs. Furthermore, (c)neither general nor specific human capital of
managers has an impact on their performance, and (d) a simple formula
outperforms the average (and the above average) manager even when the formula
only has half of the information as compared to the manager."
Meta-analysis
Ok enough already, you may cry9. I agree. But, to conclude, let me show you that
the range of evidence I've presented here is not somehow a biased selection
designed to prove my point.
Grove et al10 consider an impressive 136
studies of simple quant models versus
humanjudgements. The range of studies
covered areas as diverse as criminal recidivism
to occupational choice, diagnosis of heart
attacks to academic performance. Across these
studies 64 clearly favoured the model, 64
showed approximately the same result
between the model and human judgement, and
a mere 8 studies found in favour of human
judgements. All of these eight shared one trait
in common; the humans had more information
than the quant models. If the quant models had
the same information it is highly likely they
would have outperformed.
Fig.4 shows the aggregate average 'hit' rate across the 136 studies that Grove et al
examined. The average person in the study (remember they were all specialists in
their respective fields) got 66.5% of the cases they were presented with correct.
However, the quant models did significantly better with an average hit ratio of
73.2%.
As Paul Meehl (one of the founding fathers of the importance of quant models
versus human judgements) wrote: There is no controversy in social science which
shows such a large body of qualitatively diverse studies coming out so uniformly
in the same direction as this one... predicting everything from the outcomes of
football games to the diagnosis of liver disease and when you can hardly come up
with a half a dozen studies showing even a weak tendencyin favour of the
clinician, it is time to draw a practical conclusion.
The good news
The good news is that in some fields quant models have become far more accepted.
For instance, Fig.5 shows the number of states in which the decision to parole has a
quant prediction instrument involved. However, in the field of finance most still
shy away from an explicit quant process. A few brave souls have gone down this
road. Two explicitly behavioural finance groups stand out as using an explicitly
quantitative process - LSV and Fuller & Thaler. Fig.6 shows the performance of
their funds relative to benchmark since inception. With only one exception all of
these funds have delivered pretty significant positive alpha. Of course, this doesn't
prove that quant investing is superior; I would need a much larger sample to draw
any valid conclusions. But it is a nice illustration of the point I suspect is true.
So why not quant?
The most likely answer is overconfidence. We all think that we know better than
simple models. The key to the quant model's performance is that it has a known
error rate while our error rates are unknown.
The most common response to these findings is to argue that surely a fund
manager should be able to use quant as an input, with the flexibility to override the
model when required. However, as mentioned above, the evidence suggests that
quant models tend to act as a ceiling rather than a floor for our behaviour.
Additionally there is plenty of evidence to suggest that we tend to overweight our
own opinions and experiences against statistical evidence. For instance, Yaniv and
Kleinberger11 have a clever experiment based on general knowledge questions
such as: In which year were the Dead Sea scrolls discovered?
Participants are asked to give a point estimate and a 95% confidence interval.
Having done this they are then presented with an advisor's suggested answer, and
asked for their final best estimate and rate of estimates. Fig.7 shows the average
mean absolute error in years for the original answer and the final answer. The final
answer is more accurate than the initial guess.
The most logical way of combining your view
with that of the advisor is to give equal weight to each answer. However,
participants were not doing this (they would have been even more accurate if they
had done so). Instead they were putting a 71% weight on their own answer. In over
half the trials the weight on their own view was actually 90-100%! This represents
egocentric discounting - the weighing of one's own opinions as much more
important than another's view.
Similarly, Simonsohn et al12 showed that in a series of experiments direct
experience is frequently much more heavily weighted than general experience,
even if the information is equally relevant and objective. They note, "If people use
their direct experience to assess the likelihood of events, they are likely to
overweight the importance of unlikely events that have occurred to them, and to
underestimate the importance of those that have not". In fact, in one of their
experiments, Simonsohn et al found that personal experience was weighted twice
as heavily as vicarious experience! This is an uncannily close estimate to that
obtained by Yaniv and Kleinberger in an entirely different setting.
Grove and Meehl13 suggest many possible reasons for ignoring the evidence
presented in this note; two in particular stand out as relevant to the discussion here.
Firstly, the fear of technological unemployment. This is obviously an example of a
self serving bias. If, say, 18 out of every 20 analysts and fund managers could be
replaced by a computer, the results are unlikely to be welcomed by the industry at
large. Secondly, the industry has a large dose of inertia contained within it. It is
pretty inconceivable for a large fund management house to turn around and say
they are scrapping most of the processes they had used for the last 20 years, in
order to implement a quant model instead.
Another consideration may be the ease of selling. We find it 'easy' to understand
the idea of analysts searching for value, and fund managers rooting out hidden
opportunities. However, selling a quant model will be much harder. The term
'black box' will be bandied around in a highly pejorative way. Consultants may
question why they are employing you at all, if 'all' you do is turn up and run the
model and then walk away again.
It is for reasons like these that quant investing is likely to remain a fringe activity,
no matter how successful it may be.
regards,
Wise Investor
--
DISCLAIMER
IIF members recommending/discussing any stock/stock idea shall without
prejudice, be deemed to be construed that, he/she may have vested interest in doing
so. Fellow IIF members are requested to complete their own research /due dligence
in addition to the stock idea and \ or consult a qualified financial advisor before
taking any action.IIF, its members and managers do not take any responsibility for
any consequences (financial, legal or otherwise) resulting from action based on
views discussed in the forum.
Only make investments that suit your particular goals and capital constraints.
https://groups.google.com/group/intelligent-investor-forum?hl=en
Saurabh Shankar Post reply
May 12 (9 days ago)
Re: [IIF:20052] "Learning the Art of Value Investing" - A new thread
Hi IIFians,
This time we would look at another bias called the "anchoring bias", my favorite as
i suffer often :( from this and the one where most investors can trip.
BIAS-2 :ANCHORING BIAS
This bias describes the common human tendency to rely too heavily, or "anchor,"
on one trait or piece of information when making decisions. During
normal decision making, anchoring occurs when individuals overly rely on a
specific piece of information to govern their thought-process. Once the anchor is
set, there is a bias toward adjusting or interpreting other information to reflect the
"anchored" information.
For a moment stop here and think at the latest stock which you had bought and
think how one single information has influenced your buying/selling heavily ( low
P/E, bad sector, growth potentianl etc etc). If this has happened then we
have unknowingly let bias come into our decision.
For example, if say you are a ardent follower of Rakesh Jhunjhunwala and
he buys Delta Corp. Internally, you will tend to ignore negatives of the company
and start to justify why this seems a great story. Similarly, this anchor could be
anything a person, an event, a ratio etc.
Views and experiences invited.
Regards,
saurabh
- show quoted text -
Brijesh Post reply
May 12 (9 days ago)
Re: [IIF:20526] "Learning the Art of Value Investing" - A new thread
Hi saurabh,
I think one should not only always think as a critic while investing (ultimately it is
our hard earned money) but also note down the points both negative or positive.
It seems very childish ( noting down ) but actually it help in a gr8 way. Human
minds are very sharp and if we note down points then it actually help our brain to
analyze the things from different perspectives which actually help to take better
decision.
One lesson which I learned from small experience that never rely on news like ( PE
fund is investing, BIg FII like Goldman, Blackstone , GMO are buying or other
Indian warren buffets kind buying...evething is useless these PE and FII are
playing with others money and only interested in their fee and hence one should
not carried away from their decision..their due diligence is ram bharose....we have
numerous example before us....
QI
Constant Seeker Post reply
May 13 (8 days ago)
Re: [IIF:20530] "Learning the Art of Value Investing" - A new thread
Hi QI,
I think one should not be a critic but rather should remain skeptical and always try
and invert.
Obviously in this process one should always note down one's thoughts and then
decide
Regard
Saurabh
On May 12, 2012 5:43 PM, "Quant Investor" <[email protected]> wrote:
Wise Investor Post reply
May 14 (7 days ago)
Re: [IIF:20536] "Learning the Art of Value Investing" - A new thread
Hi Saurabh,
Anchoring bias has big effect on decision making. Forget Stock market, if you just
think abt in variuos fields,
eg. 1 ) how media hooks us to topics and diverts our mind from ongoing affairs.
2) When we go for shopping, Anchoring plays a major role in it. In a store,
even if we dont wanna buy, At times Discounts , Clubbed items in big bazaar, or
Brands etc, we end up buying.
3) In our market also, Anchoring plays a very important role, Certain market
participants, analyst, broking House, etc, play a role of an anchor when some
information is given out through them. Our Decision gets linked by their
information.
There are lot areas if we start thinking we shall realise that Anchoring a major role
in our daily life decision also.
If any one wants to read more about it do let me know, i hv few papers worth
reading.
regards,
Wise Investor
- show quoted text -
- show quoted text -
- show quoted text -
--
DISCLAIMER
IIF members recommending/discussing any stock/stock idea shall without
prejudice, be deemed to be construed that, he/she may have vested interest in doing
so. Fellow IIF members are requested to complete their own research /due dligence
in addition to the stock idea and \ or consult a qualified financial advisor before
taking any action.IIF, its members and managers do not take any responsibility for
any consequences (financial, legal or otherwise) resulting from action based on
views discussed in the forum.
Only make investments that suit your particular goals and capital constraints.
https://groups.google.com/group/intelligent-investor-forum?hl=en
Constant Seeker Post reply
May 14 (7 days ago)
Re: [IIF:20536] "Learning the Art of Value Investing" - A new thread
Hi Wise Investor,
Please send across the papers. Yes, anchoring is a huge bias in all my decisions and
i didn't even knew about this bias 4-5 month ago :P.
Regards,
Saurabh
- show quoted text -
Brijesh Post reply
May 17 (4 days ago)
Re: [IIF:20536] "Learning the Art of Value Investing" - A new thread
Hi,
Interesting read....
It's earnings season, so before buying into an analyst recommendation make sure to
sanity check it. Here are ways to spot outrageous claims.
1. Style over Substance Beware of the table-pounder who promotes stocks without hard evidence. These
bulls are charismatic and personable, but rely on emotion sprinkled with faulty
logic. They sometimes mask ulterior motives. Even after the embarrassing
revelations of financial bubbles, analysts still push stocks of banking clients and
are richly rewarded. [More from Forbes: How to pick a financial advisor]
What stops the bulls? The cliff. In the endgame, a data point can nullify
conventional wisdom sending the stock into a freefall.
But not all analysts are shady salesmen. A small percentage has industry expertise
and does homework. They do surveys for feedback, and they find contrary
indicators. A tiny subset has forensic accounting skills and digs into financials
cross-checking with third-party resources from the government, industry or other
companies. These analysts look for inconsistencies and gather enough facts to
make bold bearish calls. [More from Forbes: Is it time to fire your financial
advisor?]
2. Vague Descriptions
A company description should be quantified and concise. An example is: "Cisco is
a $45 B company that makes routers, switches and servers for enterprise
networks". A bad one is, "Cisco is a global leader in communications innovation".
You invest in products and services not vagaries. A key way to identify B.S. is to
look for long streams of adjectives, like "state of the arts, low bit error rate
equipment with many bells and whistles". My experience is the uninformed
combine long descriptions with clichés.
3. Excessive Adjectives Confusing adjectives have no place in financial analysis. Calling a quarter "strong,
weak, good or bad" connotes nothing. "Qualcomm missed the quarter based on
component shortages but the outlook is good" is contradictory. It does not give the
essential elements that investors need, namely catalysts (contracts or deals), costs
(supply chain) and milestones (sales forecasts). The analyst should quantify
performance and cite time periods. Without these details, the analysis should be
ignored. [More from Forbes: How to give difficult feedback]
4. Hype and Hyperbole
Financial analysis is not advertising, so claims of "truly amazing performance" or
"enormous gains" and other exaggerations don't fit. Hyperbole and superlatives
create buying frenzies, which are black holes for investors.
5. Techno-Speak Poor analysts lapse into industry jargon and stats, like "The New iPad has a 2048 X
1536 retina display, an A6 processor and supports 4G LTE". Analysts should
explain cost-benefits for new features. An assessment of customer price sensitivity
would be good. [More from Forbes: 10 ways to be more confident at work]
6. Questionable Valuations
Stock valuations are standard formula to predict stock prices and are based on
projected revenue or profits. Results may differ from reality as there are many
unaccounted variables in future streams discounted to the present. Watch out for
use non-standard metrics, like taking the company's cash out of the analysis. They
make the valuation look lower (better).
7. Investor Saturation For the stock to go up, investor demand must exceed supply. If your nanny just
bought a share of Apple, chances are the market is saturated and it won't climb
even if revenues grow 70%. At some point, good news is discounted into the stock,
or expectations may have run away.
8. Fantasy Price Targets
Price targets are an arms race that serves the analyst, not the investor. There is little
downside for an analyst to bid up a price. When Amazon was trading at $200,
Henry Blodget, who was later barred from the securities industry, set his one-year
price target at $400. His rationale: if right, I will become a rock star and if wrong,
no one will remember. The stock hit the target in a month, and emboldened Henry
produced excessive hype mislabeled as financial analysis. He was wrong and
everyone remembered. A reasonable analyst sets price targets with 20% headroom
and recalibrates on news. The $1000 price targets on Apple, now trading at $560
may be fantasy. [More from Forbes: What makes emerging markets great
investments]
9. Repetition
Ignore the pump-and-dumpers that scream at every 2% contraction, it is
"Christmas in June".
10. Starmine Sweepstakes
A recent study suggests Starmine, which ranks analysts according to accuracy of
forecasts, may be gamed. A serial winner in Starmine rankings with top marks
across-the-board for most of their companies may be a cheat.
Rgds,
QI