Bogle: Arithmetic Quants vs Algorithmic Quants

From a recent speech by John Bogle:

"As I see it, the plain and simple, well-armed, lightly-dressed, unencumbered shepherd is the index fund, a portfolio holding all 500 stocks in the Standard & Poor’s 500 Index. The David approach to investing, then, is 'buy a diversified portfolio of stocks operated at rock-bottom costs, and hold it forever.' The index fund relies on simple arithmetic, a mathematical tautology that could be calculated by a second grader: gross return in the stock market, minus the frictional costs of investing, equals the net return that is shared by all investors as a group. Taking the lion's share of those costs out of the equation is the key to successful long-term investing.

In contrast, many (most?) Goliaths of academia and quantitative investing believe the contrary: the application of multiple complex equations—the language of science and technology, of engineering and mathematics (yes, STEM), developed with computers processing Big Data, and trading stocks at the speed of light—make our Goliaths far stronger and more powerful than are we indexing Davids. The question posed in my title is essentially, 'who wins?'—the arithmetic quants or the algorithmic quants."

In the early days, when the hedge fund Goliaths* were individually smaller in size and part of a much smaller industry (assets of $ 120 billion in 1997), annualized returns were impressive: 11.8 percent vs 7.2 percent for the S&P 500 from 1990 to 2008.

By 2008, the Goliaths had $ 1.4 trillion in assets that have now grown to roughly $ 2.8 trillion and their relative performance has suffered a bunch: 5.3 percent vs 13.5 percent for the S&P 500 from 2009 to 2016.

Will there prove to be, in the long run, any advantage to all this additional complexity? Is the additional size the main cause of the more recent underperformance?  Is it the additional competition from capable individuals entering what is, if nothing else, a potentially rather lucrative profession? Or is it the addition of less capable managers entering the industry? For Bogle this all just reflects what is an inevitable reversion to the mean. The extra muscle and heavy armor -- in terms of industry assets -- has certainly led to huge compensation for the Goliaths.
(Bogle estimates ~$ 84 billion in annual fees while The New York Times reported that the top 25 managers alone were paid an average of $ 465 million in 2014.)

In any case, not unlike the classic battle, all that additional muscle and armor didn't make the Hedge Fund Goliaths a more formidable opponent to the indexing Davids; instead, it appears -- at least based upon the more recent results -- to have made them vulnerable to a much simpler and low cost approach.

Huge frictional costs -- roughly 3 percent per year or more according to Bogle -- are, of course, a meaningful factor but, with a greater than 8 percent annualized gap since 2009, it comes down to more than just those costs. Keep in mind that in the early days the drag of these heavy frictional costs also existed.

The range of outcomes is also a concern. Over the past 5 years, according to Bogle, individual hedge fund returns have been between -91 percent to 157 percent.

Yikes.

These Goliaths may perform much better in the future, of course. There's, as always, just no way to know. Yet I think it's fair to ask whether such long-term outcomes deserves so much time, talent, and capital especially when much less costly, simple, and effective alternatives exist.

If nothing else, over the long haul, the headwind coming from all the frictional costs is no small thing for most to overcome. Some exceptional managers no doubt will overcome those costs -- whether through pure chance or skill or a bit of both -- but that doesn't change the reality that a hedge fund with typical fees must outperform by ~3 percent each year just to keep up with the indexing Davids.

Adam

Related posts:
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* It's worth noting the wide variety of investment and trading strategies employed by hedge funds. Still, what most have in common is vastly greater complexity and cost.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Forecasting Folly Revisited

In the book, One Up on Wall Street, Peter Lynch wrote that many economists are "employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they'd all be millionaires by now."

Lynch then adds:

"...as far as I know, most of them are still gainfully employed, which ought to tell us something."

Charlie Munger said the following in an interview with Susie Gharib back in 2009:

GHARIB: "When do you see the recovery coming?"

MUNGER: "We don't have any special ability to make that kind of macro economic prediction."

The good news is that successfully predicting macroeconomic outcomes isn't required for investors.

In fact, trying to do so is a distraction.

There's also the following dynamic to consider:

"Because there is no way to hold financial forecasters accountable for their incorrect predictions, they get more out of making wild ones. Wild predictions pay because the downside of being wrong is zilch, but the upside is lifelong fame."

So some in the business of making predictions are, in some ways, simply doing what's necessary for marketing purposes.

Prognosticators would argue otherwise but, given the complexity of the system they're attempting to understand, to me it seems effectively impossible to reliably make useful predictions.

Figuring out what a good business is worth and what to pay for it isn't an easy task, but at least it's not effectively an impossible task.

In 2003, Charlie Munger said the following at a speech to the University of California, Santa Babara Economics Department:

"...there's too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It's like trying to master medicine without knowing anatomy and chemistry. Also, the discipline of microeconomics is a lot of fun. It helps you correctly understand macroeconomics. And it's a perfect circus to do. In contrast, I don't think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand."

Consider the findings of professor Philip Tetlock.

A study by professor Tetlock found that those "who earn their livings by holding forth confidently on the basis of limited information...make worse predictions about political and economic trends than they would by random chance." In fact, "the most famous and the most confident" are generally the worst at making predictions.*

According to Tetlock, the best forecasters tend to be more like foxes than hedgehogs.**

So ,while economic forecasting has certainly become more sophisticated, that doesn't mean they're becoming more useful.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen." - Warren Buffett in the 1994 Berkshire (BRKa) Hathaway Shareholder Letter

Practically speaking, at least to me, it's mostly a waste of energy trying to makes guesses -- even very well informed guesses -- about what might happen in an uncertain world.

The focus should be on figuring out what's likely to do well over a longer time horizon even as the inevitably unpredictable world will bring many surprises and challenges. Will a good business be able maintain all or most of their competitive advantages for a very long time? Better yet, does the business have characteristics that make it likely those advantages will even be strengthened over time?

"If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

The stock market did just fine over the past century or so despite what almost certainly be a whole host of major economic and political shocks. Stock prices, will no doubt respond to these events. That a crisis of some kind -- or maybe even several -- will undoubtedly emerge in the coming decades hardly makes it impossible to invest. The risks of attempting to time the market are not small. In fact, attempts at timing will likely do more harm than good.

"The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions." - Warren Buffett in the 2012 Berkshire Hathaway shareholder letter

Keep in mind that 17,320% doesn't include a century of dividends.

Time in the market generally beats timing the market in the long run.

Stick to what can be understood then pay a price that reflects uncertainties. That there'll be challenging economic environments and upheavals is almost a given. There will never be any guarantees. Future difficulties may exceed all from the past century or so.

Being frozen by this reality is no investment strategy.

Expect market fluctuations. Forget about reliably predicting when and by how much. Ignore those who try to do so.***

John Kenneth Galbraith once said: "There are two kinds of forecasters: those who don't know, and those who don't know they don't know."

Munger and Buffett haven't needed to be brilliant forecasters to get investment results.

Adam

Long position in BRKb established at much lower than recent market prices

Other related posts:
Forecasting Folly
Henry Singleton: Why Flexibility Beats Long-Range Planning
Forecasters & Fortune Tellers
Charlie Munger: Snare and a Delusion
On Forecasting
James Grant on Economic Forecasting

* An excerpt from Susan Cain's book Quiet.
** Professor Tetlock puts it this way: "Hedgehogs are big-idea thinkers in love with grand theories" while "foxes are better at curbing their ideological enthusiasms." He goes on to say foxes tend to not over-simplify and are more aware of the limits to their arguments. As a result, they become less prone to mistakes.
*** I think this quote by Charlie Munger on macroeconomic predictions captures it well.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Forecasting Folly

"There are two kinds of forecasters: those who don't know, and those who don't know they don't know." - John Kenneth Galbraith

With this Galbraith quote in mind, consider what Professor Daniel Kahneman wrote in an article back in 2011.

In that article, Kahneman explains that he was responsible for evaluating candidates for officer training during his time in the military several decades ago. The methods he and others at the time used were apparently developed by the British Army during World War II. Part of his job was to, after careful observation of potential officers, offer what were thought to be useful predictions about how these candidates were likely to perform in the future. Seems straightforward enough: simply figure out who was clearly qualified and who was not via a sound methodology.

Since certain individuals appeared to have strong leadership skills while others plainly did not, Kahneman (and others) felt quite comfortable making definitive predictions.

Unfortunately, that confidence was unfounded:

"...despite our certainty about the potential of individual candidates, our forecasts were largely useless. The evidence was overwhelming."

In the same article Kahneman also added -- and this might at least partially help explain why prognosticators continue to confidently prognosticate despite the folly of it -- the following:

"The statistical evidence of our failure should have shaken our confidence in our judgments of particular candidates, but it did not. It should also have caused us to moderate our predictions, but it did not. We knew as a general fact that our predictions were little better than random guesses, but we continued to feel and act as if each particular prediction was valid. I was reminded of visual illusions, which remain compelling even when you know that what you see is false. I was so struck by the analogy that I coined a term for our experience: the illusion of validity.

I had discovered my first cognitive fallacy."

If it's difficult to predict how one individual is going to perform, then the inherent difficulty of predicting what will happen with the stock market or something as complex as the global economy shouldn't exactly be a surprise.

Forecasting is tough to do reliably well. This article by Barry Ritholtz puts its more bluntly:

Pro Forecasters Stink, You're Worse

That doesn't stop many from trying to predict what is mostly just not predictable. There is, and there will continue to be, no shortage of experts making forecasts about, among other things, the markets and the economy. Many of them are extremely smart, informed, well-intentioned, credible sounding, and a number even have some interesting things to say.

The problem is that those well-intentioned experts may not necessarily be producing something that's genuinely useful. There naturally will be exceptions but, especially as the forecasts become more macro-oriented, I think it increasingly makes sense to be skeptical. The world has always been an uncertain place and will continue to be that way. Being flexible and open-minded beats rigid certitude.

Expert forecasters will no doubt continue looking into their crystal ball and offer what at least sounds like compelling thoughts about the future.

The fact that they continue to do so with a high level of confidence just might be, at least in part, the "illusion of validity" at work.

Unfortunately, some of us will also likely pay way too much attention to it.

From a separate article written by Ritholtz late last year:

"Despite the abysmal track record of almost all forecasters, the news media still loves them. It has air time and pages to fill and seems little concerned about giving space to money-losing prognosticators.

As I first wrote a decade ago, to forecast is folly. Today, we have Google Search to help us prove it. Pundits may forget, but not the Internet."

At a minimum, it seems like not a bad idea at all to at least pause for a second or two and consider carefully whether someone's predictions deserves any more consideration than the outcome of a coin flip.

Adam

Related posts:
Henry Singleton: Why Flexibility Beats Long-Range Planning
Forecasters & Fortune Tellers
Charlie Munger: Snare and a Delusion
On Forecasting
James Grant on Economic Forecasting

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

John Kay: Decline in Equity Issuance

In 2012, John Kay produced a report on UK equity markets that was focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

This post from last year focused on the first section of that report.

John Kay on Equity Markets: Exit, Voice, and Short-termism

In the second section of the report, the emphasis is on new equity issuance or, more specifically, the lack of it:

"Equity markets have not been an important source of capital for new investment in British business for many years. Large UK companies are self-financing – the cash flow they obtain from operations through profits and depreciation is more than sufficient for their investment needs. This is true of the quoted company sector as a whole and of a large majority of companies within it."

and

"Finance raised through placings and rights issues by established companies, and initial public offerings (IPOs) by new companies, have generally been more than offset by the acquisition of shares for cash in takeovers and through share buyback..."

As a result, the issuance of equities has been negative over the last decade even if the situation has recently improved somewhat.

Why has there been a decline?

"There are many reasons for the decline in the role of equity issues in investment. In a modern economy, investment in physical capital is much less important than it was."

Yet...

"Even companies in sectors that have large capital requirements – such as oil and utilities – make little or no use of primary equity markets, relying instead on debt and internal funding."

There are many explanations for why equity issuance has declined -- and some of them are valid to an extent -- but the report states "we do not find them adequate" while adding "we believe the fundamental reasons go deeper, and reflect the nature of financial intermediation itself."

The combined impact of regulatory and cultural changes over the years led to "the rise of an ethos which emphasised transactions and trading over relationships. This ethos permeated all areas" of financial services and "the shift from relationship to trading, from voice to exit, came to affect not only the interaction between shareholders and companies but between corporate executives and their companies: some managers came to see themselves as traders, engaged in the management of a portfolio of businesses to which they owed no particular attachment."

The United States has had more than its fair share of influence on the changes that have occurred in recent decades. Equity markets, of course, need to facilitate the funding of new and existing businesses. If working well, equity capital efficiently gets where it's needed while misallocation and mispricing is minimized.

Increasingly, that's not their primary function.

Equity markets are also "one of the means by which investors who support fledgling companies can hope to realise value. Equity markets provide a means of oversight of the principal mechanism of capital allocation, which takes place within companies. Promoting stewardship and good corporate governance is not an incidental function of equity markets."

Not only is it important "that equity markets remain an attractive means of obtaining funding", policies should "ensure there are no unnecessary disincentives to using equity markets, either for companies or for their investors. And we believe that our recommendations to encourage asset managers to act as long-term stewards of more concentrated, less liquid equity portfolios will mean a greater willingness to invest funds across a broader range of companies, including smaller businesses who wish to raise equity finance, but are currently unable to do so."

Warren Buffett's long-term oriented investing behavior -- whether in equity markets or how Berkshire Hathaway's (BRKa) many businesses are operated -- would be a prime example of what would become more commonplace.

This requires no less than a fundamental culture change.

For an example closer to home in the UK, as this article points out, look no further than the way that Neil Woodford operates:

"To many, he [Woodford] is an example of what John Kay, commissioned by the government to encourage long-term investment, should look for in a fund manager, holding shares for 15 years rather than switching in and out in search of a quick buck."

Woodford recently left Invesco after more than 25 years at the firm to start a fund management company and launched a new fund, Woodford Equity Income.

There are certainly a number of other good examples.

The focus of John Kay's work is the UK but many of the same problems, as well as potential solutions, are more than a little bit similar to the US.

IPOs have come back somewhat recently in the US, though still are well below what we saw in the 1990s.

Progress on this front starts with recognizing the costly long-term implications of not making some sensible adjustments.

Adam

Long position in BRKa established at much lower than recent market prices

* Excerpts in this post are from sections 2.6, 2.7, 2.12, 2.13, 2.18, 2.28, 2.32, and 2.33 of the report.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes

The latest GMO quarterly letter was recently released.*

Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economics from his section of the letter:

"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).

We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."

To me, this latest letter is Grantham at his best.
(His section begins on page 6.)

Well worth reading in its entirety.

Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:

1) Japanese equity bubble - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.

2) Japanese land bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:

"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."

3) U.S. equity bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.

4) U.S. housing bubble - According to Grantham this was the first bubble that was truly global.

Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.

He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.

"...so I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."

Warren Buffett has previously made a similar point.

Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.

Buffett has said the same applies to finance.

Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:

"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."

Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:

"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."

His primary reason?

To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.

That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:

"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."

The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.

"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."

Grantham is, not surprisingly, not quite so complimentary of Fama:

"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."

Grantham has mentioned this so-called "special case" before.

Now, to get an idea how Eugene Fama looks at bubbles, consider what he said when presented with the following back in 2010:

Interview With Eugene Fama

"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."

He responded this way:

"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."

That comment from Fama just might help begin to explain how such ideas and assumptions have been able to maintain their widespread -- some, including myself, would argue rather more than a little bit damaging -- influence for so long.

From later in the same interview:

"But you are skeptical about the claims about how irrationality affects market prices?"

Fama's response:

"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."**

Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, these recent bubbles don't offer much evidence. Also, for certain things "to be shown", we'll probably need several more centuries of data (if not more) for sufficient empirical evidence to exist. In the meantime most of us have to make judgments lacking that evidence.

Other related articles:
-In praise of empiricism: a Nobel prize for everyday economics
-It's the Data, Stupid! Empiricists grab this year's Nobel Prizes.
-Eugene Fama, King of Predictable Markets**

Fama continues to think, more or less, that efficient markets made up of even-tempered and rational participants exist in the real world. This way of thinking at least implies that it's tough to distinguish between what's been mispriced and changes to risk.

Fama seems to generally view any variation in market price as being rational and the reward one gets for taking on risk. In other words, if the market price changes then it must necessarily be a reflection of changes in risk.

Shiller's view seems to be that, at least in the shorter run, less than rational psychological forces may take hold that leads to mispriced assets but, in the longer run, those mispricings tend to be corrected.

Fama does, in fact, seem to have an almost unflappable confidence in things like efficient markets.

Shiller, of course, does not.

Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.

Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:

"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."

CNBC Video: Robert Shiller on Eugene Fama

Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.

That doesn't really seem a stretch at all.

Well, in any case, Fama, Shiller, and Hansen have won a big prize.

No doubt winning it involved lots of hard work by what are well-intentioned and smart people.

Still, consider me more than a little bit skeptical of thinking that's built upon the foundation of efficient markets and rational expectations. I happen to be rather convinced that the influence of these theories over time have not been a good thing at all for civilization.

To me, the sooner they lose influence the better.

Naturally, some very capable proponents of these theories (and the many related models) will offer a more favorable view.

In any case, the outcome of this debate has important consequences.

To me, the market isn't terribly efficient. Yet outperforming the market as a whole remains extremely difficult. Some use market efficiency as the explanation for this difficulty. Well, there's no reason why capital markets can't have some inefficiencies AND be difficult to outperform.

To me, these things coexist just fine.

For example, a relatively small proportion of participants might have certain capabilities (both temperamental and intellectual) to consistently benefit from mispricings while the great majority of participants overestimate their ability to do so.

The logical way to go, with this in mind, will continue to be index funds for most market participants.

Adam

Related posts:
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Also published in Barron's.
** Fama is described as "a careful empiricist" in the article.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Market Freezes Up

Those watching business news yesterday had to listen to talking heads acting like -- if not the end of the world -- that not being able to trade Nasdaq stocks for a few hours was yet another blow to market participant confidence.

Nasdaq market paralyzed by three hour shutdown

Well that may be the case but a marketable stock is, first and foremost, partial ownership of an operating business.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

So, if the market system happens to malfunction from time to time -- as it seems almost certain to do, and maybe to a much greater extent than this most recent episode -- it doesn't change the per share intrinsic value of that underlying operating business. Those with an investment time horizon were fine; traders maybe less so.
(In the flash crash certain stocks temporarily were significantly impacted. That event similarly had no impact on underlying business value. An investor who did nothing, or maybe even bought shares they liked that became a bit cheaper, was just fine.)

Now, as Charlie Munger pointed out in a conversation at Harvard-Westlake back in early 2010, there is a real benefit to knowing one can sell, relatively easily, part or all of an investment that they've made; that those risking capital become more apt to invest if they feel certain they'll generally have, when the appropriate times comes along, a straightforward, low cost, way to sell.

As Munger says: "It's not like buying a restaurant in the wrong place."

That doesn't logically mean one must be able to sell their shares every second, minute, and hour of every trading day. The beneficial aspects of this ease of conversion -- from one investment to another -- exists as long as what should be an advantage isn't turned into a disadvantage by doing lots of unnecessary trading.

Actual investment (as opposed to trading price action) just doesn't require all that much buying and selling.*

Certainly not anywhere near the amount that our hyperactive modern market system allows participants to theoretically do.

In fact, in many ways, capital formation and investment is undoubtedly negatively impacted by this hyperactivity and other forms of short-termism.

Closing a market for five years may be extremely unlikely, but it's true that a few hours should matter little to the true investor.

It's what the business does over an investment horizon that matters.

Nasdaq Flash Freeze Called 'Inexcusable'

Nasdaq OMX connectivity disaster highlights stumbling markets

Words like "inexcusable" and "disaster" may apply in some ways but, if anything, the problem seems more that we have too many market participants focused on frenetically trading in and out of marketable stocks (not to mention their derivatives). Adding layers of activity and related costs with mostly no particular enduring value added (and, as we've seen from the financial crisis, some of it plainly destructive).

It's renting price action -- what is often a zero-sum game before the frictional costs -- instead of owning pieces of businesses then benefiting from what they produce over the long haul.

Profiting from speculation on near-term price action depends upon cleverly timed trades to get good results.

In contrast, the primary drivers of investment returns come from changes to intrinsic value and the discipline to not overpay in the first place.**

An actual investment is definitely not zero sum; it depends not upon brilliant trading.

Considering the power of long run compounding effects, it seems foolish to no allow those forces to work for the investor. What initially seems like a minor tailwind becomes anything but with the benefit of longer time frames. Well, all this frenetic trading and resultant frictional costs can only, in aggregate, subtract from the magic of compounding returns.
(John Bogle calls this "the tyranny of compounding cost".)

There has certainly been lots of scientific and technological advancements that have enabled all this market hyperactivity.

James Grant once said that in science and engineering more generally (i.e. not just as it relates to finance and financial systems), progress tends to be cumulative.

Unfortunately, that's not really the case in finance.

"Progress is cumulative in science and engineering, but cyclical in finance." - James Grant in Money of the Mind

Grant put it the following way in his latest letter:

"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.

Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013

Apparently, when scientific and technological progress meets financial progress, it is the latter's inherent cyclicality that wins.
(Cyclical in the sense that the same, or at least similar, mistakes seem to be repeated but the size of the financial sector as a percentage of U.S. GDP has been anything but cyclical -- especially since the 1940s.)

The systems have certainly become more sophisticated and technically complex. Whether, as a result, it's serving us better in most of the important ways seems debatable at best.

A market freeze up certainly matters for someone who has funds exposed to the market that are needed in the near term. Of course, funds needed in the near or even intermediate term shouldn't really be exposed to equities in the first place.
(Investment is ideally measured in decades, not years, but the appropriate time horizon is necessarily imprecise and unique to each situation. 2-3 years may seem long-term to some folks but, in my book, that kind of time horizon is simply not an investment horizon.)

A market disturbance like the one yesterday no doubt can pose real problems for the active trader. Yet Buffett and Munger explained back in May of this year why these sort of events should be of little concern to the long-term investor.

During such similar disturbances, the long-term investor who bought (via a marketable stock) part of a quality business at a reasonable valuation in the first place isn't hurt (again, even if the quoted price is temporarily an unpleasant one).

In fact, if it ended up being more than a short-term event, the reduced price should also not bother the long-term owner.

Why?

Well, it not only allows that owner to buy more shares cheap over time, it also allows the funds being allocated to share buybacks to go further. The highest quality businesses generally will throw off excess cash at a high return on capital. So a long-term investor focused on per share intrinsic business value should logically prefer lower stock prices in the near-term (and, for that matter, even the intermediate-term...the longer the low price persists the more powerful a buyback becomes when consistently executed below per share intrinsic value) while the business itself remains, at least, relatively sound.

Naturally an investor should want the earning power of a business to do well over the long haul but, as Warren Buffett has previously explained, a stock price that temporarily (or longer) lags is hardly a problem for the long-term investor.

Investment is about what the business itself produces over time.

Why Buffett Wants IBM's Shares "To Languish"

The intrinsic value of a productive asset (in this case a business that happens to be partially owned via a publicly traded marketable stock), especially one with durable advantages, just will not generally change nearly as much in underlying value as the daily quoted prices might otherwise suggest. There's inevitably lots of noise and, well, emotion in the short-term "votes" of a publicly traded company. A private business owner has no such noise and emotion to consider. With no daily quoted prices to distract, a long-term oriented private business owner can theoretically just focus on making sure the business is being run in a way that creates enduring value.
(Still, even with this longer term focus many businesses will do poorly or fail, of course.)

It need be no different for owners of a high quality business that happens to be publicly traded.

So these almost-certain-to-occur-from-time-to-time market disturbances matter a whole bunch for traders but not so much for investors. When justifiably confident in per share value, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.

Highly volatile, unpredictable markets (whether due to self-inflicted instability/uncertainty -- market structure, poor system design -- or an external shock) can impact the real economy if severe enough to damage business and consumer confidence.

This can also keep investors who otherwise might participate in the capital markets from doing so.

That's quite a different but potentially very real problem.

Yesterday seemed pretty mild, but I don't doubt that the more serious versions of these kind of events adversely impacts confidence. Yet a more deeply embedded -- culturally and systemically -- longer term perspective among a greater proportion of participants just might mitigate this. Some education -- the development of an alternative trained response to market fluctuations -- and the right incentives can take us a long way toward material improvement in this regard.

So both a cultural shift and systemic changes will certainly be necessary. Well, I think it's fair to say that this kind of fundamental shift is unlikely to happen fast even in the best of circumstances.

In any case, for those with a longer investment horizon, the markets should be made as welcoming as possible.

For pure near-term speculation on price action, markets should be made a less welcoming place.

That'd make for a better balance than what's currently in place.

In the meantime, a long-term investor can still do just fine if they follow sound investment principles.

Buy only what is well understood.***

Focus on underlying business value.

Always have a margin of safety.

Ignore the near-term noise.

In fact, even better yet, is allowing the inevitable market fluctuations resulting from disturbances both small -- as in what happened yesterday -- and large -- as in the financial crisis -- to work for the investor.

The right temperament goes a long way in investing.

Adam

* Charlie Munger also points out -- using Alan Greenspan as an example but there are many others, of course -- some economists are in a camp that thinks "if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization." He also adds that some "presumably are looking forward to trillions" of shares being traded and then says:

"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously..."

Munger states that Alan Greenspan's view of the world when he was leading the Federal Reserve was the the result of having "overdosed on Ayn Rand." Greenspan's views may have changed since (or, maybe, directly as a result of) the financial crisis but were a real factor at the time. At the very least he has seemingly been willing to modify his world view in light of what happened. Others appear less inclined to do so.
** It's buying shares of well understood businesses, with a margin of safety, and for the most part judging correctly -- within a range -- the core long-term economics. False precision in investing just leads to trouble. Act accordingly. It's recognizing what can't be reliably known or predicted. Margin of safety can be seen as just the humble acceptance of one's own limits; the understanding that an inevitably uncertain world exists. Overconfidence in one's own ability to forecast future outcomes will likely lead to more risks taken for less reward over the long haul. When an investor always strives to pay a price that requires nothing great to happen to get a good result, there should be few complaints if things go better than expected. This requires patience, discipline, and often a fair amount of work, but eventually the market usually offers an attractive price of something that is well understood. When it does decisive action is required. Easier said than done if not impossible. When an investor protects against permanent capital loss by employing sufficient margin of safety, the good news is it then also allows unforeseen (or unforeseeable) upside to remain a possibility.
*** Naturally, whether an investment can be understood well is necessarily unique to each investor. Those who make a particular investment because someone else thinks it has attractive long-term prospects (i.e. without having come to that conclusion via their own analysis) just aren't likely to have the conviction needed to hang in there -- or, well, to not hang in there if a mistake was made -- when the price action goes the wrong way. Stick with what you know.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Munger: "Cognitive Failure" In Economics

From this conversation with Charlie Munger at Harvard-Westlake:

"Alan Greenspan at the Federal Reserve overdosed on Ayn Rand. Basically he kind of thought anything that happened in the free market, even if it was an axe murder, had to be ok. He's a smart man and [a] good man, but he got it wrong. Generally, an over-belief in any one ideology is going to do you in if you extrapolate it too hard, and that's what happened in economics."

So, according to Munger, what caused this "cognitive failure" in economics?

"They reasoned correctly that a free market would be way more predictive than anything else, and they reasoned correctly that once you had a fairly advanced capitalist system – if the people that were putting up the capital could sell their pieces of ownership in the company to other people, they'd be more inclined to invest because it gave them an option to get out if they wanted to leave. It's not like buying a restaurant in the wrong place. Then they reasoned that if that was true, if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization."

Having a million shares trade in a day was a rare occurrence when Munger attended Harvard Law School. Now billions of shares trade each day. He guesses that those who think along these lines are probably looking forward to when trillions of shares will trade in a day. Munger then adds...

"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously, and of course three or four billion shares is way too many. We have computer programs that are trading with other computer programs. We have many of the bright people who ought to be doing our engineering going to work at hedge funds and investment banks and algorithmic trading places and so on and so on."

Munger goes on to say "at any rate, these people got the idea [that] unlimited trading is a big plus for civilization."

Well, John Maynard Keynes certainly thought otherwise as Munger further explains:

"[Keynes] said a liquid market of securities is one of the most attractive gambling devices ever created. It has all the joy of gambling, plus it's respectable. Furthermore, instead of being a zero-sum game, where you are bound to lose the frictional cost, it's a game where you can pay the frictional cost and actually make a profit. This is one of the most seductive gambling devices ever invented by man, and some nut who took economics thinks that the bigger and better it gets, the better it is for wider civilization."

Now, consider that speaking to Forbes back in 1974, Warren Buffett described the business of investing in the following manner:

"I call investing the greatest business in the world...because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."

Investing can certainly be a great business but all this hyperactivity is directly at odds with the reasons why.

Compared to all this rapid trading of price action, waiting patiently for something you understand to get cheap enough, then owning it for a very long time, is a completely different game.

Modern capital markets are an incredibly convenient way to buy part of a good business that's priced attractively with minimal frictional costs.

To me, it seems quite the shame to see something so incredibly useful and powerful converted into a casino; see it turned into something less than it otherwise might be.*

So more of something doesn't automatically make it better. There's often optimal amount -- at least within some range -- and, of course, diminishing returns or worse. Some short-term oriented speculative activity is necessary and even desirable. That doesn't logically mean that unlimited amounts of it is a good thing. 

The amount of speculation relative to investment matters and the former is currently swamping the latter. What John Bogle describes as The Triumph of Speculation over Investment.

There may not be a precisely knowable correct ratio of speculation to investment, but I think it's safe to say we are far from what makes sense. I've used the petrol engine as a simple -- even if a limited and imperfect one -- example of this. 

The petrol engine just doesn't function all that well if the air-fuel ratio strays too far from what's optimal (and, eventually, it won't function at all if there's too much of either substance).

As with most any system, even what is a comparably simple one, the proportion matters rather a lot.

If efficiently and effectively allocating capital and strong long-term business performance are the primary goals then, in their current hyperactive form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.

Check out the entire conversation with Charlie Munger at Harvard-Westlake. 

Lots of useful thoughts and insights.

That 1974 Forbes article is a pretty worthwhile read too even if not exactly breaking news.

Adam

* Capital markets exist to move funds to where they're needed efficiently, to make sure owners of public companies have some reasonable visibility into how well what they own is being managed for the long haul so they can act accordingly, with frictional costs no higher than necessary. It's not a casino that exists to mostly serve the active participants themselves.

Charlie Munger at Harvard-Westlake

John Kay on Equity Markets: Exit, Voice, and Short-termism

A year ago, John Kay produced what can only be described as a rather long report focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

Kay's work more than implies that the fault lies both with shareholders and company decision-makers alike. Naturally, the behavior of owners (and, too often, what amounts to "renters" of stock) influence how the board and senior management behaves and vice versa.

The Kay Review of UK Equity Markets and Long-Term Decision Making

Short-termism
Increasingly, business executives, for a variety of reasons, too often end up focused on shorter term outcomes and quick fixes.

From the report:

"Short-termism, or myopic behaviour, is the natural human tendency to make decisions in search of immediate gratification at the expense of future returns..."

Longer tenure among competent senior executives and the right kind of compensation systems would certainly help. The CEO with a short tenure and lots of pressure to perform quarter-to-quarter is less likely think and act longer term. Few would seem likely to focus on long-term effects if the prevailing pay systems, in combination with shorter in duration tenure, frequently reward the next person who gets the job.

A system that tends to reward the next CEO for the long-term decision-making of the current CEO is a system destined to fail.

As far as short-termism goes it's not just executives, of course.

Corporate boards, regulators, and market participants all play a role.

John Kay makes it rather clear nothing short of a major cultural shift is required. That's unlikely to happen quickly under the best of circumstances.

Market participants have shorter time horizons by almost any standard these days; and it is not just the high frequency trading types.

It's an increased number fund managers and other participants who increasingly emphasize shorter term price action and outcomes in markets (w/holding periods maybe not measured in seconds or less but still hardly investing with long-term effects mostly in mind).

Also, the layers of middle men -- investment consultants and financial advisors among others -- not only tend to add frictional costs, but also increasingly create a buffer between those who've invested the capital at some risk and the companies they partially own.

This reduces shareholder engagement.

"Short-termism can also manifest itself in hyperactivity."

Well, as the report points out, individuals that are hyperactive generally "fail to give sustained attention to tasks" but what does this hyperactivity mean for the corporate sector?

"In the corporate sector, hyperactivity can be seen in frequent internal reorganisation, corporate strategies designed around extensive mergers and acquisitions, and financial re-engineering which may preoccupy senior management but have little relevance to the capabilities of the underlying business."

The civilized world has for a very long time attempted "to construct devices and institutions to combat our instinctive short-termism. The central question for this Review is whether capital markets in Britain today dissuade or stimulate the search for instant gratification in the corporate sector."

 In fact, as Kay notes, attempts to combat this instinct can even be found in the epic story of Ulysses.

"The outcome, not the process, is what matters, and that perspective has been central to this Review. From the outset, we have emphasised that the goals of equity markets are to operate and sustain high performing companies and to earn good returns..."

It's important to note that the report is focused on the more established relatively large public companies that are traded in London (see bottom of page 15). Of course, smaller, less mature, and not quite as established businesses will require very different things from the capital markets. Many will need efficient access to capital to build their businesses and generally have had more difficulty accessing funding since the financial crisis. Yet, much like the more established businesses, they'd still benefit from a reduced culture of short-termism.

Larger and smaller businesses have that in common even if their needs are otherwise rather different.

Business investment has declined in the past decade in the UK, but it's not because the larger companies are lacking funds.

"Quoted companies, both taken as a whole and in most individual cases, generate more cash from operations than they use for investment. They are not short of cash; they are awash with it. The value of the cash holdings of British business today is larger than the value of its plant and machinery."

And it's not necessarily just about encouraging more shareholder engagement...

"Shareholder engagement is neither good nor bad in itself: it is the character and quality of that engagement that matters."

Exit and Voice
The report also refers to "economist Albert Hirschman's famous distinction between the courses of action available to buyers when the quality of a relationship is inadequate: 'voice' – attempting to improve outcomes within the context of the market relationship; and 'exit' – withdrawal from the market relationship*. These alternatives apply just as much to a shareholder concerned with corporate governance or company performance as to a customer dissatisfied with the produce at the local supermarket. The unhappy shopper can complain to the management, or go elsewhere. And so can the contemporary shareholder."

The problem is that structure and regulation have the emphasis wrong.

"...the structure and regulation of equity markets today overwhelmingly emphasise exit over voice and this has often led to shareholder engagement of superficial character and low quality. We believe equity markets will function more effectively if there are more trust relationships which are based on voice and fewer trading relationships emphasising exit.

The focus of the report is on the UK equity markets but the problems, as well as potential solutions, seem likely to be more similar than different for the United States.

Kay rightly criticizes the hyperactive behavior of senior management and market participants who pursue "immediate gratification". Well, behavior that is longer term oriented is more likely to follow if the right incentives are put in place and enough conflicts of interest can be eliminated.

Considering this apparent attention deficit for anything but what can deliver the quickest rewards, it seems unlikely that this not at all short report will even reach enough of its target audience in the first place (never mind get the focused attention it deserves).

This report -- and the subject more generally -- certainly requires that the reader not have such a deficit.

So, in contrast to short-termism, no quick payback or reward will be found in reading Kay's report. It's certainly a worthwhile read for those who'd like to see long run systemic improvements; it's a worthwhile read for those less conflicted (or, at least those who can mostly set conflicts of interest aside for the bigger picture), less susceptible to short-termism, and willing to invest some time to seriously consider what really needs to be changed.
(Though, of course, it's not as if Kay's work could possibly provide all the answers.)

Changes that might make equity markets better serve their purpose for existing in the first place. In reality, nothing appears likely to be fixed anytime soon. The conflicts of interest, wrong incentives, and embedded industry cultural forces are just too powerful.

It's still worth better understanding how the status quo might be failing us.

Adam

Related post:
Buffett & Bogle: Overcoming Short-termism

* Hirschman, A. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.