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I like to start these talks with a story that illustrates some of the problems that we face when trying to be good, active investors.
And it considers a fellow who dies– he’s an Uber driver–and he dies in a crackup, goes up to heaven, sees Saint Peter, and goes right past him because he sees Einstein sitting at the center of this huge group of people. And he waddles his way in and Einstein says, “Hi, Albert Einstein–welcome to heaven.
What’s your IQ?”And the driver said, you know, I have been trying forever to get a job at Google and, you know, I just can’t get in.
I’ve been there three times. I googled the questions they’re going to ask me, I think I’ve got it down–I know everything about physics, I know everything about electrical engineering, I know everything about computers–but I just keep failing the questions.
And Einstein, yeah, yeah, that can be hard, I know. I watch that group–they’re very, very bright–I get it. What is your IQ? And the guy goes, well, I don’t want to brag or anything but my IQ is 175.And Einstein goes, this is incredible. We’ll be able to talk about unified field theory, about string theory, about everything that’s been going on in the world of physics since I’d died. Oh, my god, you wait right over there–I want to get in a conversation with you right away. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
I want to figure this spooky action at a distance out. Maybe you’ll be able to help me out. He points to another guy. He says, hi, Albert Einstein, welcome to heaven. What’s your IQ? And the guy goes, well, it’s not 175.I guess I’m a bit average, right, so my IQ is about 120.Einstein thinks about this for a minute and he goes, well, OK, OK. Maybe we can talk about what’s happening politically down on earth and maybe we can talk about what movies you like.
And if you’re reading anything, which I probably highly doubt, but if you are reading something I really, really want to hear what you’re reading and keep in mind if it’s something that is a pot boiler, I don’t consider that reading. And the guy goes, duly noted.
And he kind of walked away dejected because that’s really all he had. He points at the next guy and he goes, hi, Albert Einstein, welcome to heaven. What’s your IQ? And so the guy looks at him and he goes, I’m not going to tell you. And he goes, come on, come on– you’re in heaven.
You’re going to have infinite knowledge–everything that the universe is you are going to know as soon as you stepped through those gates, so it doesn’t really matter what your IQ was when you were on earth. The guy pauses, takes a deep breath, and he goes, all right, I make Forrest Gump look like a genius.
My IQ is 52.And Einstein says, so, what do you think the market’s going to do tomorrow? [LAUGHTER]I think that we all too often feel like Forrest might have a better answer than we do, so I wrote a paper recently about why it is so hard to be an active investor and what I want to talk to you today is about that. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
We’ve all seen the herd mentality move many, many people to passive indexes. I would remind you that things like the S&P 500are strategies, right? The strategy there is buy big stocks–single-line strategy. Globally, it’s buy these global big stocks based on their market capitalization.
Through the research that I and my team have conducted, we have found that there are very many other factors that work significantly better than buy big stocks. The challenge that we face there however is, by definition, our portfolios are very different than the bench mark if the benchmark is the S&P 500. And the first thing that we really want to think about is passive investors–they face one point of failure, right–presuming they’re well diversified, et cetera. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
The only point of failure that an active investor faces is panicking near a market bottom and selling out of all of his or her index funds, OK? That’s really the only thing they have to worry about because, by definition, they’re getting the average return, they’re getting the low costs–they’re getting a lot of really good things. But they do facet hat point of failure and, sadly, I have seen many, many people who swore that they would never ever do such a thing do exactly that. But us poor hapless active investors face two points of failure.
The first is the same as the index investor, right? We panic and we sell out before or near the bottom of a market–but the second one is really more insidious. The second point of failure that we face is we suddenly are comparing our returns of our investment strategy or our ETF or our mutual fund with its benchmark, right? Everything has a benchmark and if you’re a value investor and it’s a large cap strategy, your benchmark is the Russell 1000 Value Index. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
If you’re a small cap value, it’s the Small-Cap Russell Value Index. And we compare these things constantly and what I have witnessed over my entire career is that really human behavior never changes–we’re going to get back to that in a minute.
But typically what happens is that people mismatch their time frames, right? So the majority of people who are actually making decisions on whether they’re going to stick to an active strategy are using possibly the worst time frame to look at and that is three years.
I won’t bore you with a lot of people that I know who do it on a quarterly basis, but what I can tell you is that if you do this on a quarterly basis, I will guarantee that you will fail because quarterly data–there is no signal, it is all noise. And because of the nature of human beings, we always will clamp a narrative around anything that we see and the narrative is going to sound really interesting. You’re going to watch CNBC and you’re going to hear some guy say, well, this quarter happened because of x,y, and z.
Well, let me be the one to tell you–having been on CNBC a lot–he is absolutely full of it. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
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He thought about that on the way over there, honestly, because he has no idea why the quarter did what it did–no one does. And so when we accept that fact and start trying to look at longer periods of time, we’re much, much better off. But three years?
Absolutely one of the worst things that you could look at. As a matter of fact, a friend of mine Josh Brown, who blogs at a site called The Reformed Broker, found a really neat study.
And this study basically showed that investors who fired an active manager for under-performance and hired somebody else–guess what happens? The manager they fired goes on to do vastly better than the manager they hired.
I’m sure many of you are engineers, so you understand the concept of reversion to the mean. They had a bad three-year period generally– not always–but generally followed by a good 3-year period. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
The manager that was hired, well, guess what? They’re coming off a great 3-year period and we love those numbers. We just love seeing them beat that benchmark and yet we really don’t know why they might have done it.
Two stories that I think are interesting that will help us understand why the long term is against us. The first is human nature–we are very temporal creatures and there is a bias in behavioral finance called the recency bias and we are all subject to it.
Everyone in this room, everyone on this campus, everyone in the state and in this country.
Recency bias simply says we pay the greatest attention to what has happened recently and then, to compound our error, we forecast whatever has been happening recently into the future–a very, very bad mistake to make. So I’ll tell you about something I did that demonstrated recency bias.
So when I was a young guy and beginning to look into why stocks did what they did and a big believer in factors–underlying things like PE ratios, dividend yields, et cetera–I had a cousin, Jerry, who is a true wild man.
And he had called me on the phone and he goes, Jim, you’ve got to get into this stock. This thing is going to explode, it’s going to get taken over, this is my industry, I know it– this is fantastic. So what did I do? I bought it—of course, I bought it. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
And I looked it up in the newspaper every day and I was a little put off by the fact that rather than going up and up and up, it went down and down and down. So I kept calling, Jerry–Jerry, what’s going on? You told me? Don’t worry about it. They delayed the announcement. It’s going to come out, just keep on buying– buy it, buy it. You can’t lose. Any time you hear the term you can’t lose, I can tell you, you will lose, so I did.
And sure enough, as you probably can anticipate, the stock cratered–it did horribly. Why? Because I telescoped my feelings into the here and now and when we do that, we are inordinately made to think only of the here and now. And smart phones aren’t helping us, right? So I’m glad I don’t see too many people on their smart phone, but it is reducing our attention span from quarters to quarter of seconds, right? And so very, very difficult to think differently.
The other story, which is kind of a sad story–at least for the guy, not for his kids–was I had a good friend and this guy is super smart. I don’t know if he was smart enough to work at Google, but he was very good in real estate, switched on, knew everything about everything–just a really, really, really smart guy.
And so it occurred that he became our contrary indicator. In other words, whenever Art called me on the phone and said Jim, put me all in. Put me all in your most aggressive strategy. I would say, are you sure you want to do that because, what had happened? Obviously, it had done really well over the past year or two. And yep, you got to do it. You got to do it for me. And I went, OK, will do. Hang up the phone, get on the speaker that everyone at the firm working for me at the time can hear, and I said, we’ve just called a market top. And it virtually always worked. Of course, he did the same thing on the way out. Get the call from Art, “Jim, sell me out of everything.
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This market looks horrible.”And he’d enumerate all sorts of reasons why, and I’m like, “Art, you realize that you really don’t want to do this. You really should be buying now, not selling.””No, Jim. No, no, I know–I’m selling.”Get back on the box, the market has bottomed. And here’s what’s cool. He had his kids invested inexactly the same strategy that he used. And guess what? He didn’t touch their investments, right.
It was only his own position that he felt comfortable playing with. Well five, seven years later, Art found that his kids were much richer than Art because they just did nothing. They simply stayed in the strategy and let it do its work. And, so that is kind of in a nut shell what we’re facing. And I mentioned recency bias. So, recency bias is really interesting– you’re going to have to unlock this again for me. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
Recency bias is interesting because it really infects everything that we do. I’ll give you two examples. So the first example, let’s say you have a doctor and he’s been reading the docs on a particular medicine that he wants to use. And he’s looking at it, and basically the efficacy is 50/50. You’re flipping a coin. And so he decides he likes some of the way it’s done, and so he tries it on a patient. And, wonder of wonders, that patient does really, really well. How do you think the doctor interacts with the next patient with the same disease? He says, I want to try this on you, the 50/50 flip.
And how does he get the guy to do it? He says, it’s working really well with the last guy I tried it on. He totally ignores all of the descriptive data saying this is a coin toss. And yet everybody he says that to says, great, I want to use that medicine. A second one is more market-oriented and it is basically the Bloomberg surveys that they do of investors. Well, you can see this one coming a mile away. When are they absolutely at their most bullish? Well, the last extremes that we noted were in the dot-com bubble. The vast majority of every investor that they talked to and surveyed–wildly, crazy bullish on the market. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
When was the lowest amount of bullishness in the market? Near the bottom of the financial crisis. And what’s interesting is we can’t help ourselves. So when our ancient ancestors were on that plane in Africa and the bush was rattling, one of them ran away, the other one went, oh I wonder what’s in that bush. Guess whose genes got passed down to us? The guy who ran away. So the idea that flee–let’s get out of here–came down us through our genetic inheritance, and it is very, very difficult to overcome.
There’s actually a pair of Swedish scientists who did a report– and I can make all these links available to you if you’re interested in reading the source material–and what they did was pretty clever. They took identical twins, so 100% genes matched. And they looked at their investment techniques, and what they found was really, really disconcerting. Basically in their paper they claimed that 45% of all of the investment choices that we make are genetic and cannot be educated against. Think about that for a minute.45% genetic, education has no effect on that.
I often wonder—because I’m Spock, right, I’m not Captain Kirk–but it’s like, why don’t people pay attention? We’ve had all this data forever and ever and ever. And that kind of turned the light on for me. And I said, oh, I realize why we don’t. We don’t because we are in an environment where our very genes are rebelling against us and letting things like recency bias and availability bias–I love that one.
Availability bias is how easy do we remember something. So if we’re watching the TV news and a terrorist attack happens, guess what we get afraid of? We get afraid that we’re going to die in a terrorist attack, even though if you look statistically the chances of that happening are virtually nonexistent. So a good long-term performance– you know, Cliff Asness who runs AQR–had a great quote, which was, “If you can have and really live by a good long-term investment outlook, that is as close to an investment super power as you will ever be able to achieve.”And the fact is, the stats show virtually no one can do that. So problem number one.
Problem number two is, again, us. The next thing that we focus on whenyou wants to be a good investor is, good investor’s value process over outcome. What does that mean? Deming had a great quote which was, “If you cannot describe what you do as a process, you don’t know what you are doing.”So basically, if you’re a good active investor, you will always value the process over the outcome. Why is that? Well, because if you know nothing about a process and you’re just looking at two numbers, you’re basing your decision on outcome. Like right here. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
This is the five-year result of buying the 50 stocks with the best sales gain– annual sales gains. And if we were looking at this just in isolation, we’d say, wow, simple strategy makes a good deal of sense to me. I’m going to do that. This strategy outperformed the S&P 500in four of the five years that we’re looking at here, and it doubled the total return of the S&P 500.Right, so you’d think, if I’m looking at that outcome, I love it.
And keep in mind, it would not appear to you in a vacuum. Morningstar would have a five star rating on this fund. CNBC would have this manager on and talking about why this is such a great strategy.”Forbes, “Fortune,””Wall Street Journal,””Barron’s” would all be writing glowing stories about this guy or gal. They would say they’ve got the keys to the kingdom there. This is amazing. OK, this is what happens when you value outcome over process.
Let’s go to the next slide and see what really happens here. Well, what really happens here is you’re wiped out. This is the data between 1964 and 2009.Over to the left is that very same strategy. That strategy did vastly worse than T-bills. Everything else killed it. So let’s all imagine that there is a bar graph therefore the S&P 500 that says you put your money there, you got $640,000.And all stocks doesn’t even have a number but it’s better than the S&P 500.The point is pretty simple one. If you have access to the long-term data, you’re going to get much better information about whether the process that you’re looking at actually makes sense. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
For the most part, they don’t. Like buying the stock with the 50 highest sales– oh, by the way, these numbers are from 1964 to 1968.People who don’t understand market history it’s like Twain said, history doesn’t repeat itself, but it rhymes, right. So in 1964 to 1968we had a bubble just like the dot-com bubble, and it led to all sorts of things that we don’t have time to get into? But in terms of practical human nature, they behaved exactly the same then as they did in the dot-com bubble.
And then for people who don’t like the idea of– well,’60s, that’s meaningless– this same strategy for the three years ending February of 2000compounded at 66% per year for the prior three years as of February 2000.Boy, that’s really difficult to ignore. And the only way you can ignore its if you look at the much, much longer term in terms of the underlying strategy and how it performs. When you value process over outcome what becomes important to you is to study as much data as you have available to you to see how things in general turn out. You’re not always going to be right. Just a quick reminder, you can click any link on this Tesler App Review site to go to the original Tesler Website.
So, one of the reasons why that strategy does very poorly is because, guess what happens. Everyone buys those stocks and they become enormously expensive. They’re priced to perfection, and they don’t achieve it. So Murphy would be good here. Murphy was an optimist. If it can go wrong, it will go wrong and generally does. What we’ve found doing this study is that when you pay for the most expensive stocks you manage to subtract about 6.2% from the return from the index. Think about it like it was a lemonade stand.