Value investor drought

Pity the poor value investors.

Although they have excellent long term records, value investor results over the past couple of years have been poor relative to the market.

Consider Bill Miller at Legg Mason. After beating the S&P 500 for 15 years in a row, he has had a dreadful 2 1/2 years. His performance has been so bad his mutual fund investors are leaving in droves.

Does this mean value investing no longer works? Should investors pursue another methodology? If value investing hasn’t worked, what has?

The answer is momentum. If you simply invested in the things that were going up, you would have easily beaten the market. Invest in natural resources, such as oil or gold, after they went up and they’d just keep going up.

Is that a good way to invest now? Not normally, and probably not going forward.

You see, the market goes through periods when one thing works and others don’t. This rarely lasts because everyone jumps on the bandwagon until it’s full and no one else is left to jump on board. I think we’re close to that point now.

The last time momentum out-performed value investing was in the 1998-1999 period. After that, value investing clearly beat momentum investing for several years running.

Usually, when the market goes down, value investing handily out-performs. But in this down market, momentum has been winning. You have to go all the way back to the early 1990’s to find a similar situation. Guess what happened after that? That’s when Bill Miller’s record 15 years of out-performing the S&P 500 began.

Don’t pity the poor value investors–JOIN THEM. Every time value investing has performed poorly in the past has proven to be an excellent time to get on the value investing bandwagon. Right now, people are getting off, and that’s precisely why you should be getting on!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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In investing, beware the halo effect

People frequently–and incorrectly–attribute wonderful characteristics to something that has succeeded. Just because something has succeeded does not necessarily mean it’s specifc attributes are also excellent.

This issue is succinctly highlighted in the third part of Michael Mauboussin’s Legg Mason article.

The “halo effect is the human proclivity to make specific inferences based on general impressions.” This was first noted over 80 years ago by psychologist Edward Thorndike and was recently described in detail in Phil Rosenzweig’s book, The Halo Effect.

What Thorndike found by studying military officer reviews was that superiors tended to attribute overwhelmingly positive specific attributes to subordinate officers who they had good overall impressions of. In other words, they assigned impossibly high ratings to their intelligence, physique, leadership, etc. based on their high overall opinion.

This tendency can be particularly dangerous in picking investments. Those who attribute outstanding specific characteristics to Apple or Google simply because they have done well in the past and everyone seems to love them may be in for a rude surprise if they invest in these companies at current prices.

The same can be true on the downside as well. People tend to assume that companies whose stock has performed poorly or whose profitability has lagged have universally negative specific characteristics. This is unlikely to always be the case.

The halo effect partly explains why popular stocks tend to under-perform and unpopular stocks tend to out-perform.

People tend to assume that popular stocks have great specific attributes, reflecting popularity more than excellence. When an inevitable blemish appears, the stock tanks because it was priced for perfection

In reverse, people tend to assume that unpopular stocks have universally negative attributes. When it turns out the business isn’t as bad as everyone believed, the stock takes off because it was priced for bankruptcy.

In selecting investments, it’s very important to gain a clear view. Popularity is no way to judge an investment. Look critically at every investment opportunity, no matter how much people love it. And, companies that everyone things are doing poorly may be a great place to invest because good characteristics may have been overlooked.

To avoid the halo effect, look for disconfirming evidence–evidence that conflicts with the popular view. Work hard to understand both the good and bad characteristics of an investment. This will help you rationally assess its prospects, and almost certainly lead to better investment results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What separates good investors from great investors

Michael Mauboussin, from Legg Mason, recently released a great article about the difference between good and great investors.

The first issue he highlights is that great investors avoid being destroyed by high impact, rare events. For example, many value investors avoided investing in dot-com stocks during the late 90’s and looked liked fools until the market tanked between 2000-2002. Great investors aren’t great because they can predict such events, but because they have learned to avoid them.

The second issue he highlights is that great investors have the right temperament. By this, he means they don’t get sucked into the psychological traps that most people get sucked into.

For example, most people feel the pain of losses (loss aversion) so much more than the pleasure from gains that they make bad choices. What if I offered you a game where you had a 95% (19 out of 20) chance of losing $5 and a 5% (1 out of 20) chance of making $100, would you play? Would you play if you could play it an unlimited number of times? Most people wouldn’t play this game because they would feel the pain of losing more than the benefit of gaining, even though they would make money with no effort as long as they kept playing the game. Great investors understand this math and would play.

Great investors also understand the difference between probability and impact. In the example above, you have a high probability of losing, but when you win it has a very high positive impact. Most people over-emphasize the probability and under-emphasize the impact. Great investors understand the difference and play accordingly.

Great investors also grasp the randomness of any game they play. Short term results in the stock market are so random that someone with little skill can get wonderful returns over short periods of time (like a day, month, year or even 3 years). Only over the long term can you see who has skill. Great investors get this and judge their investing options over the appropriate time horizon.

Mauboussin concludes his article by pointing out that high impact, rare events, loss aversion, probability and impact, and randomness requires great investors to focus on 3 things: process versus results, a constant search for favorable odds while recognizing risks, and an understanding of the role of time.

Investors who follow this advice and can act on it have the potential of being great instead of merely good or even bad investors.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.