Don’t just do something, stand there!

We’re a can-do people.  From a young age, we’re taught that effort leads to results.  But, when it comes to investing, activity is not the same as effort.  In other words, it is frequently better–as an investor–to stand there instead of doing something.

This is tough for can-do people to swallow.  They want to trade and switch and act to achieve success.  This may work well in many fields, but investing is not one of them.  This is as true for professional as non-professional investors.

This point is well made in Michael Mauboussin’s latest article, “The Coffee Can Approach.”

Mauboussin’s article refers to a professional investor’s experience with a client.  The client had copied some of the professional’s initial investment choices in their own separate portfolio and then just forgotten about it for years.  Over time, the forgotten portfolio had greatly out-performed the professional’s own record.  Some investments had done poorly, but others had done so well it was best to leave them alone.  Instead of doing something, the professional investor–and his clients–would have been better off doing nothing after the initial allocation.

The difficulty is that this method takes great patience and many years to work out.  If you examine your portfolio too frequently, you’ll make changes that tend to yield sub-optimal results.  Just as a watched pot doesn’t boil, an over-examined portfolio doesn’t grow.

This framework is born out by research from the investment field.

John Bogle found that exchange-trade fund (ETF) investors were on average under-performing the reported returns of the ETFs they invested in–by a whopping 4.5% a year!  Why?  Investors were buying things that had gone up and selling things that had gone down.  They would have gotten significantly better returns if they had patiently stayed where they were.

Professional investors don’t do much better.  Institutional plan sponsors–usually investment committees of professionals–consistently fire managers that have recently done poorly and hire managers that have recently done well.  The result: the fired managers subsequently out-perform the hired managers by a wide margin.  Plan participants would have been significantly better off if plan sponsors had left things alone.

People, both professionals and non-professionals, tend to evaluate investment managers over three year periods.  And yet, research indicates that you need a period of a decade or more to confidently conclude a manager has skill.

In fact, some research suggests that only 35% of skilled managers show up in the top 10% over 1 year periods, and only 50% of skilled managers show up in the top 10%–even with a 10 year evaluation period!

When it comes to investing, picking good investments or good managers should focus much more on the initial decision, and then being patient with that choice over time.  Without a doubt, this is hard for can-do people to embrace.

The evidence, however, is clear: recent out-performance is no guarantee of future out-performance, and recent under-performance is no proof of poor future performance.  With investing–once an good initial decision is made–it’s better to stand there than do something.

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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Don’t just do something, stand there!

Skill vs. Probability.

Lucky, or good? This question gets asked a lot, but few realize how important it is.

Having just finished Michael Mauboussin’s book, Think Twice, I couldn’t help but reconsider this question across a range of areas.

It turns out to be crucial in sports, business, politics, investing, and even parenting!

The basic issue is that the outcomes we see are one part skill, and one part probability, (i.e. luck). Where we get wrapped around the axle is when we assume that bad luck means bad skill, or, more frequently, that good luck means good skill.

Sports seems like the most obvious example. People assume hot and cold streaks are due to controllable skill, when they’re much more likely due to good and bad luck. A 60% free throw basketball shooter has a 7.8% chance of making 5 in a row; a 40% shooter has a 1% chance of 5 in a row. But, that doesn’t mean that on any given night the 40% shooter won’t shoot better than the 60% shooter. Sorry, that’s just probability.

A better example is the Sports Illustrated jinx. Teams or athletes tend to do worse after they appear on the cover of Sports Illustrated. Luck or skill? They were probably on the cover because they had skill and a streak of good luck. The did worse afterward because they had skill and a streak of bad luck. Fans will probably claim otherwise, but it’s more likely a change in luck than skill.

The same phenomenon occurs in business. Companies and managers that appear on the front of Business Week, Forbes and Fortune tend to under-perform afterward (both their stock and underlying performance metrics). Were they on the cover because they were terribly skillful, or because they had skill and were a bit luckier than average? This doesn’t bode well for Apple, Google or Hewlett Packard that have graced a lot of magazine covers recently.

You can see the same thing in a business’s underlying performance. If a company is shooting the lights on in sales and profits, it’s part luck and part skill. A company with terrible performance may be terrible, but it’s also likely to be partly bad luck. The statistics show that performance tends to regress to the mean over time–the good get worse and the bad get better.

Politics and entertainment are also good examples. Was Bush purely to blame for 9/11 and hurricane Katrina, or was he unlucky? Likely, he was both unlucky and unskillful, but he’s frequently blamed as if it were all bad skill. Same for Obama. Was he unlucky or unskillful to have the housing market meltdown and a giant oil spill in the Gulf of Mexico on his watch? People aren’t very objective in judging politicians and the degree to which luck plays a part, especially when they go into situations with political prejudices.

I’ve found luck and skill even play a part in parenting. If you’re saying “DUH!?” right now, I agree with you. When my almost 3 year old daughter is sick or teething (which I consider luck, not skill on my part), things go worse. This means tantrums galore! When she isn’t sick or teething, things go a lot better. She occasionally even listens to me! My skill is the same (or at least relatively stable), but my results are different because luck plays a part.

No where is this more obvious in my life than with investing. Luck plays a major part in investing because the outcomes are due to so many complex factors. Predicting economic outcomes, weather patterns, competitive dynamics, etc. makes investing a terribly difficult area to separate skill from luck. And yet, both good and bad luck are there along with skill.

That’s why its so important to look at a managers long term record. If he or she does well over the long run but hasn’t done well recently, bad luck is probably playing a part and good luck will eventually come back. On the flip side, a good record doesn’t necessarily mean skill and good luck, it could just be good luck. This burns investors more than anything else in the investing world, and it counts when looking at investing managers as much as specific investments (Apple, anyone?).

Skill or statistics? Lucky or good. You be the judge. But, don’t fool yourself that both good and bad luck aren’t playing a roll. They most certainly are.

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.

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.

Social influence plays a big part in outcomes

The success or failure of a venture can be greatly influenced by the early reactions of people.

This statement may seem obvious to you, but a recent academic study recently showed just how important initial reactions can be on success or failure.

I read about the study in Michael Mauboussin’s recent Legg Mason article. Three Columbia University sociology researchers set up a website where people could download music. 20% of the people who went to the website were provided with no information about what others had downloaded. Another 8 groups (10% each) were formed which could see download rankings.

The study showed that top songs tended to finish in the top, and bottom songs tended to finish at the bottom regardless of whether download rankings were available. But, the vast majority of songs in the middle were ranked very differently depending on whether people could see download frequency.

In fact, the study showed that once 1/3 of the participants had downloaded songs, the next 2/3 of people followed their lead. This lead to very different outcomes between the 8 groups who could see download frequency.

In other words, the intrinsic quality of songs was trumped by the cumulative advantage of social influence for the vast majority of songs. Songs downloaded frequently by a group were then downloaded more frequently by others, creating cumulative advantage.

This may seem obvious when you think about Betamax versus VHS digital video tapes, or Apple versus Microsoft Windows, or, more recently, iPod versus any other MP3 player.

The same is undoubtedly true for picking investments. In the short term, people pile into the same investments that everyone else is talking about, regardless of the intrinsic value of the underlying business.

Luckily, the market has the benefit of quarterly and annual earnings reports, which force stock prices to track with underlying value over the fullness of time.

This doesn’t mean that stock prices are always right–quite the opposite.

Don’t judge an investment by what it’s stock does over the short term if you’re a long term investor. Otherwise, you may suffer from the social influence of following the crowd.

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.