Until next time,
Kendall J. Anderson, CFA
The Importance of Being Different
“Whenever people agree with me, I always feel I must be wrong.”
I don’t know if Oscar Wilde was successful as an investor -- or whether he was an investor at all, for that matter. But from my perspective, judging from the above quote, he certainly would have started with the right attitude.
Beware Investment Myths
Periodically, theories catch the imagination of the investing crowd about how the world works. At first, they intuitively make sense, then they seem to be confirmed by fancy academic literature and finally, they may be endorsed by prestigious experts. As they become widely accepted, these theories eventually turn into undisputed myths that, for a time, rule the investment world. But, just as often as not, many are eventually proven wrong. Distrusting such theories in principle thus seems a good idea.
The Efficient Market Hypothesis (EMH), which influenced professional investment thinking from roughly the mid-1960s to the mid-1990s, was one of those myths. Back in the 1930s and 1940s, research by Alfred Cowles had already indicated that most professional investors fail to outperform the market. Many subsequent, similar observations led to the broad acceptance of the Efficient Market Hypothesis in the mid-1960s, when it was proposed by University of Chicago Professor Eugene Fama and endorsed by economics Nobel Prize winner Paul Samuelson.
Without going into too much detail, EMH claims that prices on stocks, bonds and other traded assets reflect all the information publicly available at the time an investment is made. The corollary is that, over time, one cannot achieve returns in excess of average market returns— at least not without accepting more risk. And the implication is that you would be better off just buying an index fund designed to mimic “the market” or applying other supposedly sophisticated methods of diversification.
Theoreticians, Groupies and Common Sense Practitioners
Although, as we will see, the Efficient Market Hypothesis has since been largely discredited, it left a legacy of practices (and the superstructures that thrive on them), which in my view generally hamper rather than improve the investment process. Among those are the Modern Portfolio Theory (MPT) developed by another economics Nobel Prize winner, Harry Markowitz, which aims to mathematically model what diversification between asset classes should be. The Modern Portfolio Theory itself gave birth to a whole industry of consultants, asset allocators, funds of funds and others which, as far as I can tell, more visibly added to management fees than to investment performance.
While picking on Nobel Prize winners’ contributions to investment science, we should not forget that Long-Term Capital Management, a fleetingly famous hedge fund that incurred 1998 losses so catastrophic as to require the intervention of the Federal Reserve, counted two Nobel laureates on its board. Of course, not all work by economics Nobel Prize winners is eventually doomed, but these examples vividly remind us that, in the realm of investments, there is a big and dangerous gap between theory and practice.
Warren Buffet was the first to convincingly challenge the idea that equity markets are efficient, in a May, 1984 speech at Columbia University. He documented that, over periods ranging from 12 to 18 years, nine successful investment funds, all of them managed by alumni of Benjamin Graham and using different tactics but following the same value investing philosophy, had all outperformed their market benchmarks by a significant margin.
Using a more recent period and a different list of ten funds suggested by Bob Goldfarb, of the Sequoia Fund, Louis Lowenstein, professor at Columbia University, made a similar point: “In the turbulent boom-crash-rebound years of 1999-2003 … every one of the ten funds outperformed the [S&P 500] index, and as a group they did so by an average of 11% per year…” (Searching for Rational Investors in a Perfect Storm – Columbia Law and Economics Working Paper No. 255).
Finally, in recent years, the rising influence of behavioral finance, which studies the often irrational behavior of investors, has again documented the likelihood that a rational investor can indeed outperform the market. As I mentioned earlier, this has helped discredit the Efficient Market Hypothesis and hopefully its sequels of falsely scientific disciplines.
Statistics Look Professional, but Are They Meaningful?
Even though performance should be evaluated, there are two main caveats in using it:
- To be relevant, performance must be measured over longer periods than is the common practice. There are about 10,000 investment advisers registered with the United States Securities and Exchange Commission and probably close to double that number worldwide. A well-known exercise assumes that we ask 20,000 advisers to toss a coin. They will win if the coin lands “heads” up and lose if it lands “tails” up.
Half of them, or 10,000 advisers, will probably “outperform” the sample average in the first year. If we do the same thing next year, 5,000 advisers will outperform the remaining sample and will thus have beaten the average for two years in a row. At the end of the third year, 2,500 outperformers will remain, and so on. If we continue, 625 advisers will achieve a 5-year record of steady outperformance TOTALLY BY CHANCE!
This is about as far back as most consultants and rating services look back. Yet, even at the end of ten years, which for most analysts and consultants is a time immemorial, twenty advisers will have shown an uninterrupted 10-year record of lucky outperformance… Beware the naked numbers: even the examples cited earlier in support of my views deserve further scrutiny.
- True outperformance is rarely smooth. Most superior investment managers have experienced occasional stretches of underperformance or outright losses, including some of the most iconic ones. The main reason is that, except in the very long term, stock prices are determined more by the mood of the investment crowd than by fundamental factors such as sales, earnings, cash flow or book value, for example. In the longer term, fundamentals prevail: the stock market does rise along with companies’ earnings and assets, which is why excellent investors that pay attention to these fundamental factors and are armed with patience can match or surpass the returns on the market indices. But in the short-term, volatility prevails and often it is the greater fool theory that rules: you can always buy at an inflated price a stock that already has gone up a lot, because there will always be a greater fool to buy it back from you at an even higher price. Obviously, this is followed by equivalent losses when the psychology changes.
It is important to judge managers on their stated investment philosophy, and on how disciplined they are in applying that philosophy. The alternative, i.e. relying solely on historical performance numbers without gaining a full understanding of how these numbers were achieved, may lead one to invest in or recommend Madoff-like schemes, as many professionals and consultants did. The Madoff episode is just a stark reminder that guaranteed returns, especially superior ones with the promise no risk, are a fool’s trap.
Volatility is a natural companion of superior long-term returns but it is very different from risk, which is the possibility of permanently losing one’s capital. Volatility, by contrast, is merely a series of shorter-term aberrations that, for serious investors, should be viewed as opportunities.
Taking Advantage of Market Volatility
If volatility resulting from the cycles of crowd psychology is to be treated as a source of investment opportunities rather than as a “risk”, it is first necessary to acknowledge that the crowd’s consensus can be right: if everyone says it is raining outside, it is not wise to go out without an umbrella.
Second, it is important to distinguish between the momentum and contrarian approaches to investing. Briefly, the momentum approach sides with the crowd most of the time, in assuming that markets or even individual securities will continue to perform as they recently have. Rather, the contrarian approach assumes that the crowd is both poorly informed and overly emotional and therefore tends to be wrong on markets. The contrarian investor thus tends to take investment positions different from – if not opposite to -- those of the crowd.
The irony is that momentum followers are right most of the time. However, while they are, they usually do not stand to make as much money as they hoped because the consensus expectations for the future that underlie the momentum approach (a continuation of the recent past) are already largely incorporated in the current prices for securities and the markets. In contrast, contrarian investors are right mostly at major turning points, after securities or markets have become grossly overvalued or undervalued. As a result, they are right less often but, when they are, they stand to make large profits or avoid large losses.
This is one of the most important rules of successful investing: It is not how often you are right that counts, it is how much you stand to earn if you are right or to lose if you are wrong.
This is why contrarian investing and value investing so often go hand in hand and why Tocqueville Asset Management elected to label its original discipline as “contrarian value investing”.
Tocqueville Asset Management
Disclosure: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.