Hi Guys,
I finished reading Daniel Kahneman’s “Thinking, Fast and Slow” a few days ago. Many financial and investment maxims can be gleaned from its information dense pages.
Kahneman’s work reinforces marketwise wisdom that Benjamin Graham recognized and documented in such sage advice as “Investors purchase stock like they purchase groceries – not like they purchase perfume” and most cogently with regard to his book, “ Investment should be based not on optimism but arithmetic.”
In his masterpiece, Kahneman focuses on the fast, the intuitive, the survival instinctive portion of the brain as dominant over the so-called lazy, analytical, reflective portion of it. He consistently references our propensity towards the WYSIATI (What You See Is All There Is) syndrome.
We use heuristics and take cognitive short-cuts when making reflexive-dominated decisions. Sometimes that works to perfection, but not always so. The shortfall culprits are associated with cognitive biases such as overconfidence, false anchoring, illusions, and other mental aberrations.
In his book Kahneman introduces a two selves concept; he defines a distinction between our actual real world experiences and our remembrances, our imperfect memory, of those experiences. We tend to distort facts, to overweight brief segments, and to ignore the impact of cumulative exposure considerations. Since future decisions will be dependent upon our murky memory of past events, our decisions are likely to be suboptimum, and often violate the rational-man model so ubiquitous in economic and financial theory.
Kahneman recommends ignoring daily market perturbations. Daily price changes reflect emotional reactions. They are noise when contrasted against longer term market performance which more fundamentally represents macroeconomic inputs. Projecting market trendlines is not an easy task.
As Bill Gross recognized “ The one investment certainty is that we are all frequently wrong.” Most of us suffer from the Illusion of Validity and rate our performance better than it really is..
Individual investors often seek advice and recommendations from market mavens, gurus, and witch doctors. In essence, we search for expert judgment and hope these wizards can direct us to the Holy Grail.
Expert judgment is overrated in most professions. It is valid in chess, but is notoriously flawed in both the economics and stock picking disciplines. Historically, this financial-oriented contingent has an eroding record in the intermediate and distant future timeframes. Forecasting is a hazardous business.
For these longer timeframes immediate feedback is obviously lacking, and does not foster productive learning which a chess player or football quarterback gets with every contest. That learning experience contributes to the skill development process. In Malcolm Gladwell’s “Outlier” book, he cites studies that document the need for about 10,000 hours of vigorous involvement (study, practice, active participation, after-action reviews) before attaining an expert’s skill set.
The mediocre record of the financial gurus listed by CXO Advisory Group documents their numerous shortfalls. Their average performance hovers just south of the 50% accuracy rating. Famous market mavens like Jim Cramer, John Mauldin, and Abby Joseph Cohen have very unimpressive historical success records as scored by CXO. It’s almost like a repetitive coin tossing series. Sometimes, a fortunate coin flipper can toss 10 consecutive Heads. He is likely not skilled at that task, just plain lucky. In general, financial gurus do not even seem to have much luck favoring them. Investment genius is a rare commodity.
One perennial enigma is why private investors persist in seeking these faulty forecasts even when they are made aware of their historically inaccurate record. Hope springs eternal.
Countless scientific studies demonstrate that very simple, linear correlations of the same data sets that the experts access can be used to mathematically produce a more reliable, more repeatable prediction then that generated by the so-called experts. The expert judgments are influenced by random factors like happiness state, health status, current hunger, and deleterious anchoring exposures; also these pros show a recency bias and other behavioral traps. Kahneman discusses a bucketful of these traps.
Daniel Kahneman eats his own cooking when investing. He does not trust the investment wisdom of market wizards. The future is a murky cloud that can not be penetrated by anyone; uncertainty dominates. Therefore, he and other academic scholars mostly invest in Index products; they only rarely venture into the active equity management field. When they do so, it is only with a small portion of their portfolio holdings.
Although not designed to be an investing tutorial, Kahneman’s book yields a few exploitable investment guidelines. Investment decisions (actually all decisions) are best made slowly when in a well-rested and hunger-satisfied condition. That state encourages use of the contemplative segments of the brain to restrain the emotional, intuitive portions that demand entry into the decision process.
Kahneman outlines a huge distortion between our actual investment experiences and our remembrances of our past performance. Our memory is fuzzy at best. It favors selected recall of positive outcomes while it more likely suppresses losing actions. To combat this bias performance records should be carefully maintained and reviewed. Remember the erroneous reporting that the infamous Beardstown Ladies documented in their popular book a few years ago.
Kahneman emphasizes the persistence of a Regression-to-the-Mean law. We incorrectly do not acknowledge superior performance as being an unusual outlier event. Bill Miller’s recent mutual fund performance is a superb illustration of the regression-to-the-mean phenomenon after 15 seasons of market beating success.
Given the spotty predictive record of market gurus, the inconsistency record of mutual fund managers, and the dismal record of professional institutional equity advisors, Kahneman concludes that experts in the financial advisory field are no more expert than the individual investor. Since it is impossible to see the future, he advocates a passive Index investment approach when constructing a portfolio.
I partially subscribe to that recommendation. Almost one-half of my equity portfolio is with Index products. The remaining portfolio is with active managers deploying a conservative, fundamental management style. The managers have long tenure, trade infrequently, and the funds operate with low client costs.
Chaos governs the marketplace. But in a sense, it is an orderly chaos that is partially decipherable in terms of familiar economic patterns and logical rules of human behavior to highly complex and interactive conditions. Although the chaos can not be controlled nor anticipated, its boundaries can be approximated and exploited to a limited extent.
From a pragmatic perspective, investors must make decisions. I try to use the findings from Kahneman’s behavioral work and merge it with generic guidance from Chaos Theory and Complexity Modeling to inform my decisions.
Kahneman advices to integrate the thinking brain with the intuitive brain in all decisions. That utilization of the mind’s full resources helps to anchor any investment decision. By engaging the reflective brain’s inputs we might mitigate the deadly trap of a spurious anchor that wrongly influences our final judgment.
How to do this? Use long term statistics to establish a base-rate expected return. Remember that statistics are simply an orderly way to organize historical data as a tool for decision making; it is a point of departure. As mentioned earlier, Francis Galton’s Regression-to-the-Mean eureka moment is a powerful rule that is a reliable forecasting aid in many instances. So use historical averages to inform your base-rate projections.
How do you adjust the base-rate? You can use Chaos Theory and Complexity concepts to fine-tune away from that baseline prediction based on your assessments of current market and economic conditions. Chaos Theory proposes that the real world offers a more wild ride than conventional Bell curve statistics suggests. Market returns are not Normally (Bell curve) distributed. They have fat-tails and are better modeled as Power Law distributions, especially at their extremes.
Chaos and Complexity concepts are in concert with Behavioral findings which conclude that human modifications from a base-rate are typically too modest (risk aversion) and need a more aggressive alteration to capture real returns.
I wish all of us the wisdom to appreciate our imperfect perception of the scope and complexity of investment decisions. It is a hard, uncertain world without silver bullets. Good luck.
Best Regards.
Comments
I note that your author is mostly an "Indexer." Reversion to the Mean governs his choice to be such, I suppose. And I suppose that Reversion to the Mean may very well be the overarching rule under which all else operates, investing-wise. Is Reversion to the Mean the "umbrella" under which the whole "Machine" does what it does as we watch it, from day to day?
I believe that claim, about Reversion to the Mean. But I cannot be an Indexer. For one thing, I'm too greedy to settle for reaping merely a statistical norm. But secondly, I attempt to hold such greed in check because of the simple awareness that unchecked greed leads to quick poverty. It's like becoming a Millionaire: simply start out as a Billionaire, and then choose to own and run an airline. THAT will lose you a buncha money, for sure.
I choose to WANT to trust the judgment of Fund Managers who are not trying to constantly "shoot the moon." I figure they know more than I do, and I'd be foolish to do this investing thing as a Lone Ranger. But I DO NOT want a fund manager who runs hot-and-cold. When TAVIX ran cold for too long, I switched out of it, for example. We should never consider ourselves MARRIED to a fund or Fund Manager. I seek consistently good results, and like to uncover gems that might on the SURFACE seem like a bad choice---like MACSX. I've owned it since '03, even though a look at its M* profile might steer you away right now, these days.
OK, I better stop. Again, thanks for the Kahneman book report, MJG.