The Investment Circus: Why Mean-Ignorant Monkeys Beat Median-Jumping Clowns 24 comments
- Nick Gogerty's articles on Seeking Alpha
- Visit Nick's site: Designing Better Futures
-
Font Size:
-
Print
- TweetThis
Occasionally a bored business publication goes to the zoo, rents a monkey and pits him or her against a mutual fund manager. Lo and behold the monkey who doesn't know a beta from a bunghole beats a significant majority of the active managers. Barron's should probably create a yearly Monkey Roundtable. These journalists must be pretty good monkey pickers and should probably start a MFoF (Monkey Fund of Funds) charging 2% and 20%. We are the Third Chimpanzee and it seems as if evolution must have robbed us of our stock picking skills, but boy can we pick monkeys.
So what is going on? Charlie Munger and Warren Buffett both hint at it in various writings and books; my favorite is Charlie's Poor Charlie's Almanack. Warren calls it de-worsification, or the fact that many portfolios get worse as more components are added to them. The theory which he pretty well proves via his actions is that the more holdings you have, the less likely you are to know a lot about any of them. He doesn't say it, but most managers also jump the median, the investment equivalent of jumping the shark. Buffett and Munger both hint at investing being similar to parimutuel betting.
The reason mean monkeys beat median jumping clowns is that most fund managers really don't understand the sustainable economic value drivers behind the businesses they invest in, and therefore can't allocate well at the individual equity level.
Mean Monkeys picked by journalists have one of the key behavioral principles in investing; ignorance. They don't know or even pretend to know anything.
Stock returns as exhibited on page 73 of Mebane Faber's great new book, The Ivy Portfolio, shows the problem. Stock returns are log normally distributed having fat tails.
The charts are sourced from Blackstar funds and reflect data from 1983-2007.
The Mean Ignorant Monkeys
When I tell my wife that ignorance and apathy are key investment traits, she just rolls her eyes. Put another way, know what you don't know and be patient, as activity kills in this game. Ignorant Mean Monkeys beat funds because they allocate naively, i.e. equally in their portfolios. God forbid the monkeys start running mean variance optimizers or the game is over. Mean variance portfolio allocation is probably one of the most costly rearview mirrors of all time.
Suppose that out of the universe of 8,000 equities above, Mr. Mean Monkey takes on Mr. or Ms. Median jumping manager by throwing his darts. Most of these competitions stop right there. Rarely do the journalists ask the monkey about next quarter's earnings projections or where the Dow will be next week. The monkey's bets are spread equally across the selected equities and the race with the clowns is on. The clowns' performance is usually measured by their fund's returns.
The monkeys should perform roughly the same as a naive (unweighted) index with a small cap bias. Why? The monkeys are simply taking a random sample of the markets, so the returns should be roughly equivalent to the chart above. The smaller cap bias will reflect the greater number of smaller cap firms present in any sampled universe of investable firms.
Imagine that from the 8,000 stocks, the monkey selects 8. One could think of the chart above broken into 8 bins. That is what the monkey's return will equate to. The monkey is an approximate unbiased sample of the market.
Send in the Median Jumping Clowns
The active fund manager "median jumper" clown does the same thing with his or her 8 picks, ideas, gambles, allocations or whatever glossy euphemism he or she uses in their marketing literature. But the clown is at a disadvantage because they don't know what they don't know, so they decide to weight the portfolio according to the "best" picks. Uh oh, here is where the trouble starts; they just jumped the median and probably picked something closer to the mode, the most commonly occurring sample.
The Median is not the Mean
The statistical mean is what most people consider the average of returns. More important is the median and mode, the most likely sample to be chosen, and the number separating the higher and lower half of the sample. It works like this: You and 7 of your friends find yourselves in a room playing bridge with Bill Gates and Warren Buffett. The mean (average) net worth of the individuals in the room is measured in the billions, but you don't feel any richer, because most likely you are one of the 8 representing the mode, or most common sample in the room, which is below the median and the mean.
The median and mode for shares' returns is actually well below the cap weighted index which is closer to the mean. The charts above indicate 64% of shares underperform the index. This means that managers who "tilt" or weight their portfolio to their best idea are statistically taking a random sample and doing bad things, increasing the odds of picking a sub-index performer, and in so doing also diminishing the allocations to the potentially significantly positive outliers that help deliver the mean performance.
This is classic behavior flaw 101; people with more information believe they know more about something. So the fund manager takes the useless sell side research reports, technical analysis and other hocus pocus that they haven't back tested or thought through, and parks a few more chips on red.
Few managers really understand businesses. Not many money managers have actually run a competitive business and understand the dynamics of a "market for goods and services". When it comes to fund management and equity selection, I will bet on a humble person who has run a successful small business over somebody who can tell me what they think the Fed is doing.
Stock "business" selection skills are different from macro economic analysis and best learned by doing. People straight from school and fed into the investment banking world are put into an environment that demands answers even when there aren't any. Smart people who don't have answers or admit ignorance get weeded out. This is an environment rarely interested in posing interesting new questions, which is a far more interesting and important skill requiring imagination. Even Buffett ran a gas station into the ground and probably learned as much from it as from his Columbia MBA.
Transaction and operational costs etc. also injure manager returns. This is the case of apathy / patience proving things out. Fund managers are like trapped animals. They get caught, then get nervous and waste energy trading and allocating instead of sitting quietly and thinking about what the dynamics of the game they play truly are. My suggestion: shut off the screen and Blackberry and go fishing etc. for awhile and reflect. Maybe a few answers will pop into your head, if you are truly lucky a profound question will arise.
The well known reality is that most fund managers underperform a passive representative index. Managers don't know what they don't know. They are often in the giving answers business as they rise from analysts to portfolio managers; some are just great salesman stock brokers. Cramer is the worst public example of an analyst gone wild. He is a bottomless pit of useless answers filling the airwaves to pimp cars, cereal and pills for CNBC. Felix Salmon has his own equivalent answer hole in Ben Stein.
An answer hole (my term) is a bottomless pit where questions are thrown in and answers are always on offer. The only thing not found in the answer hole is an honest phrase such as "I don't know."
Most Mutual Fund Managers could significantly increase their long term performance with an equivalent naive asset allocation across the board and less activity, assuming they have a random sample. They could at least aspire to mean monkey performance and still get the fun of throwing darts, while causing less harm.
$6.24 Trillion Dollars of Clown Self-Delusion
For fun, take a look at your fund's top few holdings ideally representing 80% of the portfolio, and allocate them equally. You might find that a Mean Monkey portfolio approach beat your manager's median jumping.
Calling mutual fund managers clowns may be rough, but if a $26 trillion industry underperforms the naive approach by 1.0% and the average fund has expenses of 1.4%, that means you or your pension fund loses $26 trillion x 2.4%= $624 billion a year playing the fund game. The label 'clown' doesn't seem too harsh and is more fun and lighthearted than the anger going around these days. Over 10 years that lost clown value would equate to $6.24 trillion, not including opportunity costs and compounding. Send in the monkeys! Figures like that sound almost stimulating don't they? (groan inducing macro pun intended)
Hedgies lost 18% on average in 2008, which beat most indexes by 20% and blew away most mutual fund managers. Please note the even with the Madoffs etc., in aggregate the Hedgies who have light regulation outperformed the highly regulated mutual fund industry scam. If I wrote the pension laws. I would limit the allocations to active mutual fund managers significantly.
I have a crude outline for a book called Circus Economics & Investing. It is all about how economics and investing works. It will have stories about monkeys, clowns, three-ring circuses, yield totters, horse races, magic tax tricks and leveraged tightropes, describing how life works under the lights in the big tent we call capitalism. I have also developed some nice "naive" parameterless algorithms for swap spreads, rates, volatility etc. with +3.0 sharpe ratios, if there are any interested hedgies out there.
If you have a large equity portfolio, I offer a portfolio risk elimination service which makes a recommendation on which of your top 10 holdings to eliminate, in order to boost returns.
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
David Fry
-
2
TraderMark
-
3
Don Dion
-
4
Cliff Wachtel
-
5
Mike Havrilla
Top Instabloggers » -
1
-
Top StockTalkers
Top
StockTalkers.-
1
David Fry
-
2
Cliff Wachtel
-
3
Mike Havrilla
-
4
David White
-
5
Hedged In
Top StockTalkers » -
1
This article has 24 comments:
Let's keep it simple.
What is too obvious is that the US and the whole world has never have this "Crisis of the Century" since the Great Depression.
Dow Jones went down from $470 in 1929 to $42 in 1932 for a massive haircut of 91%. It is understandable since the Dow Jones was a relatively young and immature market at that time.
Look at China which is still a young and immature market. It went down 72% from 2007 to 2008 despite their strong balance sheet. Many smaller countries went down more than 80%. Russia, in particular, has been crushed.
Look at Nasdaq, a young and immature index of the late 1900's. It went down more than 78% during the 2000 to 2002 tech meltdown. Dow Jones was able to symphatize with 40% haircut during the same period while SnP made a run down of 50%.
Look at monthly charts of companies. Young companies tend to retrace or correct more than 62.8% while older companies tend to retrace less than that during recessions.
Look at Dow Jones 100 year chart.
Dow Jones made a rally from $42 in 1932 to $12,000 in year 2000. A massive 28,470% price appreciation over 68 years. Or an average of 418% price increase per year.
Excessive?
Yes, and Dow Jones is now paying for those 68 years of excess rally. SnP is younger than Dow Jones and has suffered more than DJ since year 2000 top. Nasdaq never left it's own "depression" since year 2000 top.
What has been lost in this panic selling of the last 18 months?
This is only the second time in the last 100 years history that we have an economic crisis of this magnitude.
Those that did not invest during the 1930's and beyond did not reap the profits of the average 418% annual price appreciation of Dow Jones stocks over 68 years. Those that tried to chase the rally during the 80's, 90's, and early 2000's are now suffering from this massive market pullback not seen since the Great Depression. Chasing the rally is a fool's errant twice confirmed from year 2000 onward with the tech meltdown and now the housing mortgage meltdown.
Likewise, those who are too afraid to buy in this "Sale of the Century" are more likely not going to reap the profits of future rallies.
Remember, mature markets tend to correct less deeply than young and immature markets.
Don't expect Dow Jones to retrace more than 62.8% before finally making a recovery rally. If it does, then that would be a better buying opportunity than the last low of 6,469 or a discount of 54.44%.
SnP went down 57.74% from 1576 of Oct 2007 to 666 of March 2009. I was expecting SnP to be able to test a 62.8% retrace or the 600- level since it is not as mature as the Dow Jones, but that remains to be seen at this stage. SnP will still have to suffer a deeper consumer spending crunch as this spiralling unemployment rate takes it's toll.
Meanwhile, I started buying stocks in earnest in Late Feb to early March 2009 specially Financials or BKX components which suffered 85.53% retrace from $121 in 2006 to $17.75 in March 2009. BKX went down 8 months ahead of the Dow Jones and SnP and is expected to be in the first in - first out category.
A discount is a discount is a discount.
We may never be able to see this "Investing Opportunity of the Century" in our lifetime again!
In this context, any mildly competent speculator can certainly do much better elsewhere so only those who are conforming and risk-averse remain. The result is a conforming risk-averse (in terms of tracking error) portfolio that yields the index (which is neutral) minus the fees.
"Dow Jones made a rally from $42 in 1932 to $12,000 in year 2000. A massive 28,470% price appreciation over 68 years. Or an average of 418% price increase per year"
is completely wrong.
Shoot, just go thought it. 418% is more than quadrupling per year. If that didn't ring any alarm bells, then certainly just some quick calculations should have. If we quadruple for 1 year, end amount is $160, then $640 after another year, then $2560, then $10240, then $40960. Oops, we've more than doubled, more like tripled, the amount of the peak of the dow, and that only took us 5 years.
It confirms my philosophy, which has served well for decades, of buying my own stocks directly and never buying mutual funds. On average, over long periods, prudent individual investors should outperform most actively managed stock mutual fund for two reasons:
(1) Annual mutual fund fees over a decade penalize you by about 15%, and by as much as 50% over three decades.
(2) Most stock mutual funds have a mandate to buy stocks whenever they have net cash inflows, even if stock prices are stratospheric, hence unsustainable. Ironically, during bubbles, more people send them cash, and the fund average acquisition price of stocks tends to be skewed by greater buying near bubble highs. The inverse is true for selling during market troughs. By contrast, I've had no problem selling when I think prices are above intrinsic values, and holding cash for long periods (like 1997-2002 and 2006-2008); and I buy heavily when I think prices are reasonable (like 2002-2003 and 2008-2009).
I think one beneficial result of the current correction will be a downsizing of the bloated mutual fund sector. This should benefit the economy as a whole, and improve corporate governance as more individual stock owners vote their own shares instead of entrusting fund managers to vote on their behalf.
I simply divide the 28,470% by 68 years for a yield of 418% average per year for an initial investment of $42.
And the yield for $42, with no compounding is 418% per year. On the first year, profit from $42 would be 418% average. On the 2nd year, profit from the same $42 would be 418% - and so on and so forth.
Initial investment is $42 in this example. Nothing more than $42 investment, nothing less than $42 investment. Year in year out for 68 years.
No compounding. Initial investment never went over $42. Profits did.
On Apr 12 08:26 AM Tatertot wrote:
> aarc:
>
> "Dow Jones made a rally from $42 in 1932 to $12,000 in year 2000.
> A massive 28,470% price appreciation over 68 years. Or an average
> of 418% price increase per year"
> is completely wrong.
>
> Shoot, just go thought it. 418% is more than quadrupling per year.
> If that didn't ring any alarm bells, then certainly just some quick
> calculations should have. If we quadruple for 1 year, end amount
> is $160, then $640 after another year, then $2560, then $10240, then
> $40960. Oops, we've more than doubled, more like tripled, the amount
> of the peak of the dow, and that only took us 5 years.
CNBC isn't the only guilty party out there. Investors want answers so the various media outlets employ people who put forth answers. I get a kick out of the evening analysis of why the market moved the way it did that day. An honest person would answer "Damned if I know.". There are so many factors that influence the stock markets each day that is a display of ignorance to pretend that you know why the market moved.
For the most part, I don't select stocks any more. I use my timers and buy broad market ETF's. Fortunately, my timers got me out of the market in June, 2008. My portfolio beats most fund managers but I'll never be invited on CNBC because I know that I don't know!
On Apr 12 07:03 AM aarc wrote:
> Dow Jones made a rally from $42 in 1932 to $12,000 in year 2000.
> A massive 28,470% price appreciation over 68 years. Or an
> average of 418% price increase per year.
uh, that's like an 8.7% annual rate not 418%.
On Apr 12 10:21 AM aarc wrote:
> Yes, you are right with compounding. Dow Jones could be in the $7.3
> raised to the 43rd power. That should be in the range of gazillions
> already.
>
> I simply divide the 28,470% by 68 years for a yield of 418% average
> per year for an initial investment of $42.
>
> And the yield for $42, with no compounding is 418% per year. On
> the first year, profit from $42 would be 418% average. On the 2nd
> year, profit from the same $42 would be 418% - and so on and so
> forth.
>
> Initial investment is $42 in this example. Nothing more than $42
> investment, nothing less than $42 investment. Year in year out for
> 68 years.
>
> No compounding. Initial investment never went over $42. Profits
> did.
But why would you want to view it that way? We are all aware that compunding has a powerful effect on the outcomes. Plus you method is not a "common" form of comparison. Why not just do the (more standard and) simple thing of calculating the effective annual yield so that we can compare apples to apples? The effective average APR is 08.6718%. With this we can now compare it to other investment vehicles.
HardToLove
On Apr 12 07:03 AM aarc wrote:
> Too much statistical analysis.
>
> Let's keep it simple.
>
> What is too obvious is that the US and the whole world has never
> have this "Crisis of the Century" since the Great Depression. <br/>
>
> Dow Jones went down from $470 in 1929 to $42 in 1932 for a massive
> haircut of 91%. It is understandable since the Dow Jones was a
> relatively young and immature market at that time.
>
> Look at China which is still a young and immature market. It went
> down 72% from 2007 to 2008 despite their strong balance sheet.
> Many smaller countries went down more than 80%. Russia, in particular,
> has been crushed.
>
> Look at Nasdaq, a young and immature index of the late 1900's. It
> went down more than 78% during the 2000 to 2002 tech meltdown. Dow
> Jones was able to symphatize with 40% haircut during the same period
> while SnP made a run down of 50%.
>
> Look at monthly charts of companies. Young companies tend to retrace
> or correct more than 62.8% while older companies tend to retrace
> less than that during recessions.
>
> Look at Dow Jones 100 year chart.
>
> Dow Jones made a rally from $42 in 1932 to $12,000 in year 2000.
> A massive 28,470% price appreciation over 68 years. Or an average
> of 418% price increase per year.
>
> Excessive?
>
> Yes, and Dow Jones is now paying for those 68 years of excess rally.
> SnP is younger than Dow Jones and has suffered more than DJ since
> year 2000 top. Nasdaq never left it's own "depression" since year
> 2000 top.
>
> What has been lost in this panic selling of the last 18 months?<br/>
>
> This is only the second time in the last 100 years history that we
> have an economic crisis of this magnitude.
>
> Those that did not invest during the 1930's and beyond did not reap
> the profits of the average 418% annual price appreciation of Dow
> Jones stocks over 68 years. Those that tried to chase the rally
> during the 80's, 90's, and early 2000's are now suffering from this
> massive market pullback not seen since the Great Depression. Chasing
> the rally is a fool's errant twice confirmed from year 2000 onward
> with the tech meltdown and now the housing mortgage meltdown.
>
> Likewise, those who are too afraid to buy in this "Sale of the Century"
> are more likely not going to reap the profits of future rallies.
>
>
> Remember, mature markets tend to correct less deeply than young and
> immature markets.
>
> Don't expect Dow Jones to retrace more than 62.8% before finally
> making a recovery rally. If it does, then that would be a better
> buying opportunity than the last low of 6,469 or a discount of 54.44%.
>
>
> SnP went down 57.74% from 1576 of Oct 2007 to 666 of March 2009.
> I was expecting SnP to be able to test a 62.8% retrace or the 600-
> level since it is not as mature as the Dow Jones, but that remains
> to be seen at this stage. SnP will still have to suffer a deeper
> consumer spending crunch as this spiralling unemployment rate takes
> it's toll.
>
> Meanwhile, I started buying stocks in earnest in Late Feb to early
> March 2009 specially Financials or BKX components which suffered
> 85.53% retrace from $121 in 2006 to $17.75 in March 2009. BKX went
> down 8 months ahead of the Dow Jones and SnP and is expected to be
> in the first in - first out category.
>
> A discount is a discount is a discount.
>
> We may never be able to see this "Investing Opportunity of the Century"
> in our lifetime again!
I repeat the system almost collapsed and was saved only through government intervention. .
On Apr 12 12:29 PM wisdom.vs.information wrote:
> Excellent article, great comments, except calling this the worst
> crisis since the New Deal Depression. Lots of youth and short memories--
> the economy was in infinitely worse shape in 1977 than it is now.
> 1962 to 1978 was one long bad experiment that went up then straight
> down. You are having trouble seeing it b/c, relatively, the economy
> sucked all the time in the 70's; I doubt you would even believe how
> much harder it was to start or grow a business then. Of course, if
> government spending and regulation continues to go up, the economy
> will become fundamentally unsound again...
I am curious about your perspective on volatility (however you choose to measure it) based weighting. It's one of the few valuable concepts I took away from the "Trend Following" books. Essentially, they weight their positions on the historical volatility of the underlying security. The end goal is to have equal risk instead of equal weight on each position. Although the volatilities will change over time, I am considering implementing this in my portfolio. Any thoughts on the long term effects of this?
Your comment on hedge funds beating the market is also based on poor research. Any data that would support an 18% loss for all hedge funds in 2008 is woefully incomplete with a positive bias from many sources ranging from survivorship bias to voluntary reporting bias to pie in the sky valuations. At least mutual funds, by and large, have consistent and accurate performance reporting.
Minor note: The $26 trillion figure is over a year old. The current worldwide market value of all mutual funds is probably closer to $15 trillion.
2) Interesting points about how managers overthink themselves into avoiding the 25% of the market that will deliver gains. I suspect that those 25% largely represent the riskiest stocks in the market, and/or micro-caps. Perhaps there is a bias against small, risky companies compared to big, deceptively stable companies like the former AIG, GM, and Lehman. Yet I still could never force myself to buy something like GM, except incidentally through an index ETF like VTI.
3) I also suspect that fund managers and individual investors alike gravitate towards stocks that are generating discussion. We're more likely to discuss companies whose products we are familiar with (GM, Exxon), that are generating news (WFC, BAC), or that are generating buzz on investment websites (mining & shipping companies, tech companies). This approach leaves investors with a massive blind spot that covers most of the real economy and, as the author says, median jumps. The approach also tends to select companies and industries in the low-growth "market maturity" stage of development.
4) The long-term difference between bond yields and stock yields is less than 3%. If your fees add up to 1.5% and your manager can be expected to underperform by 1.5% you've basically taken on higher risk of losses to achieve bond-like results. Perhaps small investors should just buy and hold ultra-low-expense bond ETFs like BND, AGG, or LQD and leave the whole stock-picking gamble behind. It's a tortise-and-the-hare kind of race - a marathon, not a sprint.
and its interesting too! :)