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Armando Alizo
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Armando Alizo is a senior technology manager with over 20 years experience in the development of financial and trading systems. Mr. Alizo has a BA in Physics from Cornell University and an MBA from Nova-Southeastern University. Areas of expertise include: Development, testing, and... More
  • The Expert Myth 4 comments
    Mar 23, 2011 9:34 PM | about stocks: SPY
    Last year David H. Freedman authored an excellent book titled WRONG: Why experts keep failing us--and how to know when not to trust them.  In the book he catalogues all the myriad ways that so-called experts in almost all fields have led us astray. 

    Investment advice is a field particularly prone to "expert error" for a number of reasons.  These include the fact that there is a great degree of randomness in observed results - this makes it difficult to distinguish real ability from plain old luck.  Many authors have pointed out that simple probability analysis indicates that a certain number of individuals will have great track records simply as a matter of pure chance.

    So how can you be sure that an investment of financial advisor is providing valuable advice?  While there are no guarantees, I would certainly prefer someone with a record of market beating performance over someone who has performed poorly.  Yet, it constantly amazes me how many individuals present themselves as knowledgeable advisors, but do not have (or prefer not to have) an independently verifiable track record. 

    Whether it is contributors to "Seeking Alpha", or one of the many other websites dedicated to investment "advice", how many of those posting opinions also have a verifiable track record?  Very few!

    In the financial arena, sometimes exceptional track records are built on taking exceptional risks.  The case of Bill Miller, the manager of Legg Mason Value Trust (LMVTX), comes to mind here.   Mr. Miller was the darling of financial media in the 1990's as he "beat" the S&P500 for many years while making millions doing so.  Unfortunately, the 2000's weren't as kind to Mr. Miller and his fund had a Maximum Daily Drawdown of -72.54% in 2008 - much worse than the overall market. 

    Let's look at his statistics and compare them to those of simply buying an S&P500 Index Fund:

    Legg Mason Value Trust (LMVTX)
    From 12/31/1989 to 12/31/2010
    Total Gain:                            +427.41%
    Maximum Drawdown:           -72.54% on 03/09/09
    Comp Ann Return (CAR):       +8.24%
    Ulcer Index (UI):                       21.23
    CAR/UI:                                      0.388%

    S&P 500 Index Fund (VFINX)
    From 12/31/1989 to 12/31/2010
    Total Gain:                           +435.96%
    Maximum Drawdown:            -55.25% on 03/09/09
    CAR:                                        +8.32%
    Ulcer Index (UI):                       17.44
    CAR/UI:                                      0.477%

    So over the past 20+ years Mr. Miller has underperformed the results one would have obtained by holding a simple S&P 500 index fund, and he has done so while taking on 20% more risk, whether measured by the Ulcer Index or Maximum Daily Drawdown!

    Now it should be noted that his underperformance did not place without a good amount work.  A 2009 article in Barron's magazine states that:

    "Miller says his form of value investing takes 'both worlds seriously.' He invests 'in businesses, not just stocks' and tends to hold shares for a long time -- usually about five years. His portfolio, he explains, consists of names that are 'cyclically mispriced' (traditional deep value) as well as stocks that are 'secularly mispriced.' All the securities trade at a discount to the firm's assessment of their intrinsic business value. He defines that as the present value of the future free cash flows."

    Now I don't know if Mr. Miller has a team of analysts to help him do all this "analysis" of "intrinsic value" or whether he does it himself.  I am sure that many hours or work were invested in reviewing company financials and growth estimates.  Yet - and this is the critical point - if the purpose of all this analysis was to produce an investment strategy that produced better than average risk adjusted returns, then it was a dismal failure. 

    From my standpoint the take away is clear:  Things aren't always what they seem, and there is no substitute to an unbiased empirical approach to investing and trading.  While there are no guarantees, you must test everything and assume nothing!

    Happy Trading.

    P.S. If you would like to see the latest independently verified results my own trading strategy please click on the link below:

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    _______________________________________________________________
    DISCLAIMER:
      We take care to assure accuracy of contents but accuracy is not guaranteed. My posts express my opinions, and are provided solely as a supplement to your own further research. It is each reader's responsibility to decide which, if any, opinions or recommendations are suitable for their own situation, and in what manner to use the information. Past performance is not a guarantee of future results.
    Stocks: SPY
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Comments (4)
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  • Author’s reply » I received an interesting query as a result of this post, namely: Had we analyzed the performance of LMVTX in the 1990's, would it also have been obvious that Mr. Miller's performance was due to taking on added risk? This is a valid question, since conceivably his performance might have been superior during the heyday of the largest Bull market in our lifetimes.

     

    Here are the stats:

     

    Legg Mason Value Trust (LMVTX)
    From 12/31/1989 to 12/31/1999
    Total Gain: +582.90%
    Maximum Drawdown: -29.03% on 10/08/98
    CAR: +21.18%
    Ulcer Index: 6.76
    CAR/UI: 3.13

     

    S&P 500 Index Fund (VFINX)
    From 12/31/1989 to 12/31/1999
    Total Gain: +417.35%
    Maximum Drawdown: -19.20% on 08/31/98
    CAR: +17.86%
    Ulcer Index: 4.47
    CAR/UI: 3.99

     

    So the answer is clear: While absolute returns for LMVTX were higher, on a risk adjusted basis (CAR/UI) the S&P 500 still outperformed Mr. Miller during the 1990's Bull Market.

     

    I guess that it just goes to show the mood of "irrational exuberance" that prevailed in the 1990's. In spite of underperforming in terms of return vs. risk, LMVTX was still praised at the time for its "market beating" performance.
    4 Apr 2011, 09:25 PM Reply Like
  • Hi Armando,

     

    This was a very good, insightful article. This should be required reading for all investors, because it points out the unintuitive nature of the markets. Human nature is to seek out the "hot hands" and (especially for mutual fund investors) chase performance.

     

    Praveen Puri
    simple-trading-system..../
    6 Apr 2011, 02:46 AM Reply Like
  • Author’s reply » Thanks Praveen. As you mention, markets often work in an unintutive fashion, and what apparently "makes sense" often doesn't!
    6 Apr 2011, 07:29 AM Reply Like
  • Author’s reply » For those of you that are not familiar with the Ulcer Index (UI), here is some background information from Peter Martin's website. Peter is the developer of the UI.
    www.tangotools.com/ui/...

     

    "What is the Ulcer Index?
    Ulcer Index (UI) is a method for measuring investment risk that addresses the real concerns of investors, unlike the widely used standard deviation of return (SD). It is a measure of the depth and duration of drawdowns in prices from earlier highs.

     

    Using UI instead of SD can lead to very different conclusions about investment risk and risk-adjusted return, especially when evaluating strategies that seek to avoid major declines in portfolio value (market timing, dynamic asset allocation, hedge funds, etc.)"
    7 Apr 2011, 02:55 PM Reply Like
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