I am in the process of writing a short book on investing in businesses based on competitive business dynamics, moat depth and duration. The book will most likely have an audience smaller than my immediate family. So for those of you not related to me here is the introduction.Let the monkey beatings begin.
Occasionally a bored business publication, goes to the zoo, rents a monkey and pits them against a few professional mutual fund managers. Lo and behold the monkey who doesn't know his high end from his low PE often beats a significant number of the mutual fund managers. The monkey’s technique for stock selection typically involves darts thrown at a board or some other random rocket science method.
As the monkey contest goes, the monkey picks up steam roundly proceeding to beat more managers. Soon the room starts to smell foul, like evolution has crawled out from a dark place and is now running in reverse. The managers squirm and start to consider how one might discretely shoot a fast moving little monkey in a crowded place.
So what is causing this monkey effect? It obviously isn’t the fact that monkeys are so good, it is the fact that most fund managers are really that bad.
Fund managers are bright, articulate people who can tell exciting yarns about stocks, products, statistics and how they understand how the economy works. If you are lucky the manager may throw in some free policy or political advice at no extra charge, although it is usually on offer after the 18th hole and the 5th scotch.
Most fund managers have an expensive education and have spent years studying markets, charts and each other. Mutual Fund managers get paid extremely well. Mutual Fund managers suck.
If fund managers new how bad they were, they could avoid the suck factor and rise to the level of mediocrity represented by the monkey. Instead fund managers cling to their belief systems and behaviors, secretly day-dreaming of beating monkeys.
As of 2009 there were 7,600 mutual fund managers. And for every one of the 7,600 aspiring monkey beaters, there are probably 100 people aspiring to become aspirational monkey beaters. That is over 750,000 people who would like the chance to get very well paid to beat the monkey.
These aspiring would be monkey beaters wish to do so working on behalf of 178 million US equity fund account holders who trust them with managing $11 trillion dollars. The majority of these 178 million account holders are also desperate to beat the monkey or at least keep up with the little bastard.
So who is this Mysterious Monkey? Believe it or not you hear about his shenanigans and adventures every day. The way most journalists describe the monkey, he gets up to a lot more crazy stuff than Curious George ever dreamed of. During a single week, some of the World’s brightest journalist will report that the monkey has followed Europe down because of some silly number, crashed due to an industrial accident, risen due to the wandering eye of foreign investors, exploded out of euphoria about a re-calculation of a rather suspect factoid from a US government agency. To hear it told, he is an active little lad and one must pay attention at all times, to his sneaky and surprising goings on.
Journalists never report the Monkey mucking about for no reason. That’s not news, doesn’t grab attention and sell newspapers, Viagra, page views or sticky eyeballs. For those not in on the gag yet, those in the stock market commentary business are in the attention & story telling business, please enjoy the show. Next to nuclear war and social security, non-index mutual fund stock market investing is probably one of the most expensive forms of collective entertainment the human race has ever created.Monkey’s are mediocre
Mediocre is a serious word, its earlier etymology from the French in 1580 means, “of, or in the middle.” In statistics there are lots of ways of saying middle.
- The mean is what most of us think as the average, the sum of value divided by the number of values.
- The median is the numeric value separating the higher half of a sample, a population, or a probability distribution, from the lower half
- The mode is the number that occur most frequently. A trick to remember this one is to remember that mode starts with the same first two letters that most does. Most frequently
- Monkey magic is how the little hairy fella beats fund managers. I am just checking to see if you made it through the list.
The monkey is effectively the stock market index. There are lots of ways of constructing indexes, you probably think about the Dow, S & P 500, or are still upset about sock puppets and why the Nasdaq hasn’t returned to its dot-com glory days.
The monkey index we are going to talk about is the mean performance of shares. Take a bunch of shares put an equal amount of money in them and see how you do. That is the monkey technique. Why can’t managers beat this?
Monkey Magic happens when the mean and median aren’t the same thing? What? What the heck does that mean? Well, like all good stories it helps to visualize it, and like all good authors I am going to cheat and use a diagram.
Below is a chart showing the lifetime return of shares. Notice something weird? Out of 7,595 companies 1 out of 5 was either a hero or a zero -75% or +300%. 3 out of 5 were somewhere in the middle.
chart is sourced from Blackstar funds and reflect data from 1983-2007.
One of the dangerous things mutual fund managers do is to act on their confidence as a way of expressing their ignorance. Apathy would be a much safer posture. Mutual fund managers concentrate their bets on their "best" ideas or firms. Those concentrated bets reflecting deep research are intended to banish the monkey to 2nd place for ever. The Monkey doesn’t know any better and so allocates naively getting the median return.
The manager has a little problem as he concentrates his bets focusing his lack of knowledge ever deeper. That little problem is called Siegel’s paradox, don’t worry your broker and fund manager haven’t heard of it either.
Without out knowing better you would assume that playing the game over and over, the fund manager would “average” out or have a mean return equivalent to the monkey. It doesn’t work out like that. Siegel’s paradox literally means you get eaten alive bite by bite due to bad concentrations.
The problem is that losses and gains aren’t symmetric, the stock distribution is skewed against you if you naively concentrate versus the index.
At a certain point a loss doesn’t equal a gain in the long term outcome of this game. Think about it like this, you invest for a year, losing 50% of your money due to a focused bet. To make your money back you would need a 100% return.
Looking at the pattern of returns and losses it’s pretty easy to tell what is going on, bad focused fund manager bets combined with the return distribution of the available stocks mean the monkey wins. During an extreme bull market this effect could be reversed if the distribution shifted.
The detailed data set isn’t shown here, but basically for every 90% loser there aren’t enough 1,000% winners to make up for it. Or crudely, with the data here, you have a 20% chance of losing more than 75% and a 20% of making more than 300%. A 75% loss needs a 400% gain to break even so that 300% return leaves you short. The full data isn't shown, here but trust me this is what keeps the monkey in the drivers seat.
The very act of focusing one’s bets as a manager, mean’s Siegel’s paradox when drawn from this distribution eats the manager alive by producing wider swings in returns. It only happens at a 1-3% a year rate for your manager which you are probably paying 1-1.5%. If you have 20 years to retire, that is an expensive manager relationship you've got going there. Rent a monkey.
Now here is the funny part. For the rest of this book, I am going to be talking about focused bets and how to beat the market monkey. I used to push a tiny amount of money around for a hedge fund and beat the monkey by 50% during the credit crunch luck or skill, your call.
I just wanted to get some things out of the way first. Now lets beat that monkey...