Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

The following was written in "The Noise Trade Approach to Finance" in 1990 by Andrei Shleifer and Lawrence H. Summers. Both are renowned Harvard economist.

If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile ... But the stock in the efficient markets hypothesis - at least as it has traditionally been formulated—crashed along with the rest of the market on October 19, 1987. It's recovery has been less dramatic than the market.

It is fascinating that after a price shock or crash, people realize inefficiency, yet others continue with this belief. To be sure, here are some reminders: (click titles to watch)

Greenspan Admits Flaw in His Beliefs: That Markets are Rational and Efficient

How Greenspan's Framework and Efficient Market Hypothesis Went Awry - Daniel Kahneman

Live as if you were to die tomorrow. Learn as if you were to live forever.

                                                             - Mahatma Gandhi

A happy man is too satisfied with the present to dwell too much on the future.

                                                                      - Albert Einstein 

Discovery consists of seeing what everybody has seen and thinking what nobody has thought.

          Albert Szent-Gyorgyi (Hungarian Biochemist, 1937 Nobel Prize for Medicine)

I am not a "Buffett hater" but I notice something that is interesting. Have you ever noticed, or wondered why, Warren Buffett's Shareholder Letters for Berkshire Hathaway report its "corporate performance" as Annual Percentage Change Year in Per-Share Book Value of Berkshire vs. the S&P 500 stock (price) index? 

That is, they compare their estimate of Book Value to the price change of the S&P 500 stock index. Have you ever wondered why? I wonder why they don't compare the Book Value of Berkshire to the S&P 500 Book Value and then compare the price return of Berkshire to the price return of the S&P 500 stock index? 

Does it make a difference?

Well, it seems 2008 was a year that made a difference for a lot of people. That is, they learned if their risk tolerance and/or risk capacity matched their investments. If we look at just that one year, the Letter to Shareholders shows a loss of just -9.6% for 2008 as they measure its Per-Share Book Value. But, if you look at the actual price performance, including dividends, it declined about -50% during 2008 and closed that year down around -30%. That's a bit more than -9.6%. 

Source: stockcharts.com

Most people just want what everyone else gets. The trouble is, in investment management that's not necessarily good. If most people have poor results, you may consider that it may necessarily mean that the majority do the wrong things.

For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputations to fail conventionally than succeed unconventionally.

-- John Maynard Keynes 

Mediocre: of only ordinary or moderate quality; neither good nor bad; barely adequate.

Eccentric: deviating from the recognized or customary character, practice, etc

Unconventional: not bound by or conforming to convention, rule, or precedent; free from conventionality

Those who believe it can't be done should not interrupt those who are doing it.

As time passes, investor behavior doesn't change as much as you may think.

There is a lot of buzz about "program trading" and "the machines". They get the blame for the recent market volatility. 

The truth is, 5% daily swings is more likely a sign of indecision and people panic selling on down days and panic buying on up days. As I said in a prior post, people mostly oscillate between the fear of missing out and the fear of losing money. Fortunately, they create trends for me.

To put things in perspective, I suggest watching the first 10 minutes of Wall Street Week episode hosted by Louis Rukeyser from Friday October 23, 1987. That was just after the stock market crashed down 22.61% on Black Monday October 19, 1987 when the stock indices. Louis Rukeyser said:

...will be remembered as a day when computers went wild and through the wonders of so-called program trading turned a normal correction into a early Halloween

This time isn't different. Rather than trying to figure out what's going to happen next and who or what can be blamed, I suggest people accept that markets are risky. The only way to deal with it is to actively direct and control risk by increasing and decreasing the possibility of loss. It seems to be those who don't direct and control their risk that do the blaming on everyone but themselves. 

Click on the video below. I miss that ole' boy.

A great truth from Trend Commandments:

For the last 30 years, there has been a sophisticated marketing campaign, boosted by an even more sophisticated political lobbying campaign, all designed to convince everyone attached to the matrix that they could do no better than guessing or throwing darts, so in turn just “invest all of your money in mutual funds and hold on for the long term” (long term is never usefully defined of course; it could be your death). For a man who has the numbers against him, Fama remains defiant in the face of his intellectual defeat. Recently he was asked this question about technical trading (read: trend following): “Some researchers argue that a market-timing strategy based on buy/sell signals generated by a 50- or 200-day moving average offers a more appealing combination of risk and return than a buy-and-hold approach. What is your view?” Fama responded: “An ancient tale with no empirical support.” Clearly, Fama has no answer for the reality of trend following performance. He would rather commit Seppuku—a form of Japanese ritual suicide—than admit an error. He would rather die with honor than fall into the hands of superior market wisdom.6 Having lived through the financial crisis of 2007–08, the man in the street knows markets are not efficient. But the Efficient-Market Hypothesis, like a Hollywood monster, has proved very hard to kill off.7

Fortunately for you, there is a way out. There is inspiration. The great trend followers are not academics, magicians, charlatans, or pedigreed investment bankers. They are self-starter entrepreneurs who, through concentration, drive, and fierce independent streaks, have cultivated that rare knowledge to mint money. Trend following proves daily that the Efficient-Markets Hypothesis has more in common with Scientology, versus any useful trading enlightenment. Understand the comparisons made herein. It’s all part of you interpreting the puzzle.

Source: Covel, Michael W. (2011). Trend Commandments: Trading for Exceptional Returns (Kindle Locations 1197-1200). FT Press. Kindle Edition.

From my post last week "An interesting performance incentive fee" came several conversations about incentives and what motivates people. I was reminded of the thought-provoking book "Drive: The Surprising Truth About What Motivates Us" by Daniel Pink. 

An interesting animation about it: (click the video)

Outcome bias is the tendency to judge a decision by its eventual outcome instead of based on the quality of the decision at the time it was made. Investors and traders often experience pain from outcome bias - as if what they know today could have been known then. Nicholas Taleb gives an interesting alternative:

One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).

Nassim Nicholas Taleb, Fooled by Randomness.

I was talking to my friend Joe O. today about my lifelong search for the truth about asset management when he made one of the best comments I've heard in a long time.

Any lie has to have an element of truth in it to get you to bite the hook. The bait that wraps the hook is the truth, but the hook is the lie.

The only way the devil can get you to believe something is to have some amount of truth to it.

What the devil said to Eve was close enough to what God said to her that she went for it.

You can’t distinguish what a lie is unless you know the truth.

Wow... have a great weekend!