Sunday, June 15, 2014

Good Investment Outcomes Can Lead to Poor Investment Results


In last week's post I mentioned that much of what I have learned about investment analysis I learned at the racetrack, and that a bet on California Chrome while understandable, was a bad bet from a rate of return basis. Some have asked me what about handicapping, the term used for analyzing horse races that I find so appealing. My initial response was that within the half hour between races one could make a thought-out decision and shortly thereafter you learned whether you were right.

As with most rapid response answers this one was not fully responsive for it focused only on results. The real benefit from handicapping races at the track, particularly with knowledgeable other people, is not about their choices but rather observing their well-reasoned thinking. After the race there was often a post-mortem on what we did not fully appreciate in the past performance tables we studied. In the case of the Belmont Stakes the very fast workout a few days before the race by California Chrome was combined with the fact that the eventual winner was more rested than the favorite, as it did not run in the Kentucky Derby. Another item that should have factored in the analysis was that there were a few more horses entered in the race than normal for the Belmont.

The above elements give greater depth to the results. Many who will follow the favorite's future races will focus only on the disappointing results or blame the jockey for a bad ride; for instance California Chrome’s jockey who described his colt as "empty" when he urged a final stretch run. I would suggest that when rested at equal weights California Chrome will be difficult to beat in the future. (Until we get more current information.)

The failure to separate outcomes from critical analysis   

A quick focus on outcomes is often used to confirm one's own thinking without looking at it as an opportunity to search for other elements of useful wisdom. One of the differences between a number of investment committees and professional investors is that investment committees want simple definitive answers that they can extrapolate into the future. The manager or fund that did not meet or beat the assigned benchmark failed, and should be replaced in favor of more promising candidates. Races are often won or lost due to the unexpected element of “racing luck” which is unlikely to be repeated in the future.

Avoiding habit-based decisions

In the current market environment of an aging bull market (980 trading days without a 10% correction), “racing luck” might be attributed to an unexpected merger or acquisition announcement. Just as a professional jockey keeps his mount out of trouble and does not fruitlessly exhaust his/her horse, a prudent portfolio manager exercises appropriate risk management. Good jockeys don't run every race the same way. They avoid habit-based decisions in trying to find new ways to win races.

In looking at various races one should be looking for what is the preferred length of the race for each horse in the race. Some are very good at short distances and try to hold on for mid distance races. Others are using a race as a warm up for a richer, longer race in the future.

Parsing the analyses

As subscribers to these posts have learned, I am a believer in breaking up a single portfolio into at least four sub-portfolios based on the expected time-span to meet the investor’s and particularly the institution's needs.

The definitions to the four Time-span Fund Portfolios are listed in my blog post last week, click here to read.

If one assigns each position to one of the sub portfolios then one can make a more incisive analysis as to whether the securities’ results are likely to be delivered against the needs of the account. Just as at the track one should separate sprinters from middle distant and longer race horses.

Another factor that one can take away from the track (particularly when looking at fillies and mares) is whether they may be good brood mares. Many believe that the male line provides the stamina and the female line the racing ability. Numerous individual and institutional investors want to hire a manager that will work with them for many years or a couple of generations. Thus, they should look at the ability to develop replacements for their key players which should include portfolio managers, analysts, traders, critical administrative personnel, and beyond.   

Other sources of good and bad investment results

If the only source of investment expertise is distilled from going to the races, there would be huge crowds at all the tracks all the time rather than the sparse crowds that normally show up. One contribution to another important element can be gleaned from a Barron's
article by Stephen Mauzy, who I don't know. In his article he describes investing as entrepreneurial rather than formula driven. He suggests while risk could be considered probabilistic, uncertainty is where the opportunities lie. The entrepreneur type of mind is used to dealing with uncertainty and the good ones thrive on it. We prefer, when possible, to invest with managers that are entrepreneurial in nature and in shops of a similar nature.

The source of what may turn out badly are some very bright people who are quite numeric, according to a New York Times interview, where the subject stated, "There's a lot of behavioral psychology around the fact that the smarter you are, the easier it is for you to make up metrics that make you think you are doing the right thing.” 

The biggest risk: the Operational (Cash) Portfolio

There is not meant to be any risk or at least very little in the most secure of the four Time-span Portfolios, the Operational Cash Portfolio. While we are used to taking risks in venture or disruptive type equity portfolios, we believe that our operational needs are completely secure in the portfolio that is set-up to fund immediate needs. The problem is as long as the Federal Reserve and other Central Banks keep manipulating interest rates so short-term interest rates are close to nil, there will be experimentation at getting elevated rates on this supposedly secure money. Probably nothing will happen, but even a potential loss of one to five cents on the dollar will cause a great deal of stress on the operating people in the family or non-profit institution. The stress from this disappointment is likely to be more intensively felt than the satisfaction from prior gains achieved from stretching. In the real world this is the difference between genuine analysis and outcome focus. So be careful, particularly now.

Whether your observe Fathers Day or not, as with horses we all have gotten a great deal from our fathers which I hope you celebrate. 

How are you safe-guarding your short-term capital accounts? 
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