Sunday, February 21, 2016

Avoid Incomplete Data + Overconfidence


Far too many investment mistakes can be blamed on incomplete data and overconfidence. In the real as distinct from the theoretical or academic world it is difficult to avoid these traps that have hurt us from time to time. The best that we can do is to be aware of the traps and to avoid putting too much confidence as to “what we know.”

Focusing on the Wrong Measurement Gaps

Perhaps Larry Summers was reading my blog post when we I was questioning the validity and perhaps the utility of building government and financial policies on Gross Domestic Product. My concern is that there is little or any attempt to include unreported income within GDP. The former President of Harvard, Secretary of Treasury, and frequent pundit stated that he wished to abolish large denomination currency bills, for instance the $ 100 dollar bill and similar sized notes in other currencies. His view is that these pieces of paper are mainly used by those involved within the higher echelons of the underworld. At least with that projection I believe he is largely accurate. But he is missing a far more important set of facts published by his own organization. The Harvard Kennedy School found that the US Tax Gap on unreported income was 14.5% of reported tax liabilities in 2006. Other countries have different degrees of shortfalls: UK 6.4%, South Africa 23%, Bangladesh 36%, Thailand 53% and Pakistan 70%. On a global basis someone at the UN felt that the global tax gap was $2.1 trillion.

As far as I know, no one has taken these tax gaps and other less than complete estimates to adjust various GDP figures. Any student of high end purchases should question the sources of the money spent and saved. I have felt that observing the inhabitants of leading countries might be a more valid factor than what one could derive from government statistics. Since ancient times as soon as many people became wealthy in their own eyes and after fulfilling the needs for conspicuous consumption they found acceptable ways to both invest and to hide some of their wealth. They have been doing this long before there were paper currencies. Abolish paper and there will be substitutes, physical and perhaps electronic.

My real concern is that the growing size of the hordes of large currency is probably the best clue as to the size and growth of unreported income. One expert believes that some small businesses and trades people could approximate 50% of their activities as transacting below the tax radar. As a student of both history and human behavior I do not expect radical changes in behavior. What I am concerned about is almost every top/down pontification by political and financial pundits starts with a verdantly express view as to what GDP will do in the immediate future, and therefore various proposed actions are appropriate. Yet the statistical base of their argument is inaccurate and possibly seriously flawed.

Thus until governments around the world massively increase the money they spend on gathering and analyzing their data, Professor Summers please do not now take away an important source of the growth of real world wealth just yet.


Just as I believe that high confidence in GDP and many other government statistics is unwise, our uncritical confidence in future actions should be avoided. This is very tough to do. In our very busy lives we do not have time to cognate about future implications of present or past actions. One of the characteristics of the human race is the ability to convince others. Those that are better at this than others are our marketers. They often start with given themes for their targets to choose. The salespeople have learned to keep their pitches compact, or in their language “Keep It Simple, Stupid” or the KISS principle. That doesn’t always work out well. As a professional investor or perhaps a surviving professional skeptic, I need to always guard against the exhilaration of an enthusiastic pitch.

Washington’s Mistakes

We can always learn from properly portrayed history. Saturday night my wife Ruth and I attended the birthday celebration for General George Washington at his Mount Vernon home as we try to do each year. Saturday night’s principal speaker was Nathaniel Philbrick, who talked about his forthcoming book Valiant Ambition, on the implications of the interactions between General Washington and Major General Benedict Arnold, an eventual traitor to America who could have caused the US to be militarily defeated. The interesting part of the discussion was the author’s contention of Washington’s ability to learn from his many mistakes. He changed his strategy from one of highly confident and occasionally well-executed battles in my home state of New Jersey and less successful battles elsewhere, to an eventually successful war of attrition that was increasingly unpopular in England.

Our Own Historical Experiences

I am always trying to learn. As a long-term investor with a fiduciary responsibility I need to be on guard as to the power of our own historical experiences. We should look well beyond our own experience to those of others in different times and places. At some point in the past, based on their experience, too many home buyers, underwriters, and mortgage owners thought that house prices would only periodically stay flat or rise, never decline. (I have not read the book or seen the film “The Big Short, which I am told is excellent. I have been reluctant to see it for it does not place the original cause for the collapse at the feet of the US Congress.) Obviously, with 20/20 hindsight it is clear all the way along the chain there was overconfidence. Part of the KISS principle in selling this paper was the growing population and their supposed growing wealth. Often one heard “Demographics is Destiny.”

Some of the same argument has been put forth for investing in Emerging and Frontier markets particularly in securities of consumer discretionary companies. In many cases these pitches drove the valuations for these securities way above those of somewhat similar companies in the developed world before they recently corrected. This is not to say that they may now be more realistically priced. (Some of these stocks are found in some of the mutual funds that we own for clients and ourselves.) The vastly reduced level of confidence and increased level of investment research improves the long-term odds for those that are patient.

At the moment I am wondering whether there is a nexus of incomplete data and recently-experienced overconfidence. There is a well documented rush to own passive index funds either through mutual funds or through companion Exchange Traded Funds (ETFs). For those who own these securities there is a high level of confidence that history will repeat itself and these vehicles will perform relatively well. The incomplete data part of the picture deals with off board trades, the aggregate size of the intraday trading long and short, the financial condition of the market makers and authorized participants that can create and contract the size of an ETF. Further correlations within markets are widening with very few large cap stocks rising and pushing major indices higher whereas the majority of stocks within the S&P 500 declined in 2015. Other signs of changing demand include an increase in the level of the VIX. Further, over the last sixteen years bonds out- performed stocks, while some believe that for the next sixteen years stocks are expected to outperform bonds.

Change in the structures of demand for securities is likely to cause a change in the structure of the market that was not anticipated.

Question for the week if not the year: What changes in the structure of the market are you prepared for?
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