Introduction
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.
Overconfidence
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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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
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