Sunday, June 12, 2016

Investing with the Uncertainty Principle


Valuable insights can be derived from the same principle when making decisions for investing in securities and betting at the race track. While I am a senior trustee at Caltech, I do not claim to understand quantum mechanics. What I do recognize is that in 1927 Werner Heisenberg identified a way of thinking now called the Uncertainty Principle. He found that there is a fundamental limit to the precision of measuring unequal objects. Stripping out all the math, which is beyond me, the mere act of measuring the difference changes its precision. Translating this to my dollars and sense world means that the value of a comparison in terms of utility declines the more it is measured. In effect the more popular an analytical relationship becomes the less valuable it is.

One Successful Asset Manager’s Application

Marathon Asset Management of London starts a section in its well-written monthly report entitled: TOO MUCH INFORMATION, with a quote from T.S. Eliot. “Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?”

What Marathon is decrying is the frequency that the modern publicly traded company is supplying information to the market directly or through analysts and the media. This flow of information is augmented by trade associations and others’ intra-period industry data. Market prices move in the direction of the perceived value of the information only to be reversed often on the interpretation of the next morsel of information. This leads to stocks turning over much more rapidly than in the past. I have noted that the increase in individual stock turnover has led to a general increase in active mutual fund turnover. Unfortunately, this trend has not added to investment returns. 

Through June 9th on a year to date basis in the fund asset class identified as US Diversified Equity funds - with one exception - the two best performing groups were the Mid-Cap Value funds + 7.80% and Small- Cap Value funds +7.68% (S&P500 Index funds were up +4.23). What is more interesting to me is an almost double gain from the one exception of +13.00% for Equity Leverage funds. This suggests to me it is not the fund’s selection skills but the use of borrowings (margin) and derivatives. One would think we are describing hedge funds. However, two others fund performance statistics tell a more complete story: Dedicated Short Bias funds -14.20% and Alternative Long/Short Equity funds -0.10%. I have now transmitted to you too much information.

Marathon would believe that the information above is a dump not a filter in terms of data discrimination, giving equal weight to each factor. There was no attempt to fathom what is missing. (I have often found that what is missing from an investment proposal is more important than what is provided.) The frequency of information input or overload leaves little time for deep thinking and pondering not only what is missing, but what weight one puts on each factor considered and how much to value what is unknown. The last exercise is critical to avoid the single biggest contributor to large losses, overconfidence. The last step often leads to a decision not to do something. While not axiomatic, lower turnover funds produce higher on average results over long-term investment periods that we favor.

Unfolding Brexit Pictures

We have one more weekend before the referendum. I hope in next week's blog post to devote more space to its impact and probabilities. However, in reaction to last week’s blog plus some conversations I had at a meeting sponsored by the London Stock Exchange on the value of listing funds at that exchange, there are three thoughts that I would like to share:

1. Unless the spread between the Remain and the Leaves is greater than 10 percentage points, the odds favor other elections on this and related topics in the UK and within the EU.

2. Regardless of the result, the 2017 elections in both Germany and France will be impacted possibly in different directions.

3. The use of foreign political leaders and foreign media comments can prove that such outside influences are counter-productive to the mass of voters.

Has the Commodity Cycle Bottomed?

As noted above, the US Diversified Equity funds have produced low to middle single digit returns year to date. There are ten sector funds that are showing on average double digit returns. Not only are these Precious Metals funds +88.89% but also Energy, Base Metals, Agriculture and Infrastructure funds. Clearly these are recovering from deep multi-year bottoms. But when the average Sector fund is up+9.58% compared with the US Diversified funds’ gain of 3.26%  are the markets telling us something? This is exactly the kind of question that Marathon and I are both calling for some deep thinking. The data above was compiled by my old firm, Lipper, Inc., part of Thomson Reuters.

A Professional Analytical Pause

On most weekends I draft these posts on Sunday, but this week because a significant concert of the New Jersey Symphony Orchestra, I am beginning to draft Saturday afternoon. But I am going to suspend my scribing to watch the 148th running of the Belmont Stakes. For many track followers this is the single most important race for three year-olds. Its importance is similar to the senior prom in many US high schools. In both cases this one event will be remembered for a lifetime and a point of passage for these equine adolescents. In almost all cases this is the only time they will be asked to race for a mile and a half. The winner will initially be highly valued as a sire of future champions.

I will be watching not only from a racing standpoint, but also from an analytical viewpoint. Earlier in the week the weather looked for rain at race time. In theory this would have helped the favorite who has won in the rain several times in the past. The backers of the favorite were hoping for a repeat set of conditions and therefore results. This may be like picking a fund on the basis of superior past performance in down markets. But in each case for the very moment the question is how will the candidate do with a change in conditions?

Conclusions After the Belmont

As is often the case, lessons from one field have application in others. The race was won by a long shot meaning the experts and the bulk of the betters were mistaken. The interesting thing for me is the application of the Uncertainty Principle. It did rain right after the race, but that did not appear to be the deciding factor why the favorite (while close during the race) faded at the end of the race to finish almost last. If one filtered all of the past performance data and only looked at what could have been expected to be the interim best time at each leadership position, one could have deducted that this year’s Belmont Stakes had too much early speed and took the favorite too much effort to get to the front and couldn’t easily overcome the early leaders. In addition, there were a couple of fresher closers at the end.

From an investment point of view there were some lessons:
Past performance needs to be carefully analyzed and broken into components. The weight of past victories in terms of money earned was not a deciding factor. Finally, betting on future trends even when right, (the rain), the timing can be slightly off and not workout as forecasted.

In Summary

We should recognize that we live and must invest in an uncertain world. We need to focus on critical subsets of information. Finally our confidence should be measured to avoid overconfidence.

What do you think?
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