Monday, May 29, 2017

Investment Success Dependent on Having Goldilocks’ Peers and Avoiding Confirmation Biases


Long-term investment success is much more dependent on people than the elements within a portfolio. This is my conclusion after studying both investments and investors. Everyday there are "learning moments" in watching and trying to understand behavior.

“Goldilocks’ peers”

Last week's blog briefly mentioned the running of The Preakness and the focus on the first three horses. I failed to point out the interaction among the first three across the finish line. While there were other horses in the race, the first three were jockeying for position with “Goldilocks' peers” for the winner (from the fairytale “Goldilocks and the Three Bears”).  The winner benefited from this interplay as the two leading horses were expending a great deal of their energy on dueling each other for the lead in the relatively short home stretch. The exertion tired them a bit and allowed the well-positioned horse under an expert jockey in the final steps to rush past the first two that were tiring. I am guessing that the race would have turned out differently if either the stretch battle or the positioning of the eventual winner was further back.

I apply these observations to competitive investing within assigned investment objective leagues. Thus, a good investment analyst of performance should understand each of the likely competitors strengths and tactics. Just focusing only on one's choice is insufficient. The eventual performance winner says as much about the peers as about the winner, but far less noted by the pundits.

Recently my associate Hylton Phillips-Page and I used portfolio structure data on fixed income from our old firm now known as Lipper Inc. In the fixed income world there are fewer investment objective leagues than in the equity universe, so there needs to be deeper analysis. I was interested in understanding why two different short-term funds were not among the leaders. What we quickly found was the league that they were being measured in had a wide assortment of different strategies being used. The maturity and quality constraints on the funds in question were much more severe than the bulk of the competitors. Thus in the current bond market the funds that were allowed to take more maturity and credit risk were producing better near-term results. Thus the owners of these funds were handicapping their choices. However, this could well be appropriate as these funds in the owner's constellation of fund holdings were designed to be reserve elements against a major bond and stock market decline. When we narrowed our view to funds that were similarly constrained, the tactical skill and relative expense ratios were more than appropriate. Thus for the owner's vantage point the key is to examine the constraints applied and not the specific choice of funds.

Confirmation Biases

(With the exceptions of the focus on mutual fund performance and the analysis of five leading securities the following thoughts and quotes are from a recent article of Farnamstreetblog.)

Often what passes for considered judgment is actually a summary of our memory. The problem with that is our memory is selective at what it retains. C.S. Carroll said "We are what we believe we are." From an investment standpoint, Warren Buffett's quote is very insightful: "What the human being is best at doing is interpreting all new information so that prior conclusions remain intact." (Luckily, according to Charlie Munger, Warren is a learning machine.) Through the ages there have been similar quotes from Tolstoy, Francis Bacon and all the way back to the ancient Greeks by Thucydides. As an appropriate warning to today's investors is the latest advice from Charles Schwab & Company:  "Investors  shouldn't get too caught up in the political wranglings with respect to investment decisions....but remain focused on your longer term goals." Perhaps the best way to identify the power of our biases is a poem by Shannon L. Adler which follows;
Read it with sorrow and you will feel hate.
Read it with anger and you will feel vengeful.
Read it with paranoia and you will confusion.
Read it with empathy and you will feel compassion.
Read it with love and you will feel flattery.
Read it with hope and you will feel positive.
Read it with humor and you will feel joy.
Read it without bias and you will feel peace.
Do not read it at all and you will not feel a thing.

One of the persistent biases we are subjected to is that Large cap funds under perform "the market." Those that spout this probably have never read a full prospectus. Rarely are funds designed to beat a securities index chosen by a committee to represent the market. From their inception, mutual funds were designed to convert savings into an investment program to meet eventual funding goals. These goals included some attention to periodic declines in the market and the need for daily liquidity and reasonable costs.

What I find of interest is that I have not seen a single media mention of the following:

Through May 25th , 2017, the year to date average of the S&P 500 Index fund is up 8.53%.

Investment objectives which doubled the 8.53% above to 17.06%, including funds that did better and worse than average, were as follows:

Global Science & Tech.                 
India  Region
Science & Tech
Pacific (ex-Japan)                               
China Region
Emerging Market                               

Quite a number of the much maligned Large-cap funds owned some of the five tech stocks that produced over half of the S&P 500 gain.

More interesting to me is that the longer maturity Mixed Asset funds also beat the market. For example the Target Date 2055 funds averaged +9.65% plus the Mixed Asset Aggressive Growth allocation was up +9.62%. In addition the average of the Target Date funds with maturities between 2035 and 2050 beat the market, Further, the average Emerging Market Local Currency Debt fund was up +8.74%.

I am not suggesting that a bunch of mutual fund portfolio managers suddenly took smart pills. What I am suggesting is that the market is dynamic and there are usually opportunities to wisely invest in funds.

The dominance of global and domestic Science and Tech has been mentioned above.  Also mentioned is confirmation bias. Biases are short cuts to prolonged thinking and occasionally difficult judgments. I am concerned that these two streams of thinking may collide soon. As previously noted five tech companies represented over half of the stock price gains of the S&P500 so far this year. They are Apple, Alphabet (Google), Microsoft, Amazon, and Facebook. Note that three of these were prominent in our discussion last week on Berkshire Hathaway and Sequoia Fund. My concern is that there may well be  confirmation biases at work due to the use of shortcuts to analytical judgments at work here and particularly by the media. Four of the five leaders have over half of the revenues from what is deemed to be a single source. (Facebook 97% from ads, Alphabet 88% ads, Amazon 72% products, and Apple 63% iPhones.) Without any specific knowledge of these companies, just based on my historical memory as an electronics analyst, all of these will eventually see a decline in some of their revenues from these identified sources. When and if this happens perhaps their stock prices will decline. From my viewpoint this could be a good buy point as all five of these companies appear to have promising developments underway. One may have to be patient due to the short cutters’ disappointment  which follows a quote from Robertson Davies "The eyes sees only what the mind is prepared to comprehend."
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A. Michael Lipper, CFA
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