Avoid Incomplete Data + Overconfidence

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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Patience Can Be Expensive To Your Portfolio

In a recent blog post, I made the statement that patience can be expensive. This thought became clearer to me after reading a number of third quarter reports that were, in effect, apologies for performing so badly. In essence, the apologists were intoning the message that fund managers buy securities well below their estimated intrinsic value. These so-called “bargain purchases” did not hold up very well in the dramatic decline in the third quarter. They were praying that their investors be patient and it will turn out alright in the end.

Premature purchases

Over the last couple of months, members of this blog community have received my views that we should be investing in Asian equities. Since these calls for action were prior to the very recent bottoms, by necessity I practiced some patience before the recent upturn. This last volatile week I was early once again, purchasing some shares in UK money managers and brokers. Luckily for me, I had only to wait until the end of the week to see positive, albeit slight, gains. I did not have to exercise patience for long. The point here is that it may be okay to be a little premature.

Long suffering patience

In contrast to my brief pain for being premature, one needs to look at the funds that are pleading for investors to be patient. In some cases they have underperformed their own identified targets 1,3,5, and 10 years. The insistence that their performance numbers will come out ahead is based on the fact that over the time since inception, these multi-billion dollar portfolios have very attractive results.

When should impatience take over?

In discussing this briefly with my sage wife Ruth, she warns that impatience can be worse than too much patience. This is all too true; for example if we had dumped our clients’ Asian fund holdings in September, or my personal UK asset management stocks early in the week. What could have compounded either error would have been not investing at all or investing in the wrong vehicles.

If you take the attitude that each day you repurchase your holdings, you should examine the research case for buying your positions today. As we live in a very dynamic world, I am getting increasingly impatient with the same rationale for buying into similar names today as what I heard 1, 3, 5, and 10 years ago. The absence of new fundamental, analytical support other than “price has made something cheaper,” is not reassuring. Some of the relatively poorer performance players have recognized these concerns; they have detailed a portion of their staff to produce the "Bear case" for their holdings. In a number of cases, the more traditional managers are attempting to learn from long-short hedge funds. Another approach is to rotate the analytical coverage of the names in the portfolios. I have yet to see much relative improvement in funds applying these techniques. (I could be too impatient.) Those analysts and portfolio managers trying the new approaches may be too junior in their organizations to have their opinions lead to prompt action.

Trading Markets vs. trading “The Market”

Most long-term investors desire to have quasi permanent holdings of securities or at least similar investment objectives. These people may very well feel that for the past ten years we have been in an essentially flat market as measured by the securities indices, therefore they have been right not to make changes, as “the market” has not spoken with clarity and force. They are going to wait patiently until it does.

At the race track, one of my two learning institutions, horses who come from behind do occasionally win, if they can get to the lead by the known finish line. With our race for acceptable returns, we don’t know where the finish line is. Yes, we do know what various “gate keepers” and fiduciaries want to see in their periodic reports. However, we don’t know when that all important breakout or breakdown reporting will be. That is the time when patience will run out and results without excuses will determine whether the institutional relationship will continue.

Multi fund managers and accounts

For those of us who have the fiduciary responsibility for these accounts, we need to deliver acceptable performance. In the best cases, we need some demonstrable winners and only a relatively few managers that try our patience. Bearing in mind Ruth’s warnings on the natural impatience of those in the market, we should periodically prune those formerly good-to-great funds that beg for our patience. We can hold a few of these if they can supply current reasons to believe that their holdings will work, but each year we should eliminate or rotate out those that do not.

What do you think?
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