Wildness Lies in Wait
By John Mauldin
May 2, 2005
The Problem of Propaganda
Information Versus Accuracy
Horse Racing and the CIA
Free Books, Red Sox and Old Friends
This week we look at the "The
Triumph of Irrational Expectations over Long Run Experience."
It is a cautionary tale, but enjoyable in the telling, and one
that investors almost invariably ignore to their own chagrin.
Also, at the end of this letter, I tell you how to get a free
coy of Andy Kessler's book, "How We got Here." This
is a book you want to read and then give to your kids.
This past weekend, I along with my partners at Altegris Investments
sponsored a conference for accredited investors. In addition
to a number of investment managers, attendees heard from Richard
Russell, Paul McCulley, Rob Arnott, Andy Kessler and Mark Finn,
as well as yours truly. We recorded the main sessions, and in
some future letter, I will tell you how you can get a copy of
their speeches for your listening pleasure.
I will spend the next few weeks going over some of the
key concepts that we heard at the conference (and add a few comments
of my own, and a point or two where I might disagree, of course).
We're going to first address a speech by Mark Finn, entitled
"Propaganda, Miracles and Past Performance," with the
subtitle as noted above: "The Triumph of Irrational Expectations
over Long Run Experience."
Mark Finn of Vantage Consulting has spent years analyzing trading
systems. He is a consultant to large pension funds and Fortune
500 companies. He is one of the more astute analysts of trading
systems, managers, and funds that I know. He's put more start-up
managers in the business than perhaps anyone in the fund management
world. He has a gift for finding new talent and deciding if their
ideas have investment merit.
He has a team of certifiable mathematical geniuses working for
him. They have access to the best pattern recognition software
available. They have run price data through every conceivable
program and come away with this conclusion:
Past performance is not indicative of future results. And that
was the thrust of his speech.
Actually, Mark says it more like: past performance is pretty
much worthless when it comes to trying to figure out the future.
I would note that past performance has its uses, but agree that
predicting the future is not one of them.
Yet we all (including me) get caught up in looking at past performance.
Today we'll look at Mark's thoughts on why that is and what we
can do to stop. Let's start with a quote from G. K. Chesterton.
(I suggest you read it twice, once to catch its meaning and once
for the beauty of the phrasing).
"The real trouble with this world of ours is not that it
is an unreasonable world, nor even that it is a reasonable one.
The commonest kind of trouble is that it is nearly reasonable,
but not quite. Life is not an illogicality, yet it is a trap
for logicians. It looks just a little more mathematical and regular
than it is; its exactitude is obvious; but its inexactitude is
hidden; its wildness lies in wait."
The Problem of Propaganda
Past performance is the most misused statistic in investments.
Mark lays part of the blame for this at the feet of propaganda,
but not the type of propaganda that we would associate with political
movements - it's far more subtle.
There are two types of propaganda. There is "hot" propaganda.
Hot propaganda is rumor with the volume turned up. It is someone
screaming that "butter is bad" without having to prove
it. "Cold" propaganda uses authoritative sources to
back its assertions. Cold propaganda relies on facts and logic.
Hot propaganda relies on innuendo, often trying to create anxiety
or concern where a more rational observation would find neither.
For propaganda to be at its most effective there needs to be
a steady flow of it. Even if an item is not true, if it is repeated
long enough and by enough sources, especially if it is through
trusted sources, it can become accepted.
Propaganda plays on our anxieties. For instance, let's look at
the anxiety we have about our investments. If we have had recent
poor performance, and we hear something negative about our current
investments, do we not become more anxious? Propaganda tries
to create a sense of urgency. We are told, "This investment
opportunity, will only be available for another two weeks. Get
in now before it goes away forever."
Of course the opportunity may in fact be going away in two weeks,
and it may be a very good one, but that sense of urgency can
short-circuit our normal rational thought process if we are not
careful.
Propaganda takes advantage of several types of psychological
processes. First there's a principle of generality. Think motherhood,
apple pie and Lassie. When something has a positive connotation,
we are less likely to give it the full scrutiny that it deserves.
We feel more comfortable with it. An example would be hedge funds.
Five to ten years ago you almost had to apologize if you introduced
a hedge fund to a private investor. The term hedge fund was fraught
with negative connotations. While there are still "issues"
about hedge funds with much of the mainstream press, hedge funds
have a more positive connotation today than in the past. And
that means it's more likely we will use past performance as the
main basis for our hedge fund selection, just as most investors
use past performance as the primary criteria for the mutual fund
selection. (More on this topic later.)
Then there is the bandwagon effect, where the more we see our
friends and other people do something, the more we feel the need
to participate. How often do we come to a street corner, and
when someone crosses against the red light, we and everybody
around us joins in? That person has "given us permission"
to break the rules. In the excellent book "The
Tipping Point" by Malcolm Gladwell, he writes about
this "permission" process in detail. Joining the crowd
is part of our human nature and is a powerful psychological motivator.
Then there is a problem of transfer. We take one set of past
facts and transfer it into a potential new reality. It's a variation
of the ever-popular "what if?" game. Specifically,
we look at the past performance of a mutual fund, hedge fund
or other investment and project those returns into the future
of our investment portfolios. What if I had done this one year
ago? Or worse: What would my portfolio look like in one year
from today if I could get returns like those in the last year?
There is no human being on earth that has not done this. It is
warp and woof of our human nature.
Mark then focused for a minute on hedge funds. In one sense,
investors had an advantage a few years ago. The track records
of most hedge funds were very short and there was very little
positive propaganda. Thus, everyone approached hedge funds cautiously.
That is beginning to change today, and Mark (and I) see this
as a potential problem. An investor should never be complacent
about any investment, let alone hedge funds. It is simply part
of human nature that long track records (past performance) give
us an inappropriate sense of confidence.
Information Versus Accuracy
Mark then refers to an essay by Richards J, Heuer, Jr. entitled
"Do You Really Need More Information?" It was published
in a book called "Inside
CIA's Private World: Declassified Articles from the Agency's
Internal Journal 1955-1992." I wrote the following about
this article last October;
Buried among articles in the book on how (and how not to!)
spy is this rather straightforward piece on what to do with the
information you get and the problems with objective and accurate
analysis that are caused by our human thought process. The essay
is quite timely, even though it was written in the spring of
1979. While reading the critique, one could not help but wish
that it would be required reading at the CIA today. Perhaps we
could have avoided a few problems. But that is a topic for someone
else. Our beat today is thinking about money. (All quotes are
from the article. If you are interested in the complete article,
you can go to http://www.cia.gov/csi/books/19104/
and/or click here).
I am guilty. Mea Culpa. I am constantly researching, looking
at (sometimes obscure) data, trying to discern patters and trends.
But what to do with all of it? How do we filter it into useful
and investable ideas?
"This article challenges the often implicit assumption that
lack of information is the principal obstacle to accurate intelligence
estimates... Once an experienced analyst has the minimum information
necessary to make an informed judgment, obtaining additional
information generally does not improve the accuracy of his estimates.
Additional information does, however, lead the analyst to become
more confident in his judgment, to the point of overconfidence."
Horse Racing and the CIA
Heuer describes a study done about betting on horse races. They
took 8 professional handicappers (someone who sets the betting
odds based on calculations of the outcome of a contest, especially
a horse race) and asked them to rank 80 different pieces of data
about a horse race as to what they thought was most important.
Do you factor in the jockey's record as well as the recent record
of the horse? The weather? The competition? How much weight is
the horse carrying? What is the length of the race? There are
scores of variables.
Then the handicappers were given what they felt was the five
most important pieces of data and asked to project the winners
for a race (actual names and races were not given, so as to not
bias the projections). They were also asked to rank their confidence
about their predictions.
Now it gets interesting. They were then given 10, 20 and 40 pieces
of what they individually considered to be the most important
information. Three of the handicappers actually showed less accuracy
as the amount of information increased, two improved their accuracy,
and three were unchanged. But as a group, their accuracy did
not improve and in fact was slightly down.
But with each increase in information, their confidence went
up. In fact, by the end, their confidence has in fact doubled.
If they had actually been at the track and betting, would they
have doubled their bets as they became more confident? Human
nature says "yes, they would." But that confidence
would not have made them any better predictors. They just doubled
their bets which magnified their gains or losses. Think of it
like adding leverage to your stock portfolio.
"A series of experiments to examine the mental processes
of medical doctors diagnosing illness found little relationship
between thoroughness of data collection and accuracy of diagnosis."
Another study was done with psychologists and patient information
and diagnosis. Again, increasing knowledge yielded no better
results but significantly increased confidence.
The inference is clear and quite important: "Experienced
analysts have an imperfect understanding of what information
they actually use in making judgments. They are unaware of the
extent to which their judgments are determined by a few dominant
factors, rather than by the systematic integration of all available
information. Analysts use much less available information than
they think they do."
How can this be? Heuer notes that individuals tend to: " ...overestimates
the importance he attributes to factors that have only a minor
impact on his judgment, and underestimates the extent to which
his decisions are based on a very few major variables... Possibly
our feeling that we can take into account a host of different
factors comes about because although we remember that at some
time or other we have attended to each of the different factors,
we fail to notice that it is seldom more than one or two that
we consider at any one time."
As I wrote in Bull's Eye Investing, "The two most common
biases are overoptimism and overconfidence. For
instance, when teachers ask a class who will finish in the top
half, on average around 80 percent of the class think they will!
Not only are people overly optimistic, but they are overconfident
as well. People are surprised more often than they expect to
be. For instance, when you ask people to make a forecast of an
event or a situation, and to establish at what point they are
98 percent confident about their predictions, we find that the
correctness of their predictions ranges between 60 and 70 percent!
What happens when we are only 75 percent sure or are playing
that 50-50 hunch?"
(As an aside, an excellent book to read on intuition and hunches
is called "Blink,"
again by Malcolm Gladwell. I may do part of an e-letter on this
book in the future. I highly recommend it).
So how can we overcome the problems of propaganda, over reliance
on past performance and overconfidence? Mark gives us a few clues.
First we should study failure. In order to be able to differentiate
between success and failure we need to know what both look like.
It is surprising how difficult it is to tell success from failure.
Sadly, success and failure often look a lot alike until the failure
event, which in hindsight we all think we recognized (another
human psychological weakness). If it were easy to see failure
in advance, no one would invest in any enterprise that one could
see was going to fail. Studying past failures gives us clues
as to the signs for which we should be looking in advance.
Secondly, we should systematically interview managers in massively
out of favor spaces. We need to keep ourselves familiar with
the potential areas of investment which are currently the "dogs"
of the market. Think commodities, gold and energy only a few
years ago. Now they are everybody's darling. Even if you don't
invest in it you should know about it. The time will come when
today's dogs will be tomorrow's top performers. Sometimes it
takes 20 years, as in the case of gold or commodities, for investment
to begin the long crawl back to the top.
I would add it also pays to think about those investments which
everybody currently loves. We all know that nothing stays on
top forever. Not only do we want to avoid being in such an investment,
which is getting ready to go down, but there are also opportunities
to take advantage of a drop in prices.
Next he tells us to beware of experts. He gave a great quote
from Thomas J. Watson, who was chairman of IBM in 1943: "I
think there is a world market for about five computers."
Experts overestimate their own edge. They have so much data they
fail to see the randomness component in their assumptions. I
am not saying that experts do not have some inherent disadvantage
relative to non-experts; however, it is the case that experts
often believe that they have it "figured it out." They
fail to see that the market prices and marginalizes their insights.
It is their familiarity with the subject that sometimes breeds
overconfidence. They often fail to see that as G. K. Chesterton
noted: "wildness lies in wait." It is the lion crouching
hidden in the tall grass, waiting to surprise us, that we should
be concerned about.
"...Life is not an illogicality, yet it is a trap for logicians.
It looks just a little more mathematical and regular than it
is; its exactitude is obvious; but its inexactitude is hidden;
its wildness lies in wait."
This is not to say that you should not rely on the advice and
expertise of counselors. It is a simple fact that modern life
is so complicated that we do indeed need experts. We also need
to realize that they are human. Solomon tells us that there is
wisdom in multiple counselors. That seems like good advice to
me.
Finally, Mark points us to what he calls "reduced clue analysis."
We need to focus on a few simple things, thinking about the context
of the problem (or investment opportunity) and controlling the
frame of the questions. Does the investment or fund have the
opportunity to make money in the future, or has all the profit
been wrung out of an opportunity? Is it at the top of its path,
or just ready to set out on a new upward course?
A brilliant manager who focuses on an area in which there is
only a small opportunity cannot work miracles. That is why relying
on past performance is so dangerous.
We should also focus on what "edge" any individual
manager brings to the table. And never forget to ask, "Where
is the manager's money?"
I wrote the following paragraphs in my chapter on "due diligence"
in Bull's Eye Investing:
"The most important thing to understand about a fund is
'Why' it makes money. If you cannot understand the 'Why' of a
fund, you should not be investing. This is the critical question
that will help you understand what the dominant factor in performance
of the fund is: skill or luck. As I stated earlier, luck always
runs out, typically just after you invest. More funds are based
upon luck or random chance than you might think, but I can guarantee
you no fund manager will admit it, and most of them would be
insulted if you said so. Genius is a rising market, and good
performance has persuaded more than one manager they are geniuses.
Avoiding such genius is crucial to capital preservation. Finding
true investment ability (genius or not) is the secret to capital
growth.
"The next most important question is 'How' the fund makes
money. What are the strategies and systems used, and what is
the risk taken? If you can get a good feeling about those two
questions, then you follow up with the more mundane but critical
questions of 'Who,' operational issues, structure, safety of
assets and, of course, performance."
Now a little full disclosure is called for here. I'm very good
friends with Mark, and we have looked at more than one fund together
over the years. I know for a fact that he actually does look
at past performance, albeit within context. I posed the following
thought to him: "Past performance does have its uses. Among
other things, it allows you to see how a manager did in a given
set of economic and financial circumstances. You must recognize
that it is not likely that the manager can repeat that performance,
unless he has the same set of economic and financial circumstances.
Past performance can also give you a clue as to the risk management
techniques of individual managers."
He shot back with, "I don't want to give people the idea
that past performance is ok. It is an addictive drug. It is like
going to the Betty Ford Clinic and telling people it is okay
to drink in moderation. It just gives them an excuse to go out
and start drinking again. Nobody I know can use past performance
appropriately. It is just too big a narcotic."
Free Books, Baseball and Old Friends
As for the free book I mentioned at the beginning of this letter,
my friend Andy Kessler has written a dynamite book called "How
we Got Here: A Slightly Irreverent History of Technology and
Markets." Expanding on themes first raised in his tour-de-force,
Running Money, Andy Kessler unpacks the entire history of Silicon
Valley and Wall Street, from the industrial revolution to computers,
communications, money, gold and stock markets. These stories
cut [by an unscrupulous editor] from the original manuscript
were intended as a Primer on the ways in which new technologies
develop from unprofitable curiosities to essential investments.
"How We Got Here" connects the dots through history
to how we got to where we are today. The book is well written
and fun. You can get a free PDF download of the book at http://andykessler.com/hwgh.html.
Or you can pre-order a copy (for June delivery) at Amazon.com.
I highly recommend this book for your kids, especially those
already in or getting ready to go to college.
My very good friend John Dawson, who is President of Youth With
A Mission, (the world's largest missionary organization), is
spending a few days in my home. It has been a few years since
we have been in the same part of the world. Having him here reminds
me how important friends are in our lives, and how easy it is
to let "busy" get in the way of the more important
work of staying in touch. We will catch up, watch the Red Sox
play the Rangers and go see Hitchhiker's Guide. John is an uncle
to my kids, and we will all have dinner on Saturday. It will
be a good week. Family, friends, sci-fi and baseball. How much
better can it get?
Your 'leaving the office early for a change' analyst,
April 30, 2005
John Mauldin
email: John@frontlinethoughts.com
Mauldin Archives
Copyright ©2005
John Mauldin. All Rights Reserved.
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