Your Inner
Spock
November 15, 2003
John Mauldin
Bringing
Out Your Inner Spock
Solving the Mutual Fund Problem
What a Tangled Web We Weave
A Little Emotion is a Good Thing
On the Home Stretch
And a Little Due Diligence
Why do we continue to make
the same classic investing mistakes, generation after generation,
throughout the world, in all times and in every culture? It is
as if history has no meaning for each new age, yet it is there
for all to read. We explore this and more in today's letter.
But first, let me offer a few
observations about the current mutual fund scandals. I find it
interesting that the funds which are the target of investigations
still have 90% of their assets. To illustrate this point, I will
first offer an insight about hedge funds. In the hedge fund world
in which I mostly reside, if a manager leaves the fund, the tendency
is to shoot first (redeem) and ask questions later. If there
is a rumor of a problem, head for the exits. It is exactly opposite
of stock trading strategy. In the hedge fund world, you sell
on the rumor and buy on the news. It doesn't make any difference
to the managers of the fund of hedge funds who have about 1/3
or so of all hedge fund assets. "Kill them all and let God
sort them out," is the attitude. Since it takes several
months (end of the quarter) to actually redeem from these funds,
the knee-jerk reaction is to send in your redemption notice and
then ask questions later.
That is in contrast to the
average mutual fund investor, who seems to tolerate the scandals
at their funds.
First, if a senior manager
leaves a fund in which I am invested or following, that is a
HUGE red flag for me, and should be for you. Ask questions immediately,
and if you don't get the answer you like, then exit. The answer
better not be, "We will soon find someone to take over the
fund and make it better." Where are they going to find a
budding All-Star manager to come in and take over a sinking ship?
And if there is new management, then whose track record are you
buying? What will he do that is different?
I would politely suggest if
you have money with a fund whose manager has just been fired,
especially for breaking the law, that you redeem from the fund.
Do it now and avoid the rush. If you like that style, then invest
in another fund with another fund family that has the same style
of investing. They just do it honestly. You have lots of choices.
I do not believe that there
is a pervasive systemic problem in the mutual fund industry.
The vast majority of managers and funds are well run and very
ethical.
There are clearly some bad
apples, though, and they need to be sorted out and soon. If you
allowed late trading, we should be talking jail time.
Market timing of mutual funds
is currently a legal practice, but if you showed your actual
portfolio to hedge fund managers or large investors and then
allowed them to trade and time, you should be required to seek
a permanent job in another industry, far from the securities
world, and after you have paid stiff fines. There has to be a
level playing field, and the job of internal compliance and external
enforcement is to insure the field stays level.
If you tell small investors
that you do not allow market timing and then allow large investors
to do so, I have a major problem with that, and so will the authorities.
For what it's worth, it should come as no surprise that some
mutual funds have what I call "weasel word" policy
statements about timing in their offering documents. It makes
it seem like they are against timing but gives them the leeway
to actually allow it on a selective basis.
And it goes without saying
that a manager or people associated with the firm should not
be allowed to trade in their own funds. "Don't bother to
clean off your desk. Just send us an address to forward your
pictures" should be the response.
So what is the response of
the Investment Company Institute (ICI), the large mutual fund
lobbying group, to the scandals? Do they come out with proposals
to make things more even? Solutions to a problem?
No, the ICI is trying to use
this to get legislation which will benefit the funds and not
the investor. Now funds can impose up to a maximum 2% early redemption
fee, but they have to figure the actual costs to the fund from
an early redemption. If they are lower than 2%, and they almost
always are, then they are supposed to charge the lower of the
actual costs or the maximum 2% fee. In practice, it is my understanding
this is not done by many funds, which means those funds are in
violation of the rules. They now want Congress to give them the
mandate to require a minimum 2% fee (or more if the fund decides)
and extend the date past five days. Some funds suggest up to
90 days. This would solve their problem of not complying with
the current rules. Simply abolish the rule!
I have seen studies on the
actual losses suffered by investors. They are rather small in
the grand scheme of things, and certainly not on a par with the
great corporate scandals or the losses in a bear market. On an
industry wide scale, you could not justify a 2% minimum (repeat
minimum) redemption fee.
Further, they are suggesting
that buy and sell orders be at the funds by 4 PM Eastern, rather
than consolidated after hours. That would mean that if you had
a Schwab account, for all practical purposes you could not make
a switch after about noon and get that days price. How much could
investors lose by not being able to make trades closer to 4 PM?
It is a whole lot more than ever would be lost by the fraction
of 1/10 of 1% of trades that might have been made illegally after
hours. The investor friendly solution would be to clean up the
process and regulate the firms which consolidate the trades for
all the large brokerages. But that does not benefit the funds.
They know that to get later day trading privileges, many investors
would move their funds directly to the fund family platforms
and thus allow the funds to make more fees.
Solving
the Mutual Fund Problem
If you want to solve the problem,
ask for truly independent boards, which the funds will resist.
Remember, an independent board could fire the manager and leave
the fund family. In a legal sense, the fund is owned by its shareholders.
In practicality, it is run and owned by the fund managers. You
think they want to open up the possibility that an independent
board could take a fund from a Fidelity manager to a Vanguard
manager, or vice versa? That the board might shop fees?
Further, you can get rid of
much of the problem by eliminating the "time arbitrage."
Simply mark you funds to market on a more active basis. If you
and I can do it on a free Yahoo web site, it is not all that
difficult for funds to do so as well. Of course, it might require
them to invest a few dollars in some software and servers. Rydex
now allows inter-day trading on some funds, which are actually
very complicated in terms of pricing, as opposed to the average
mutual fund. These Rydex funds are set up specifically for the
purpose of timing. Why not other funds?
The good news is that the US
Senate and House is busy trying to get a host of legislation
out before Christmas, and will probably not have time to focus
on this. A rush to take the powerful ICI lobbyist proposals would
hurt investors. Cool heads will hopefully prevail and real reform
will emerge. Representative Baker and his committee in the House
are especially thoughtful and serious about reform and protecting
the small investor. Let's hope we get some fresh air next session.
At the end of this letter,
I mention a web site where you can get a paper on how I do due
diligence on funds and managers. While specific to what I do,
it has broad applications in the principles of analysis of any
investment. Many have found it worthwhile.
Bringing
Out Your Inner Spock
As some of you have reminded
me, today is the self-imposed deadline for finishing my book.
I am missing it, but not by too much. So, instead of writing
another few hours on this letter, I am going to return to one
of the last chapters and see if we can get the book done by next
Friday. Today, I offer you a brief portion of the material from
a chapter on behavioral psychology and investing.
It will come as no surprise
to learn that much of the reason that investors repeat the mistakes
of their forebears is that humans have not evolved into some
new specie called Homo Investus. We are still subject to the
emotional pulls and pushes that motivated our ancestors from
times even before the Medes were trading with the Persians. We
make the same mistakes because the emotions with which we have
been endowed were ideal for hunting and gathering, or living
in small agrarian communities, but create problems for us when
we take those skills to the hunting plains of Wall Street.
This nest section is based
upon the rather substantial and very impressive research of James
Montier, the Global Equity Strategist for Dresdner, Kleinwort
Wasserstein Research based in London, England. He is the author
of the well reviewed and very readable (thus unusual in its field)
book called Behavioural Finance - Insights Into Irrational
Minds and Markets. He has produced a large body of work
analyzing numerous books, studies and research papers on the
neurological and psychological reasons for our investment decision
making process. Rather than quoting his works at length, he has
graciously consented to let me use a few of his papers as the
base for this chapter. I have edited and added a few illustrations
and examples, but the bulk of the material and conclusions is
the fruit of years of his concentrated research.
We spend much of the early
part of the chapter analyzing the reasons we are the way we are.
I will pick us up in the middle of the chapter where we examine
5 guidelines (out of 11 in the chapter) for overcoming common
investor mistakes that stem from these our basic psychological
make-up. These are all associated with the problem which come
from self-deception.
What
a Tangled Web We Weave
Economists frequently assume
that people will learn from their past mistakes. Psychologists
find that learning itself is a tricky process. Many of the self-deception
biases tend to limit our ability to learn. For instance, we are
prone to attribute good outcomes to our skill, and bad outcomes
to the luck of the draw. This is self attribution bias.
When we suffer such a bias, we are not going to learn from our
mistakes, simply because we don't see them as our mistakes. Furthermore,
we make up reasons to deceive ourselves
The two most common biases
are over-optimism and over-confidence. For instance, when
teachers ask a class who will finish in the top half, on average
around 80% of the class think they will!
Not only are people overly
optimistic, but they are over-confident 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 situation, and to establish
at what point they are 98% confident about their predictions,
we find that the correctness of their predictions ranges between
60-70%! What happens when we are only 75% sure or are playing
that 50-50 hunch?
Over-optimism and over-confidence
tend to stem from the illusion of control and the illusion
of knowledge. The illusion of knowledge is the tendency for
people to believe that the accuracy of their forecasts increases
with more information. So dangerous is this misconception that
Daniel Boorstin opined "The greatest obstacle to discovery
is not ignorance - it is the illusion of knowledge". The
simple truth is that more information is not necessarily better
information, it is what you do with it, rather than how much
you have that matters.
This leads to the first guideline:
(1) You
know less than you think you do.
The illusion of control refers
to people's belief that they have influence over the outcome
of uncontrollable events. For instance, people will pay more
for a lottery ticket which contains numbers they choose rather
than a random draw of numbers. People are more likely to accept
a bet on the toss of a coin before it has been tossed, rather
than after it has been tossed and the outcome hidden, as if they
could influence the spin of the coin in the air! Information
once again plays a role. The more information you have, the more
in control you will tend to feel.
Over-optimism and overconfidence
are a potent combination. They lead you to over-estimate your
knowledge, understate the risk, and exaggerate your ability to
control the situation. This leads to bold forecasts (over-optimism
and over-confidence) and timid choices (understate the risk.).
In order to redress these biases:
(2) Be less
certain in your views, aim for timid forecasts and bold choice.
People also tend to cling tenaciously
to a view or a forecast. Once a position has been stated most
people find it very hard to move away from that view. When movement
does occur it does so only very slowly. Psychologists call this
conservatism bias (it can lead to anchoring which we will
discuss a little later).
In the book, we show a chart
which clearly shows conservatism in stock market analysts' forecasts.
We have taken a linear time trend out of both the operating earnings
numbers, and the analysts' forecasts. A cursory glance at the
chart reveals that analysts are exceptionally good at telling
you what has just happened. Their forecasts are clearly based
upon what has just happened. They have invested too heavily in
their view, and hence will only change it when presented with
indisputable evidence of its falsehood.
[Note: this confirms and somewhat
explains the earlier studies in this book which showed the rather
sad track record of analysts - John]
Investors should note that
these analysts are professionals. We tend to think of them as
accountants sitting around looking at tables, numbers and mind-numbing
mounds of data and coming to a rationally based conclusion. The
real view is that they are all too human and their humanity shows
up all to readily in their forecasts.
This leads to our third rule:
(3) Don't
get hung up on one technique, tool, approach or view. Flexibility
and pragmatism are the order of the day.
We are inclined to look for
information that agrees with us. This thirst for agreement rather
than refutation is known as confirmatory bias. The classic
example is a simple four card test. You are shown four cards.
Each card carries one alpha-numeric symbol. The cards you see
show E, 4, K, 7. If someone tells you that if a card has a vowel
on one side, then it should have an even number on the other,
which card(s) do you need to turn over to see if they are telling
the truth?
Most people go for E and 4
[Confession: I chose E and 4 - John]. The correct answer is E
and 7. Only these two cards are capable of proving they are lying.
If you turn the E over and find an odd number then the person
was a liar, and if you turn the 7 over and find a vowel then
you know they were lying. By turning the four over you can prove
nothing. If it has a vowel then you have found information that
agrees with my statement but doesn't prove it. If you turn the
four over and find a consonant, you have proved nothing. At the
outset the person stated a vowel must have an even number. They
didn't say an even number must have a vowel!
By picking four, people are
deliberately looking for information that agrees with them. Our
natural tendency is to listen to people that agree with us. It
feels good to hear our own opinions reflected back to us. We
get those warm fuzzy feelings of content.
This is all tied up in our
human quest for certainty. It is notable that we tend to associate
with those who think like we do and confirm the rightness and
wisdom of our judgment and views, whether on investments, politics
or religion. This only re-enforces the tendency to put in concrete
wrong views and notions.
Sadly, this isn't the best
way of making optimal decisions. Instead of listening to the
people who echo our own view we should:
(4) listen
to those who don't agree with us.
The bulls should listen to
the bears, and vice versa. You should pursue such a strategy
not so that you change your mind, but rather so you are aware
of the opposite position.
Our final bias under those
related to self deception is hindsight bias. It is all
too easy to look back at the past and think that it was simple,
comprehensible and predictable. This is hindsight bias - a tendency
for people knowing the outcome to believe that they would have
predicted the outcome ex ante or beforehand. The best example
I can think of is the US stock market over the last few years.
Now pretty much everyone agrees that the US market witnessed
a bubble, but calling it a bubble in 1998/99/00 was an awful
lot harder than it is now! This faith in our ability to forecast
the past gives rise to yet more bias towards overconfidence.
This gives rise to our fifth rule:
(5) You
didn't know it all along, you just think you did.
A
Little Emotion is a Good Thing
Before we depart this section
on self-deception, let's look at one way in which confidence
is actually necessary for investment success. Albert Wang in
an article in the 2001 Academy of Sciences Journal of Financial
Intermediation [Yes, there is actually such a journal - John]
also finds that modest self-deception may be an evolutionary
stable strategy. Wang uses evolutionary game theory to study
the population dynamics of a securities market. In his model,
the growth rate of wealth accumulation drives the evolutionary
process, and is endogenously determined (by that it means that
only the data and not some outside factors influenced the determination
of winners and losers). He finds that neither under-confident investors
nor bearish sentiment can survive in the market. Massively over-confident
or bullish investors are also incapable of long run survival.
However, investors who are only moderately overconfident can
actually come to dominate the market!
In the world of our hunter-gather
ancestors, over-confidence will get you killed. Lack of confidence
will mean you sit around and starve. Cautious optimism is the
right approach.
What Wang is showing is that
the same is true in the new world of investments. It should be
self-evident that it is necessary to play if you are going to
win. Further, a willingness to accept some level of volatility
and risk is characteristic of successful investors. But taking
too much risk will soon get you sent to the sidelines.
It is not merely a matter of
getting rid of your emotions. Like Spock on Star Trek, we all
need an emotional Captain Kirk to help us sort through or decision
making process. But a Spock-like detachment is something we need
to keep us from the knee-jerk moments. Other parts of the chapter
will show that without emotions we cannot make decisions. We
need them to be healthy and balanced as investors. The key to
successful investing is to be aware of the problems they cause
and to find ways to keep them in check. We need to bring out
our Inner Spock that is also part of our basic biological design.
Over the next few weeks we will look at some other guidelines
and some ways to deal with our emotions.
On
the Home Stretch
I really am close to finishing
my book. While it is exciting to see the end of the project near
at hand, it is even more fun to go through the chapters one by
one and feel happy about what I have done. I hope readers will
enjoy it as much as I have enjoyed writing it.
My bride has fled the state,
ostensibly to see her mother, but the more likely cause is to
avoid her obsessed husband, who mutters about nothing else other
than being through with this project. In an effort to induce
her to return, I will work long and hard the next few days (Weekend?
What weekend?) to put the final touches on this draft, so I can
ship the last chapters off to my publisher.
So with that, let me run. Oh,
I promised a paper on due diligence.
Analyzing investments and investment
managers is always a difficult task. To get an idea of how I
go about the work, I have written a chapter on Doing Due Diligence
on Hedge Funds. While this is specifically about hedge funds,
I think most of the principles involved will translate to other
investment areas in which you are involved. The work has received
good reviews from my peers. You can read it at www.accreditedinvestor.ws (click on due diligence).
That is also the site where if you are an accredited investor
(basically $1,000,000 net worth), you can subscribe to my free
letter on private offerings, hedge funds and alternative investments.
For complete details see the various sections on the web site,
including the section on risks. (In this regard, I am a registered
representative with the Williams Financial Group, an NASD member
firm).
Have a great weekend, and don't
follow my example. Spend some time with family and friends.
Your 'typing as fast as he
can [Editor's
note: And lonely?]' analyst,
John Mauldin
November 14, 2003
John@frontlinethoughts.com
Copyright 2003 John Mauldin.
All Rights Reserved
http://www.frontlinethoughts.com/printarticle.asp?id=mwo111403
John Mauldin
is president of Millennium Wave Advisors, LLC, a registered investment
advisor. All material presented herein is believed to be reliable
but we cannot attest to its accuracy. Investment recommendations
may change and readers are urged to check with their investment
counselors before making any investment decisions. Opinions expressed
in these reports may change without prior notice. John Mauldin
and/or the staff at Thoughts from the Frontline may or may not
have investments in any funds cited above. Mauldin can be reached
at 800-829-7273.
This information
is not to be construed as an offer to sell or the solicitation
of an offer to buy any securities.
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