James Montier Looks at the Flaws of DCF Models
In this paper, James Montier points out the absurdity of using the Discount Cash Flows model to value financial assets. Our empirically proven inability to forecast cash flows far into the future and the extreme difficulty of defining a proper discount rate substantially limit the usefulness of the model. The author points out three alternative methods as a way to measure value. The paper is well worth the read in its entirety, but here is a quick summary of the main points:
The Underlying Dynamics of Momentum Investing
Momentum investing is based on the premise that past price performance is a good indicator of future price performance. Stocks with the highest relative strength over the past 3-12 months often remain among the best price performers over the next 3-12 months. The central idea behind this investment approach is to find an already existing price trend and a proper point of entry.
The stock market is a forward looking mechanism that constantly tries to discount collective expectations about the near-term future. Prices change when expectations change. Expectations change under the pressure of external factors, which I call catalysts. Catalysts represent new information that alters perceptions of value and boosts risk appetite, which have the potential to start a process of major re-pricing (new trend).
At the foundation of every major price trend there is either an improvement in fundamentals or (as it is in most cases) rising expectations for future improvement in fundamentals. From a bird’s eye view major changes in expectations for fundamentals are based on new social trends, business cycle, economic cycle or new regulations – all of them are sustainable sources of change and don’t just disappear overnight. This is what makes the existence of trends possible.
At the beginning of a new trend many market participants adjust slowly to new reality due to:
- Naturally ingrained conservatism. Many don’t change their mind when new facts start to appear and wait for additional confirmation before they act. Some wait for price confirmation as an evidence that other market participants have interpreted the new information in a similar way. Others wait for volume confirmation as prove of institutional involvement. The logic behind such thinking is that when institutions buy, they leave traces and if they don’t get involved, a new trend cannot be sustainable;
- Market participants are using different sources of information, take different time to analyze it and might come to totally opposing conclusions based on dissimilar investing/trading styles and time frames of operation;
- Disposition effect. Many market participants are looking for instant reward and feel fear against realizing losses. They are quick to sell winners and reluctant to sell losers, which essentially leads to slow reaction and under-discounting of new information.
The sustainability of surprises makes the existence of trends possible. In any given year, the best performing stocks are the ones that manage to surprise the most and most often. Every genuine surprise is a catalyst that changes perceptions of value and boosts prices. Several consecutive surprises in a row are needed to convince enough market participants that the underlying dynamics of the new trend are not going away any time soon. At this point the stock becomes an institutional darling and discounting becomes pro-active.
The common denominator between price and the underlying fundamentals is that they are both cyclical. The difference is that when institutions get involved, price volatility increases much faster than fundamentals’ volatility as the market tries to take into account any potential future surprises. The best case scenario, all the potential good news is getting discounted proactively. Investors like to discount both extremes. From overly conservative at the beginning of a new trend, they gradually become overly optimistic and overreact. Overreaction could be explained by dissecting the following three concepts:
- Herd mentality. Institutions have an incentive to buy the best performing stocks over the past quarter or two in order to sugarcoat statements to current and prospective investors. The real growth names are rare and everyone would like to claim in their prospects that they own them. This is what makes the stocks with the highest 3-9 months RS even stronger.
- Blind obedience to perceived authority results in a false sense of security. Investors often outsource their due diligence to people who are considered experts in their areas. While it is true that experts are more knowledgeable, have more experience and probably access to better sources of information, their incentives are not entirely clear. For example, analysts’ statements have huge impact on the market despite the fact that many of them have been proven to be lagging indicators. Their price projections are often based on: 1) the assumption that the existing earnings trend will continue infinitely and 2) simplified models that assume normal distribution of market moves in a complicated world full with outliers and fat tails. This often leads to projecting and discounting of an unsustainable scenario of growth.
- Bandwagon effect. Short-term traders may use the recent performance as a signal to buy or sell. Longer-term investors look at recent performance to confirm their convictions. The interactions between those participants might create price run-ups or –downs that can persist for many months until an eventual correction. Everyone is watching what the others are doing assuming that they know more (something). Price is considered as the ultimate sign that fundamentals are improving and will improve in the near future.
Finding a great trend is not difficult (at least in hindsight). Riding it and having a proper exit plan in place is the hard part. It is said that the difference between a great momentum investor and a good momentum investor is that the former knows how to time his exit properly.
What are some of the leads that might hint a potential danger to a great price trend:
- When the consensus opinion says that the only thing a stock can do is go higher, be careful. If everyone owns it, there are not many buyers left. There are always plenty of sellers as market participants, who operate on shorter time frames, are quick to sell their winning positions and lock in profits. Tops are formed when a stock runs out of buyers;
- Eventually the Wall Street printing press catches up with market’s demand by 1) issuing more shares of existing companies that are currently growing in an impressive pace and 2) underwriting IPOs of companies in currently popular industries. Don’t forget that investment banks are in the business of printing and marketing securities that are currently in demand;
- The appearance of negative earnings surprise or not positive enough one. When expectations are high and a stock is priced for perfection (another expression for projecting unsustainable growth), even the slightest disappointment leads to a sell off;
- Risk appetite vaporizes due to a macro event;
A Look at Value Investing
I have no doubt that value investing is based on inherently sound principles and it could be a source of consistent profits over time. I am not sure if it is a style suitable for everyone. It requires an amazing patience, an iron will to overcome naturally ingrained biases and a strong stomach to get over temporary setbacks. This is the good news for those willing to devote to this investment style. If everyone was practicing it, it would not be so profitable.
On the surface value investing looks like shopping. If an $80 shirt is suddenly on sale for $40, you got yourself a deal. Capital markets are actually quite different than consumer markets. There is a big difference between shopping for a shirt and buying a financial asset. If you are an end consumer, you buy a shirt in order to wear it. You have no intention to make money out of it by re-selling it or renting it out. You purchase a financial asset with a plan to profit from it by playing one of two roles:
- a retailer, who buys with the intention to sell for a gain later or
- an investor, who buys for the income in terms of capital gain and dividends.
In capital markets price volatility is much higher than fundamentals’ volatility. Stocks that drop from $80 to $40 look like a bargain, but they may continue to look cheap all the way to $20. The fact that an asset seems attractively priced doesn’t mean that it can’t go even lower. In theory such huge discrepancy between value and price should not exist as arbitrageurs should offset the extremes. In practice such an event occurs much more often than most investors are willing to admit. The job of a value investor is to figure out: why is the price down and why the market is not seeing the existing value? Is the reason behind the sell off fundamental or emotional?
Value investors base their market approach on the assumption that the economy and investors’ confidence are cyclical. They realize that in short-term perspective prices are heavily impacted by risk appetite, not by net asset value, cash flows or growth prospects. Occasionally emotions and biases become the main driving force of investors’ decision making. Experienced value investors know that recessions happen often enough to offer great buying opportunities and economic recoveries always follow. When they do, risk appetite comes back and prices rise.
Essentially value investors make a bet on the human nature – after all it hasn’t changed since the beginning of time. Market often acts irrationally as people forget all logic and become slave to their emotions. When people are in capital preservation mode, suddenly the return OF capital becomes more important than the return ON capital and investors rush for the exits at all cost. At this point there is not enough liquidity to meet the supply and prices might fall quickly. A patient value investor, who is also a good risk manager will come and will start to nimble, gradually building a position that he will sell later at much higher prices, probably to the same people who sold to him when they were scared.
I distinguish three basic approaches to value investing:
- very conservative: they don’t care about future cash flows and discount rates, because they realize that they cannot be forecasted with good enough precision. There is one important question to be asked -If I pay the current market price, am I going to make money in case this business liquidates tomorrow? They calculate the market value of all liquid assets; give a good 50-70% discount to the current book value of the inventory and fixed assets, assume that intangible assets’ value is zero, subtract from all that the debt and if the remaining sum is still higher than the current market cap, they’ve found an investment candidate deserving further investigation. If this company survives, its fixed assets are likely to costs much more than they were accounted for. Such positive development would be considered a bonus. Now you may wonder, why would a company sells below its net liquid assets value? There are times when emotions reign supreme, when the return of capital becomes more important than the return on capital and investors want out at any price. Such times create opportunities for patient investors with deep pockets.
- pay fair price for good businesses: recessions occur frequently enough to offer favorable entries in good businesses and the stock market eventually always come back due to the cyclical nature of the economy and investors’ risk appetite. The important question here is – is the company going to survive the economic turmoil. If yes, when the economy starts to recover, the market will recognize the value and prices come back to pre-recession levels or higher.
- using reversed engineered DCF model. By taking into account the current price, a conservative (high) discount rate and current year’s operating cash flow, the projected growth is calculated. The main question here is – is the already embedded in the price growth sustainable based on historical reference? This approach provides a general estimate of that how overvalued or undervalued is a stock. It doesn’t provide a buy or a sell signal. Market can remain irrational for a long, long time.
The goal of value investors is not to beat the market benchmark every quarter or every year. There will be periods when they will underperform for 2-3 consecutive years, followed by times when they will be up 500-600%, which will more than offset any previous disappointments. To use a baseball analogy, they are looking for home runs, not doubles and triples.
Of course, value investors also make mistakes. As Warren Buffet likes to point out – “if I ever write a book about investing mistakes, it will be autobiographical”. The most often met mistakes in value investing are associated with the timing of an entry. Sometimes you have done your analysis, all the existing evidence points out that it is right, but the market may not agree with your thesis for years. In the meantime your capital is locked in a position that doesn’t produce cash flow and if you manage other people’s money – they might start to question your analysis. If you enter too early, you might experience significant losses. Are you able to tolerate them? If you manage other people’s money – are they able to tolerate them? Someone said that if you want to make 100% return you have to be willing to experience a drawdown of 20%. You can’t go down 20% with other people’s money. If you are too leveraged and start to get redemptions from scared customers, you will become a forced seller.
There is a saying that the difference between a great value investor and a good value investor is that the former knows how to time its entry properly. Timing is hard. Trying to build big position by timing the market is harder, because catching the absolute lowest point is a matter of luck. Even if by some accident you happen to catch it, the liquidity at the bottom is usually way too shallow. Correct timing is not about catching the absolute bottom, it is about getting into a neglected stock that won’t remain neglected for too long.
Experienced value investors minimize the negative impact of timing by keeping plenty of cash and by gradually building new positions. Most of their investments could be essentially described as well in-the-money calls without an expiration date.
- ITM because there is margin of safety in the position (even if the underlying company is liquidated, what is left after debt payments will be higher than the market cap at which it was purchased);
- call options, because the potential reward could be tremendous (5-10 times the paid price or even more);
- without expiration, because they keep plenty of cash reserves and aren’t leveraged; therefore they can’t become forced sellers before their thesis materializes.
The true value investor is a very rare bird that represents a very small part of the investors’ community; probably less than 1% of all involved in the stock markets. I have a huge respect for the people who have the mind to practice this contrarian investing approach. Their abnormal long-term profits are fully deserved. From psychological stand point everything is against them. It takes a special kind of character to overcome all biases wired in the human brain – our desire for instant gratification, our inability to feel financial pain for longer periods of time, our urge to jump from one market method to another when things are not going flawlessly. At this point of my life, I realize that I am still not patient enough, not able to stomach big drawdown in my portfolio, unwilling to go against the trend in order to be a good value investor. Maybe this will change with time.
P.S: over the weekend I will take a look at the underlying dynamics of momentum investing. I will present my view on why it works, how it works and when it works.
Niederhoffer on making errors
As a squash player, I was gifted. I had all the right things going for me. I practiced. I was very good with the racket, and I had tremendous anticipation. But I tended to play an errorless game by hitting a slice on my backhand, which took a lot of power off the ball. That wasn’t a disaster, but it was definitely a weakness in my game. My opponents always used to say that on a good day they could beat me, because they could hit more spectacular shots than me. But they never did. I went for about 10 years without losing a game, except to [the great Pakistani squash player] Sharif Kahn. He made about six, seven errors a game—but he also made eight or nine winners. I would make about zero errors per game but only one or two winners. He had the edge on me about 10-4, and I regret that I was never willing to accept the risky shots and confrontations, never willing to play a more error-full game.
In my market career, I took too many risks. In my squash career, I didn’t take enough.
I wish I had applied my squash methods to my speculating. I’d be a very wealthy man if I had.
Source: slate.com
Earnings Forecasting
Lao Tzu – a 6th century BC philosopher, observed: Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.Yet, most of the investment industry seems to be obsessed with trying to guess the future.
While in school, I often wondered why would anyone assume that it is possible to forecast with precision future cash flows and interest rates. It turns out, I am not the only one. Charlie Munger points out: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools, because well they have to do something.”
To come up with an earnings estimate, analysts need to forecast economic growth, industry growth, interest rates, competitors’ moves, market share, sales, margins. There is so much room for mistakes. It is not surprising that analysts are often clueless about future cash flows and earnings estimates; therefore they rely on:
- perceived authority: the management of the company they follow is often regarded as the ultimate expert. After all, who else would know more about its company than management itself, right? The point is that management has monetary incentives not to be entirely honest.
-overconfidence: if an analyst has a good recent track record, many assume that it will continue forever. Such behavior has the highest probability of failure. The scariest thing about it is that most people would follow blindly someone with a lot of confidence and little knowledge and ignore someone with little confidence and a lot of knowledge. Vanity is my favorite sin as they say in one of my favorite movies.
- follow the herd: put their estimates close to the already existing consensus. The thinking is: if I am wrong, I won’t be the only one. We will be wrong together. There is a feeling of higher security when you are moving with the herd. You tend to feel less invincible.
Taking the above sequence into account, it is understandable why so many companies beat market’s estimates so often and why a small surprise is nothing more than a well executed guidance by companies’ management. This is why, when a company misses it is a clear indication of: 1) lack of knowledge and professionalism of the management (not knowing your own company doesn’t speak too good about you) or 2) deteriorating conditions on a macro level. Both factors are hard to reverce in one quarter. The most useful information that earnings expectations provide is that they tend to exhibit trending behavior. Prices reflect changes in expectations. Expectations are impacted by interpretations of news, forecasts and emotions.
It is said that capital markets are forward looking mechanisms that constantly try to discount any available information, both public and private. The point is that market does not only try to discount objective news, but it also try to discount forecasts. We already know that forecasts are often based either on subjective opinions or on objective analysis of unknown or imprecise data. This explains why capital markets are often irrational (of course they can remain irrational longer than you can remain solvent). The beauty of capital markets is that they tend to trend and once a trend is in place it is hard to be reversed.
If forecasts are often so flawed why so many market decisions are impacted by them? Why do we still keep forecasting? One simple answer – there is a demand for forecasts. Investors are afraid of uncertainty and any look into the future makes them feel more comfortable. The point is that it also makes them less profitable. If someone believes that he knows the future, he would be more confident in his decisions, more likely to leverage and less careful in his risk management – a recipe for disaster. A proper way to use forecasts is to treat them as cornerstones of your conditional thinking. For example: if events A and B occur simultaneously, the historic probability of event C to occur is 80%. Based on that we prepare a plan of action.
I pay huge attention to catalysts that cause high volume, price range expansion. Earnings surprises, Earnings guidance, New contracts, New regulation are catalysts with the potential to start a major process of reprising (new trend or continuation of an existing trend). My logic is simple – when institutions buy, they leave traces. They are heavy, but slow buyers, therefore I have enough time to enter and exit as they build their position. But I also understand that any new information should be interpreted only in the context of the current sentiment. When the return OF capital becomes more important than the return ON capital, emotions trump rationality and investors run for the shore of perceived safety (lately that shore has been UST, Gold, USD, JPY). No setup works all the time. The success rate of any setup is derivative of the current market environment. During severe market corrections earnings surprises and guidance don’t matter. Participants sell first and ask later. Correlation between stocks approximates 1.00.
I have a very simple philosophy – I want to be aggressively long when there is clear evidence that institutions are buying across the board. I want to be in cash or net short when there is evidence that institutions are selling.
Source: The little book of behavioral investing, James Montier
Black Swans
Black swan is regarded as a rare, unexpected event that could bring disastrous consequences for those that don’t have a contingency plan. Can you be prepared for something that by definition is unexpected? It depends on how do you look at the world. There is a difference between the impossible and the highly improbable. The latter is possible. The black swan is not the same for everyone. What looks like unexpected to one, could be totally predictable for another. For the turkey Thanksgiving day is a black swan, but this is not so for the butcher.
There is a natural tendency for human beings to underestimate the odds of seemingly unlikely events. Few realize that once in a 100 years event is equally likely to happen tomorrow as it is to happen after 95 years. And if there are insufficient data to calculate the probability of a very bad outcome, as is often the case, that doesn’t mean we should assume the probability is zero and look at contingency plans as a waste of time and efforts.
There is an Irish proverb, which I have always thought that relates very well to capital markets – The obvious rarely happens, the unexpected constantly occurs. The “unthinkable”, the “unimaginable” takes place much more often than most people are willing to accept. The stock market crash of 1987 was described at the time as a 27-standard-deviation event. That implies that the odds of such an event not happening were 99.99% with 159 more 9s after it. It was unheard of kind of event, but it happened. Those who weren’t prepared, those who were over-leveraged, didn’t survive.
When it comes to objectively assessing the real risk of any investment, there is one important question to ask: What is the worst thing that could happen and how it may impact your solvency. Human beings are naturally biased and tend to look for information that only confirms an already established thesis. Not much thinking is devoted to figuring out what could go wrong and to preparation of a contingency plan of action. People are often not prepared and when something unpleasantly surprising happens they don’t know how to react. They panick and let their emotions to rule decision making, which invariably leads to losses.
A good way to minimize the impact of emotions is to go long gamma. What are some of the characteristics of getting long premium:
- more precise risk control
When long or short equity, you don’t have full control of your potential losses. Stops are not very helpful when your position gaps against you or during sudden evaporation of liquidity. If you are long gamma, you know the exact amount of the potential maximum loss – the whole premium. Armed with that knowledge, position sizing becomes easy.
- more precise time management
You know exactly how much time you have in order to be right. If your thesis happens to remain wrong until options expiration, your position is automatically wiped and you start clean all over again. Many investors realize in hindsight that they were right on their analysis, but wrong in their timing as the market was not ready to accept their thesis. Being long premium takes away the whole aspect of having to worry about precise risk management. It is like paying for someone else to be your risk manager. You have an investment thesis and you want to go long GLD for the next 12 months. Going long gamma is the perfect way to do it. You pay a small amount to see if your thesis is right. Even if the option goes down a lot in the beginning to the point that it is worthless, you will still own it and you never know what might happen. Adverse market moves and emotions won’t shake you out of your position, because you already have a plan for the worst possible outcome – you will lose the paid premium.
- overpaying for premium, but still able to make money
You have to realize that in most of the time you will overpay for options. If you did proper due diligence that should not bother you as the move in the underlying asset will more than compensate the wasting effect of time and volatility. Especially when you move past one month options. There is a tendency to believe that people overpay for options because the research shows that IV is higher than realized volatility. That has to be the case for the seller to be willing to take the risk and to write you an option – he’s got to make some money. The difference is, he’s going to delta hedge and you’re not, so you are going to have to pay a little bit extra so that he gets compensated. You have to realize in advance, that yes you are overpaying. The seller is making his money of the delta hedge, and you are paying him a little bit by paying him more than what realized volatility is, but no one really knows in advance how big the realized volatility and the move of the underlying asset are going to be. Both the seller of the option and the buyer could make money. The profit for the seller comes from extracting the risk premia in the daily volatility and for the buyer it comes from the fact that most underlying assets tend to exhibit trending behavior.
- smaller capital allocation
Being long gamma via options allows for getting the same risk/reward with much smaller capital allocation; therefore you have less money at risk.
- smaller liquidity risk
Liquidity seems to disappear when you need it the most. If you have a huge equity position, a quick exit might be impossible. While is true that most options have wider bid/ask spread than their underlying assets, when it comes to exiting a big position options offer more alternatives – you can either exercise them if they they are ITM, roll them over to latter date or just offset them.
Despite the fact that there is substantial statistical evidence that implied volatility is less than realized volatility, (especially in shorter time frames), many experienced hedge fund managers are reluctant to go short gamma. The horrific memories from selling OTM calls against tech stocks in the late 1990s, the losses experienced due to shorting the housing sector too early have scared many for life. Being short premium via naked calls or puts exposes you for more than 100% losses. From risk management point of view, being short gamma is much harder to deal with, because as your position goes against you, it becomes larger part of your portfolio.
Insurance companies are in the business of writing premium. Those which managed to survived over time diversified properly their risk, hedged their losses by making deals with reliable counter parties and more importantly invested the received premium wisely. As Warren Buffett likes to say: “The curse of the insurance business, as well as one of the benefits of it, is that people hand you a lot of money for writing out a little piece of paper. What you put on that paper is enormously important. The money that’s coming in, which seems so easy, can tempt you into doing very, very foolish things… Simple mistakes can wipe out a lifetime of earnings – a few cents gained when you’re right and a fortune lost when you’re wrong.”
When you are leveraged 100:1, it doesn’t take an armagedon, to wipe out your equity. A one % move in unfavorable direction and you are practically insolvent. You can’t insure against all losses, but you can make sure that you will remain solvent no matter what.
Life is a Game of Inches. So is Trading
If you don’t have a plan, you will become part of someone else’s plan. Battles are won before they are fought.
SPX Statistics
S&P 500 was down 8.2% in May 2010, which is the worst monthly performance since February of 2009.
SPX was down more than 5% in a month 63 times since January 1950. In 33 out of 63 cases, the following month was negative for the index. On the graph above you may see the distribution of 5% down months. December had only one occasion where SPX was down more than 5%.
Filter the Noise
“The wise are instructed by reason, average minds by experience, the stupid by necessity and the brute by instinct”
Cicero
We are wired to constantly seek reasonable explanation behind any market move. The financial press tries to acknowledge the demand for information by analyzing with microscopic precision every small market fluctuation. When there is nothing going on in the market, we read about how nothing is going on in the market. As James Montier points out: “When it comes to investing, we seem to be addicted to information. The whole investment industry is obsessed with learning more and more about less and less, until we learn absolutely everything about nothing. Rarely, if ever, do we stop to consider how much information we actually need to know in order to make a decision”.
Every day we are bombarded with more information than we could possibly assimilate. I divide the information in three categories:
- Information that is relevant to my investment approach: signals for opening or closing a position; factors that are relevant for the particular setups that I follow. First you need to define your market approach (value, momentum, mean reversion) and then figure out which factors are important for your style. For example the P/E ratio has little forecasting power for the momentum investor. Short-term price action is random noise for the value investor. Figuring out the right signals for your market approach is not as easy as it sounds. It takes experience – your own or someone else’s. Luckily there are enough people, who have studied the capital markets and have done their share of mistakes in order to come with the factors that really matter for each particular approach. You could accelerate your learning process tremendously by studying the underlying logic behind their approaches. StockTwits is a place where such people can be found– an online community, where traders/investors with different level of experience share links and ideas. This is the place where you could find experts in the desired approach and learn from them;
- Information that helps me to better understand the underlying dynamics of capital markets, but it is not relevant to my approach (it does not provide a signal for opening or closing a position); It is about concepts, explanation of setups, analysis of new trends and changing correlation between asset classes. It is useful, it helps me to better understand the big picture, but it does not impact my decision making on a day to day basis;
- Noise: irrelevant information that doesn’t produce a signal or contribute to my growth and understanding. The majority of the articles and press releases out there don’t teach you anything of value and should be irrelevant to your investment approach. A recent example is JPM announcement last Friday that according to their model “there is 60% chance that the market has seen the lows for the year and that S&P500 is likely to close at 1300 by year end.” I saw that announcement tweeted at least 10 times by different sources like it was a big deal. For me it was nothing more than irrelevant noise.
Wall Street is a house of mirrors. There is very little original thought that is usually copied and multiplied. We are afraid of uncertainty more than anything else and all, who possess the confidence to claim that they know the future, have a tremendous impact on risk appetite and price moves. It is important to analyze some of the major sources of financial information. Understanding their incentives is essential to understanding the underlying market psychology. Excluding regulators (who are not the subject of this post), I distinguish four major influencers of social market opinion:
- Analysts: historically they have been a lagging indicator due to their over-reliance on companies’ management guidance. The majority were positive on the US bond insurers right until the end of 2008. Sell ratings started to appear after 80-90% price declines in the stock prices. Ironically those downgrades almost marked the price lows for those stocks. Analysts as everyone else are victims of self-serving bias and as such are very careful what they say and write – losing the banking business of a major client has often led to unemployment:
“An acclaimed natural gas analyst himself, Olson was fired by Merrill Lynch in 1998 after Enron left the firm out of a lucrative underwriting deal. Enron specifically cited Olson’s lack of enthusiasm for its stock as the reason for the snub. He was soon let go, a lesson that was hardly lost on his peers.
I perceive no great change in the nexus between investment banking and research,” Olson said. “It still operates as an indirect route to banking business.”
- Journalists: They realize that ideas that spread have the power to alter perceptions of value and move prices. It is not rare to see a popular website to blindly repost a press release without checking the incentives and the credibility of the source. The success of report is judged by the price impact it has on the featured stock. Most of us still have the deeply rooted belief that if something is said on TV or appeared in a widely read newspaper or magazine, it must be true. Don’t outsource your due diligence; don’t stop thinking for yourself, but keep in mind that other market participants will be influenced by the media and their reactions will impact your positions. The fact that something is immaterial to you and your time frame doesn’t mean that it doesn’t have the potential to alter risk appetite and move prices;
- Financial advisors: the majority are nothing more than trained salesmen and saleswomen, who work on commission – meaning the more they sell, the more they earn. They are trained and incentivized to suggest particular investment products that are pre-approved in advance from their central office. The new requirement for fiduciary responsibility is just dust in the eyes. Advisors options to customize financial solutions are limited;
- Experts: we could learn a lot from seasoned professionals, who have a proven track record of managing money for a living. Many are down to earth and are willing to share their knowledge, because they realize that in capital markets you never stop learning, you never cease adapting and the more you teach the more you learn. With that in mind, try not to fall into the mental trap of following someone blindly. There are way too many important factors that you probably don’t have access to when you try to mimic experts’ positions – time horizon, position size, risk management, hedging strategy. What you could do is to figure out the thought process behind their decision making, the underlying logic behind their moves and then incorporate the learned into your own method. If all of this seems like too much work, you have no place managing your own money. Find someone with proven track record and similar to yours risk preferences and wire him/her your money. Concentrate on something you have a passion for. Money managing is a serious business; it is not a hobby.
It is not hard to learn to recognize profitable setups. The biggest obstacle for the average investor/trader is the huge disparity between knowing and applying that knowledge in the heat of the moment. This concept is called an empathy gap – the difference between how we believe we will act in a future moment and how we actually act when the moment comes. We make our plans, we pledge to stick to them, but when the time comes we often forget about our intentions and we get lost in the craziness of market jungle. You can’t imagine how often I have caught myself thinking about pursuing a trade that doesn’t meet the requirements of the setups where I have an edge. Sometimes I manage to catch myself. Sometimes I don’t.
If we lost money every time when we followed our emotions, we would learn quickly not to do it. The reality is that no matter how bad we are in investing or trading, we just won’t lose every time. The worst thing that could happen to us when we emotionally open an unintended position is to make money out of it. The human brain is wired to reward us for gains, especially when they are unexpected. It releases dopamine – the chemical of satisfaction, which subconsciously teaches us to follow the same approach next time. The point is that in this case our reward was a consequence of pure luck. Much thinking and preparing were not involved in the process. Some say that it is better to be lucky than smart. I disagree with that notion for the simple fact that too much luck leads to forming bad habits, which will chase you for the rest of your investment life. In the long-run accidental profits build dangerous habits that eventually lead to disastrous consequences. Focus on the right process and the good outcome will come naturally.
Confirmation bias is the strongest in the heat of the moment. We are wired to like people who think like us, especially when they provide insights that make our investing case even stronger and more logical. Learn to respect people who think differently than you do. Often you might learn a lot from someone who criticizes your position.
We suffer from a deeply rooted desire for instant gratification, which urges us to sell profitable positions way too soon. We are also risk averse, meaning that between winning a $1000 and not losing a $1000, most of us would prefer the later. As a consequence, we are likely to stick to our losing positions until we break even at least.
In the heat of the moment we are not as cool and rational as we believe we would be. Often people are much more emotionally driven that they expect. Research shows that even experience doesn’t help when decisions have to be taken under time pressure in the heat of the moment. Human biases trump experience. The keys to minimizing the negative impact of our biases are in preparation (battles are won before they are fought) and selectivity (fight only battles that you can win). Run your screens based the factors that are important for your approach and create a plan of action when you are in a cold state of mind. If you have a long-term horizon, it is a good idea to isolate yourself from the market noise. Stop checking the quotes of your stocks every two minutes and changing your mind by every new rumor or opinion.
Understanding the concept of empathy gap is absolutely essential. If you contemplate this concept, then you will be able to figure out the main source of your investing mistakes – you.
It is the peculiar quality of a fool to perceive the faults of others and to forget his own
Cicero