If you don't like the rules, change them...
The PURPOSE of investing is not to be proven right, says Tim Price on his blog for Price Value Partners.
Many of the best traders are perfectly happy to admit when they've called the market wrong. Their edge is that they can change their opinion on a dime.
The market is not an intellectual debate, but a bank account. What ultimately matters is the size of your balance. The purpose of investing is not to show that your investment model, your understanding of the market, your 'paradigm', is superior to everyone else's. There are practically an infinite number of investment strategies, just as there are, to all intents and purposes, practically an infinite number of investible choices out there. The fundamental purpose of investing, however, is simply:
Winning the game.
The investment market, in all its various guises – Finance World, if you like – is not a creature of the natural world. The laws of the physical sciences do not apply. Given that traditional economics is essentially an unstable philosophical platform of principles 'borrowed' from the world of physics, it stands to reason that we cannot expect traditional economics to give us much of an edge when it comes to managing our investments.
Know your enemy. As the British economist Joan Robinson puts it,
"The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists."
The complex network of monetary and investment interactions otherwise known as Finance World was brought into being entirely by us. The concept of equity in a business is entirely a human invention. As is the concept of debt. The same for currency. The same for futures and forward contracts – in anything.
Most of the evidence denoting these voluntary exchanges has become entirely dematerialised. It doesn't even exist on paper any more. It finds its form just as a sequence of electronic blips on a screen. Our entire monetary system, in the words of Satyajit Das, has now become the abstraction of an abstraction.
If humanity were to be suddenly extinguished in some disastrous global cataclysm – the re-election of Joe Biden, for example, or of either the Tories or the Labour Party – the financial markets would instantaneously disappear alongside us. The physical world would still turn. The sun would still rise in the East. The rest of Nature would still be here. But as humanity flickered out, Finance World would cease to exist alongside it.
The best metaphor to express the nature of financial markets is not drawn from the world of Nature but from that of Man. We are all playing a gigantic global game. The objective of investing is simply to win that game. Warren Buffett expressed the same sentiment when he remarked,
"If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy."
We can also go some way to avoid being the patsy in investment by acknowledging that not everyone who plays the game is following the same rules as us. We can then adapt accordingly.
Dr.Andrew Lo is a Professor of Finance at the MIT Sloan School of Management. He holds a BA in economics from Yale as well as a PhD in economics from Harvard. His investment firm, AlphaSimplex Group, founded in 1999, is a specialist in quantitative and trend-following strategies.
As part of a recent presentation on markets, Dr.Lo used the slide above to differentiate between some of the institutions all 'playing' within the markets.
As you move from right to left in this slide, the 'players' display a diminishing amount of risk aversion; in other words, depending on where they sit on the risk spectrum, the more comfortable they become in taking on portfolio risk, or rather anticipated volatility.
Central banks, for example, although it may not seem like it at times, are actually extremely risk-averse. They can't really afford to speculate with the capital they manage – they certainly can't afford to incur a significant and permanent loss of capital – or their country is bankrupt. (The Swiss National Bank, which just announced a loss of $143 billion for 2022, would appear to be playing an entirely different game to everyone else on the planet.)
Endowments, such as the Yale Endowment managed by the late, celebrated investor David Swensen, can take a longer term perspective, and they can handle more risk. They are managing wealth across generations.
Corporate pension plans can also take a longer term perspective, and again can handle a higher degree of risk in their portfolios – which are being managed across an investment horizon of decades.
Government pension plans can take on even more risk, on the admittedly pragmatic basis that if they do run into funding difficulties, their sponsoring government can ultimately bail them out.
Sovereign wealth funds also have a different attitude to risk. To an extent, they're already playing "with the House's money".
Note that Dr.Lo's list doesn't even include individual investors.
The flora and fauna of Finance World is dense and widely varied. Each participant is playing a slightly different game.
High frequency traders, for example, don't feature on Dr.Lo's slide. But imagine the typical duration of one of their holdings, which is likely to be in fractions of a second, or seconds at most, versus the investment horizon of an endowment or a government pension scheme. Barely the same game at all.
And what Buffett critically referred to as 'the institutional imperative' also offers opportunities for those investors capable of framing the game in a different way.
Interviewed by Steven Drobny back in 2006 (in 'Inside the House of Money', published by John Wiley & Sons) Barclays Capital's portfolio director John Porter made an interesting statement about his trading activities:
"What I am doing at Barclays nowadays is engaging in time horizon arbitrage. All investors these days are replicating the same very short-term style. Whether it is hedge funds, funds of funds, prop desks or real money, the good old days of a strategy session to discuss portfolio changes are over.
"Nobody can do that now. Everybody is held to parameters that don't allow for any volatility in earnings. To me, that's a good thing, as long as I don't have to follow that formula. I believe that by executing a strategy that nobody else can, I will outperform. Does that make me any better ? Not necessarily, but it gives me an edge."
We can also call it: playing the same game, but using different rules.
Other than a handful of laws that we all have to work within, the beauty of the financial markets is that they comprise a game with very few constraining rules.
What to buy ? How much to buy ? How many positions to hold ? How much capital to deploy ? How long to hold for ? When to take profits ? Every institutional manager operates within a world of constraints in each case. Every fund manager of other people's money has to manage his portfolio with a thousand people looking over his shoulder.
As a private investor you are free to answer each of these questions in your own way.
Falcon Management's Jim Leitner, in the same book, makes a similar observation to Porter. The capital markets are constantly channelling billions of Dollars towards fund (and hedge fund) managers with redemption terms varying from daily to monthly or quarterly. Depending on those terms, those managers are forced to manage their own liquidity accordingly:
"If all investors allocate money to a one-month time frame, by definition there are going to be fewer opportunities there.. there's just too much competition over short-term trading, which is a timing-driven business. With timing, sometimes you're going to be right and sometimes you're going to be wrong, but it's not going to be consistent over time...Meanwhile, the longer-term opportunities still exist because there hasn't been that much money allocated with multi-year lockups.. That's not happening yet and probably won't because investors are way too nervous and short-sighted."
What Keynes called 'the fetish of liquidity', for example, is just that – an obsessive and abnormal focus on something that really isn't that important. For the asset manager who offers his investors the right to daily redemptions, liquidity is clearly an issue that needs to be managed within his own portfolio. He can't afford to have most of his holdings in the form of illiquid assets that it will take time to exit from.
But what matters to him has little or no relevance to how you as a private investor choose to play the game. If you don't have the same operating constraints as he does, play the game by your rules, not by his.
A January 2011 article for Bloomberg News by Richard Teitelbaum shows how absurd 'the institutional imperative' can get:
"[CEO Lloyd] Blankfein and his charges have pushed efforts to 'Goldmanize' Goldman Sachs Asset Management, according to a former GSAM executive. Among other things, that means assessing performance on short-term, rather than long-term, results.
"At one point, two former employees say, Goldman's top management was demanding hourly profit and loss statements from certain teams."
The idea that a mutual fund's portfolio managers would be obligated to report their P&L on an hourly basis for the purposes of risk management is just too ridiculous for words. But that's just how someone else chooses to play the game.
The business of investing is a game – and first, foremost and always, it is a mind-game. If, as investors, we can keep our minds open and avoid the institutional mind-set that constrains most professional players, we can, over time, achieve a deliverable edge over them.
There are at least five separate ways in which institutional fund managers enter the boxing ring with their hands effectively tied behind their backs:
Whether they admit it or not, nearly every institutional investor is obliged to acknowledge, and therefore to try and outperform, some kind of benchmark. That benchmark might be the S&P 500 for large cap US stocks, or the MSCI World Index for global stocks.
A typical institutional manager has no real flexibility to invest much outside those benchmarks, because they are assessed on the basis of their relative performance versus those benchmarks. A typical manager will therefore track those benchmarks instinctively. If they vary too far from their benchmark, they run the risk of losing assets under management, of losing out on a bonus, and in extremis of losing their job. For this reason a typical fund manager will regard himself as a hero if he outperforms his benchmark, even if his portfolio still makes an outright loss for his investors.
Benchmarking encourages herd thinking, consensus position-taking, and the overvaluation of many stocks in the index simply because fund managers have no choice but to own them, irrespective of how attractive or expensive they are.
As a private investor you have no such constraints. You can buy what you like. We run a global 'value' equity fund, for example, but for all of the reasons cited above, it deliberately isn't benchmarked to any specific index so that we can try and benefit from as much operational flexibility as possible.
No end of data strongly suggests that the single biggest drag on fund performance over time is what the fund manager charges simply to manage the portfolio. You don't have to worry about any of the factors that inhibit the typical fund, and your management fee is simply the amount of time you dedicate to watching your investments.
As a private investor you don't have to worry about keeping other investors in your fund onside. You don't have to make business trips around the world to meet prospective investors or hold the hands of clients who are big investors in your fund. You don't need to bankroll an army of research analysts. You don't need a compliance department. As at the end of 2014, for example, Citigroup had 30,000 staff on its payroll just to work on regulation and compliance.
There's an iron law to asset management – the bigger you get, the more difficult it becomes to outperform everybody else. After a certain point, you effectively become the market. Once you are the market, you clearly cannot beat yourself. Buffett acknowledged this fact when he told his shareholders in 1989 that:
"A high growth rate eventually forges its own anchor."
Berkshire Hathaway made its best investment returns when it was a small business.
As a private investor you can buy what you want. Even if you buy a concentrated position within your own portfolio, you're not going to move the market against you while you establish that position. Large fund managers have that problem day in, day out. You don't have to limit yourself to the largest stocks in your benchmark – because you don't have a benchmark.
Nobody is trying to pick you off or profit from your trading habits.
Large cap domestic stocks, small cap foreign stocks, mid-cap emerging market stocks – you can buy literally anything you want. Institutional fund managers simply don't have that flexibility. They have to buy from a comparatively small, fixed template of stocks, and they constantly have to worry about managing the liquidity profile of that portfolio.
The institutional fund manager lives and dies by his monthly returns, relative to his benchmark. Woe to the manager if he underperforms versus his peer group over even a month – he can be replaced, and in many cases, he will be. Institutional money is fickle. In extremis, the managers of mutual funds can see half or more of their assets under management disappear within a day.
As a private investor, you don't even have to report your returns to anybody else. You certainly don't need to worry about the risk of client redemptions. You are free to take a considered view of out-of-favour investment opportunities, for example, and wait, patiently, for Mr.Market to value them appropriately.
#5. Career risk
The British economist John Maynard Keynes encapsulated the concept of career risk and agency risk when he wrote, in his 'General Theory of Employment, Interest and Money' (1935), that the business of professional investing was like judging the prettiest faces in a photo competition.
The prize will go to the competitor whose choice corresponds most closely to the average preference of competitors as a whole.
"Each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.
"We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."
The 'Keynesian beauty contest' is the perfect metaphor for investing in the modern financial market. The fund manager is merely an agent, not a principal, constantly trying to second-guess the other economic agents at play in the market.
But it's worth remembering that Keynes was describing professional investing, not investing as conducted by the private individual.
Professional managers operate under a variety of largely self-imposed constraints, all of which the private investor can ignore of he or she wishes. Choose which rules you wish to play by.
The challenges of today's financial environment are hardly trivial: central bank monetary debauchery; energy wars; currency wars; the rising systemic risk associated with an unpayable mountain of global government debt; inflation throughout the West of a severity not seen since the 1970s.
For all this, the financial historian Russell Napier suggests that there is nothing really new in Finance World. Everything that we experience has happened before. The strategist Ben Hunt of Salient Partners agrees:
"The New Normal turns out to be an Old Normal, or at least an Intermittent Normal, and history provides a crucial lesson for active investors seeking to ride out the current storm. Risk-On/Risk-Off behaviour is nothing new, you just have to look back before World War II.
"Risk-On/Risk-Off was an accepted fact of market life in the US for 100 years, from at least the 1850s all the way through the 1940s, because the conditions that create a structure where Risk-On/Risk-Off behaviour emerges – global financial crisis + new technology + regulatory regime change – were so commonplace. We think that the Internet has changed the way we make investment decisions...imagine what the telegraph and the telephone did. We worry about central bank decisions to expand their balance sheets...imagine the concern over the creation of fiat currency and the outlawing of gold ownership.
"The New York Stock Exchange survived a Civil War and two World Wars quite nicely, thank you, and there were actual human investors who thrived during these decades, all without the benefit of Modern Portfolio Theory. It might behoove us to learn a thing or two from these men."
Hunt points out that what the pre-World War II investors he studied – the likes of Andrew Carnegie, Jay Gould and Cornelius Vanderbilt – had in common was that they were all game players.
"The notion that they would make any investment without strategically considering the decision-making process of other investors would be laughable. In fact, most of their public investments were driven by the strategic calculus of 'corners', 'bulges', and 'points'. These men played the player, not the cards, in almost everything they did."
The subjects of game-playing in the financial markets have clearly changed, just as some of the rules have changed. The days of "corners" are behind us, and such activity is now illegal. Insider dealing is illegal, too. Unless you happen to be Speaker of the House.
"But the nature of game-playing hasn't changed, and the centrality of game-playing to successful investment, particularly during periods of global economic stress, hasn't changed at all."
As Jean-Claude Juncker, former Prime Minister of Luxembourg and former President of the European Commission once notoriously said, with reference to market communications,
"When it becomes serious, you have to lie."
Even if the information behind a given market narrative is not a deliberate lie, it may have little or nothing to do by way of correlation to that narrative.
The financial news media are in a special bind here, and we should understand that. They have to be saying something, and they have to be saying something all the time. So they will. That doesn't automatically make any of the advisory output from the financial media worthy of our attention. What we choose to listen to should be up to us.
So don't follow someone else's news agenda. The only thing that should matter to you is winning the game.
The link between narrative and our own behaviour is what Hunt calls Common Knowledge – what everyone knows that everyone knows. An example would be the following prevailing belief:
Everyone knows that everyone knows that central banks are capable of supporting the stock market and suppressing interest rates. This Common Knowledge is currently the conventional wisdom. Whether it's even correct or not is not the issue. What matters is that enough other people believe it to be true. And for as long as it remains Common Knowledge, we should play the game accordingly.
We have often discussed the 'David vs Goliath' environment in which the private investor can take advantage of 'the institutional imperative' that impedes the professional fund manager.
This isn't merely glass-half-full thinking on our part. Adopting a different mind-set can help us win the game, even if we think we're at a disadvantage versus supposedly superior players.
The political scientist Ivan Arreguín-Toft has written a book, 'How the weak win wars'. It's a study of every war fought during the past two centuries "between strong and weak combatants". Goliaths won in 71.5 per cent of those conflicts. In wars in which one side was at least 10 times more powerful than its opponent (in terms of military resources and population), the weaker side, intriguingly, won almost a third of the time.
What happened when underdogs acknowledged their weaknesses and chose an unconventional strategy ?
In those cases, David's winning per centage went from 28.5 to 63.6. When underdogs choose not to play by Goliath's rules, they win, Arreguín-Toft concluded, "even when everything we think we know about power says they shouldn't."
Arreguín-Toft discovered another interesting point: over the past two centuries the weaker players have been winning at a higher and higher rate. For instance, strong actors prevailed in 88 per cent of the conflicts from 1800 to 1849, but the rate dropped very close to 50% from 1950 to 1999.
So what explains these results?
After reviewing and dismissing a number of possible explanations for these findings, Arreguín-Toft suggests that an analysis of strategic interactions best explains the results. Specifically, when the strong and weak actors go toe-to-toe, the weak actor loses roughly 80 per cent of the time because "there is nothing to mediate or deflect a strong player's power advantage."
In contrast, when the weak actors choose to compete on a different strategic basis, they lose less than 40 per cent of the time "because the weak refuse to engage where the strong actor has a power advantage."
Weak actors have been winning more conflicts over the years because they see and imitate the successful strategies of other actors and have come to the realization that refusing to fight on the strong actor's terms improves their chances of victory.
But not everyone wants to risk losing unconventionally. The theory goes that if you compete conventionally and lose, tough luck, but if you compete unconventionally and lose, well, you might lose your job. This might be a reason that competition between lopsided opponents is so, well, lopsided. As Keynes said:
"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
In a justly famous essay, Charles 'Charley' Ellis, the investment consultant who founded Greenwich Associates, pointed out, citing the work of scientist Simon Ramo in the process, that there was not in fact one game of tennis, but two. There was tennis as played by the professionals, and then tennis as played by the rest of us.
In the professional game, the player wins points. In the amateur game, the player loses points.
Professional tennis players are a dream to watch, as they vault, dive, lunge and volley. They rarely make errors.
Amateur tennis players: not so much.
The tennis pro is playing a winner's game. Victory is down to winning more points than your opponent.
The amateur is playing a loser's game. Victory is achieved, not very stylishly, by getting a higher score than your opponent, because he or she loses more points than you do. Amateur tennis is a game full of errors. Ramo even tallied the scores.
The verdict: in professional tennis, about 80 per cent of the points are won. In amateur tennis, roughly 80 per cent of the points are lost – ie, in unforced errors.
For the amateur tennis player, the best strategy for victory is to avoid mistakes. The best way to avoid mistakes is to be conservative and keep the ball in play. Give the other player enough rope to hang himself.
Clearly the analogy is useful for the private investor versus the supposed professional.
Although human nature doesn't change, the composition of the financial markets has evidently changed over the past century. Ellis suggests that during the 1930s and 1940s – a period during which the work of the value investor Benjamin Graham would come to growing prominence – preservation of capital and prudent investment approaches would come to dominate. The bull market of the 1950s attracted new types of aggressive, hot money investors. The people who were drawn to the Wall Street of the 1960s had always been winners – in debating teams or in sports teams. But as the markets sucked in more and more winners and people who urgently wanted to win, the dynamic of the markets changed.
In the 10 years prior to Ellis' 1975 essay, institutional investors went from representing 30 per cent of the turnover on Wall Street to 70 per cent.
Ellis' advice to anyone trying to beat the professionals at their own game ?
- Know your investment policies very well and play according to them consistently. Let the other fellow make the mistakes. Let him track the benchmarks – leave your own portfolio entirely unconstrained.
- Keep it simple. In the words of the golfer Tommy Armour, "Play the shot you've got the greatest chance of playing well." Wait for the fat pitch. Do nothing otherwise. This is a luxury the institutional fund manager does not have.
- Focus on defence. In a loser's game, researchers should spend most of their time making sell decisions, not purchases. To put it another way, limit your number of purchases. Better a concentrated portfolio where each of the positions is well understood, than a 'diworsified' portfolio consisting of little or no underlying investment conviction. Data strongly suggest that the optimal number of portfolio holdings is around 16 or so. [Within our fund and within our discretionary portfolios, we target between 15 and 30 holdings.] Many successful investors get by with less than 10. You don't need to own "the market". A focused portfolio of high conviction stocks is something you can hold that most professional investors simply can't.
- Don't take it personally. "Most of the people in the investment business are "winners" who have won all their lives by being bright, articulate, disciplined and willing to work hard. They are so accustomed to succeeding by trying harder and are so used to believing that failure to succeed is the failure's own fault that they may take it personally when they see that the average professionally managed fund cannot keep pace with the market.." You don't have to worry about peer group performance. There's no rush – you just need to shepherd your capital so that you can stay in the game.
Value investing gives you an automatic edge over most market professionals because it's a game very few of them can even play. They don't have the luxury of time, and they don't have the flexibility to go off benchmark and invest freely into the best opportunities. They are more concerned with keeping their jobs and running with the herd than with maximising returns.
In summary, ask yourself two questions: what does it cost ? And how much is it worth ? Then quietly ask yourself a third: do I sincerely want to be rich ? And finally ask yourself a fourth: do I sincerely want to stay rich ?