In this summary, you will learn
What investors do, and do not, understand about financial markets, based on knowledge from various unrelated fields; and
What lessons investors can learn from sources as diverse as the U.S. Social Security system and the average bee hive.
Financial theory is inadequate to explain, or even approximate, market behavior.
Investors, especially professional investors, should emphasize process rather than outcome. A good outcome does not justify a bad process.
As difficult as it is, some investors consistently outperform the market. Sustained, consistent outperformance does indicate superior skill. It isn't just random.
Let expected value guide your investment decisions, not myopic aversion to loss.
Behavioral finance illuminates many things about human decision making, but it hasn't provided the key to understanding the market.
Use a multidisciplinary approach to figure out market moves and make decisions.
Study social insects, such as bees, for some useful insights into market behavior.
Removing emotion from the investment decision is a big mistake - but so is being whipped around by your feelings.
The price/earnings ratio, while arguably not completely useless, may be nearly so.
A crowd of nonexperts is one powerful mechanisms for solving a problem.
Process versus Outcome
“Despite the high stakes and considerable resources researchers have committed to understanding markets, there is much we do not grasp.”
Investment decisions should depend on investment philosophy, but the right philosophy is more a matter of having the right temperament than a record-breaking IQ. Being patient and diligent in pursuing a sound investment process is more important than achieving great investment outcomes. A good outcome does not justify a bad process. But even though a good process may sometimes produce a bad outcome, in the long run it will outperform a bad process. Sadly, the investment community often encourages an excessive focus on outcome rather than process.
Beating the Market
“In investing, our innate desire to connect cause and effect collides with the elusiveness of such links. So...naturally, we make up stories to explain cause and effect.”
Although beating the market is very hard, some outstanding money managers consistently achieve this goal. In general, they differ from average money managers several ways:
They have lower portfolio turnover.
They put more money in their top stocks, in a higher concentration than the index.
They are value investors and buy bargains.
Most are not based in New York or Boston.
Investors argue about whether investing is a profession or a business. In recent years, business has dominated professionalism. Professionals think for the long term, charge low fees and invest as contrarians. Yet, an investment firm prospers as a business when it emphasizes the short term, charges high fees and sells what the market demands. Most superinvestors are in the profession - not the business - of investing. Holding for the long term makes professional investors immune to the fluctuations of volatile market moves. They save on fees because they do not pay frequent transaction costs. However, they may risk their very jobs doing what makes sense, for example, weathering a market downturn that depresses the value of their portfolios. Business considerations, ironically enough, can lead to the firings of the best money managers.
“The message for investors is that even when you are competent, favorable situations - where you have a clear-cut variant perception vis-à-vis the market - don't appear very often.”
Babe Ruth was a great home run hitter, yet he struck out often. How often you are right doesn't matter; what counts is how right you are when you are right. Because many people suffer from myopic loss aversion, the more often they are right, even for small stakes, the happier they are. In terms of probabilities, they would be better off being wrong now and then in order to be right for bigger stakes. In all probability-based exercises, especially investing and gambling, success shares some characteristics:
Expertise - Good professional gamblers develop competence in a specific game.
Kiss a lot of frogs - Examine many different situations to find rare opportunities.
Few opportunities - The odds are seldom in your favor, even if you check the ramifications many options.
Bet carefully - In a casino, you have to bet in order to play. Investing is better because you don't have to bet - that is, invest - until the odds favor you.
“The investment community, because of incentives and measurement systems, is too focused on outcome and not enough on process.”
Standard financial theory focuses on a company's attributes, but great investors analyze the company's circumstances. Although many streaks are lucky, great investors seem to have more lucky streaks than other investors. Though the so-called "hot hands" phenomenon does not really exist in basketball, a highly skilled player will have more hot streaks than a less skilled player. Long winning streaks really do indicate skill.
Behavioral finance has revealed new facts about economic decision making, but it has not provided a consistent or comprehensive way of thinking about the markets. The markets are collectives, not individuals. When many investors make independent mistakes, the sum total of their mistakes can - paradoxically - be correct. So understanding the markets requires more than knowing yourself and your beliefs (though that is important); it also demands understanding what other people believe and what they are going to do. Many stress factors affect today's markets. Change, innovation and fast investment turnover allow less predictability and control. As a consequence, managers are thinking short-term and exhibiting unhealthy responses to stress.
“Secular trends in the economy and in the money management industry are contributing mightily to the sensation of less predictability and control.”
Like everyone else, investors are subject to psychological and emotional forces. Tupperware parties, to take one example, succeed because they appeal to common psychological tendencies toward reciprocity, consistency, social pressure, affection, authority and overcoming scarcity. For instance, someone who recommended a stock may feel compelled to keep buying it just to be consistent. Investors also tend to heed data that confirms a decision they've made and to ignore contrary information. Imitation is also a powerful market force. Sometimes it can lead to better decisions based on collective wisdom, but it can trap investors into dangerous herd behavior, too. The investing decision is not strictly rational. Intuitive and emotional factors do not merely intrude on a decision, they are actually necessary to making a good decision. Yet emotions and feelings can lead investors astray. Great money managers seem less prone to this sway of emotions, but they are aware of their feelings. They understand the reasons for their decisions.
“The central message is that across domains, long streaks typically indicate skill.”
Due to massive change and innovation over the past century, most of the securities in the first Dow index no longer exist. These changes were not massive or sudden; they were slow, small and incremental. Innovation's cumulative effect creates its impact. Innovation is inevitable. Investors must be able to understand the patterns of change without deceiving themselves into seeing patterns that are not really present.
Economist Paul Romer believes that ideas and instructions are today's source of wealth. The ability to command physical resources brought wealth in the past, but today intellectual resources matter more. Innovation now depends on reassembling ideas. Digital language makes it possible to assemble, reassemble and communicate ideas with unprecedented speed and flexibility.
“A firm grasp of innovation's underlying principles may not help you anticipate what stocks your grandchildren will hold, but it will aid immensely in your ability to anticipate changes for your portfolio.”
A child's brain develops by both creating and pruning away connections between synapses. Industry seems to progress the same way. Industries such as auto manufacturing, television and computers began with a proliferation of companies and connections, only to see them pruned away later. The best time to invest in a new industry is after this pruning. Prices may be down, because initial investors who lose money in the early stages become averse to going further. Do not look only at innovation; study the market's response to it. Adjust your expectations in light of creative destruction. Innovative companies provide higher returns, but not indefinitely. Most of the excess return comes in the first five years. Then, for 15 years, the erstwhile innovator runs roughly in pace with the industry average. After two decades, the innovator underperforms. In the earliest stages, the market undervalues an innovation; then, it overvalues it.
“The companies that outperform the market are 'temporary members of a permanent class'.”
Although managers and investors need to think long-term, thinking too far ahead is as big an error as being shortsighted. A long-term game plan can be a real handicap. Change is too rapid to tie your organization or your investment strategy to a rigid plan. Instead, set a few simple rules and allow decision makers to react to circumstances as they deem appropriate within those rules. A good system of autonomous agents following simple rules for decision making can translate into a very powerful enterprise indeed. As golf champion Tiger Woods illustrated when he worked to improve his golf swing (accepting a short-term deterioration of his performance while learning a better technique for the long term), companies and investors may need to adjust their practices and accept a period of underperformance to lay the foundation for market-beating.
“Companies should develop long-term decision rules that are flexible enough to allow managers to make the right decisions in the short term. [Then] the company is managing for the long run even when it has no information about what the future holds.”
Changes Over Time
The U.S. Social Security system, astonishing as this may seem, holds some lessons for investors. Social Security's problems have emerged from changes in its underlying demographics. Its managers looked at history to calculate life expectancies and ratios of workers to retirees, but history was not a good guide. Investors make a similar error when they use historical price/earnings ratios as a guide to the value of securities. Historical data may be no more reliable than historic demographics.
“Said bluntly, the historical-average price/earnings ratio provides investors little or no guidance about market returns over the typical investment horizon.”
As anyone who studied elementary finance knows, investors consider taxes, inflation and the cost of transactions when they decide on an appropriate price for a security. Yet taxes and inflation changed during the twentieth century, as the foundation of the world economy moved from physical to intellectual capital. Intangible capital and the businesses built on it do not work the same way as tangible capital and the businesses built on it.
The so-called equity risk premium, the compensation that investors demand for holding a relatively risky security, is also changeable. Some argue that the price/earnings ratio should move up because knowledge companies write off their R&D as an expense under the current accounting regimen, and because those companies constitute a greater share of the economy. However, you could also contend that the price/earnings ratio might move down or remain unchanged, since knowledge companies may find it more difficult to sustain competitive advantage than older tangible-asset companies. Either way, take the price/earnings ratio and the multiples derived from it with a grain of salt. Be prepared for accelerating industry change, and thus wider portfolios and perhaps higher portfolio turnover than was optimum in the past. The price/earnings ratio is a shorthand based on market expectations of growth and return. Growth alone may be good, bad or neither. If a security is a good investment, it will return more than the cost of capital, sustain the excess return and recover if returns fail.
Companies generally do not generate excess returns indefinitely. New capital flows in, pushing returns down to the level of the cost of capital. However, some companies do consistently earn high returns. In a study of 1,700 companies from 1960 to 1996, more than 10% sustained excess returns. A note of caution though: Value investors, of course, prefer to buy companies that are cheap relative to their returns. A company may be cheap because the market does not properly value its returns - or the market may rightly perceive that a company can't turn around. Another study of 1,200 companies found that most do not recover after a downturn. The lesson is that most cheap stocks deserve to be cheap and fallen angels have only a slender chance of soaring again.
“It's often difficult to know where the next beneficial idea will come from. The evidence suggests that exposure to diverse information sources can improve the likelihood of finding a useful idea.”
Recent research finds, surprisingly, that people without particular expertise can collectively solve problems that stump experts. Ants, for example, have no central direction, yet they do a good job of solving complex problems. Ants optimize the location of the park, the trash heap and the colony by instinct, not by math. Ants are designed by nature to seek and exploit diversity. An ant colony tolerates inefficiency, noise and random running around because that ensures that it finds new food sources. Bees, like ants, do a great job of solving tough problems. When a worker bee returns to the hive, it dances to tell the colony that it has found food and where the food is. The dance is longer or shorter depending on how badly the colony needs that kind of resource.
“We are all so busy talking on the phone, answering e-mails, and going to meetings that we don't have any time left to read, think and play with ideas.”
Remarkably, social insects do not rely on any central direction or commander. They are utterly decentralized, yet they work collectively to solve difficult problems and ensure the colony's long-term success. They rely on temporary specialists to do many jobs. Depending on the colony's needs, individual ants may even move from one job to another.
Humans can learn a lesson from the ants: The collective behavior of individuals who work independently may very well be more powerful than the advice of the best-trained experts. The stock market may be a sort of ultimate ant colony. Individuals working without central direction and drawing on various information sources do generally seem to arrive at a remarkably sound assessment of values. Although crowds occasionally go off the deep end into hysteria and madness, such exceptions seem to happen when investors stop behaving as independent, diverse agents and begin acting in concert. These episodes are rare, but they are massively consequential. Do not think of the market as a normal distribution. A normal analysis of the stock market would have discovered that the magnitude of the October 1987 market crash was so great that its occurrence was all but theoretically impossible. Yet it happened.