Avoiding Mob ThoughtsSubmitted by ADVISOR.INVESTMENTS on February 22nd, 2018
DIS and DAT - Avoiding Mob Thoughts - February 2018
Our periodic communication that reminds you to ask, “Should I react to those headlines?”
“Never act upon wishful thinking. Act without checking the facts, and chances are that you will be swept away along with the mob.”
― Jim Rogers, A Gift to My Children: A Father's Lessons for Life and Investing
Investing, for the majority of end users (individual investors), proves to be a disappointing adventure for one simple reason: Most individual investors attempt to increase their returns by selecting a “hot investment,” then – as though they possessed some type of mystical power to see the future of the market – hope to sell out of the investment right as it goes “cold.”
We at Advisor.Investments certainly possess no ability to perfectly predict such a thing, but we also believe that one does not need special powers to be successful at investing. We aim to show in this edition the difference in two approaches. First, the “Keynesian Beauty Contest” describes what happens when market participants try to play that game of “outguess the guessers.” We will also spend some time talking about “value investing” and our approach.
Keynes believed that investors typically behave similar to the judges at a rather unique beauty contest where they were asked to choose not who they believed to be most attractive, but who they believed would be the most popular selection by others. His quote below summarizes what happened:
"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that 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 practice the fourth, fifth and higher degrees." (Keynes, General Theory of Employment, Interest and Money, 1936).
(You can read more about this unusual contest at the link at the end.)
Instead of acting upon the “wishful thinking” that Rogers describes in the opening quote or participating in the “Keynesian beauty contest,” we choose to approach investing in a different manner.
Fundamental to our approach is the belief that investment value can be separated from the actual market price. This basic concept throws us into a broad category labeled “value investors,” where each and every practitioner have their own way of implementing the concepts. The value investing approach relies more on analyzing a company’s fundamentals, such as their financial statements. Value investing also involves research to consider the possible future cash flows, the growth and risks involved. The time allotted toward the market realizing the company value is typically measured in years, not days. As you may have guessed, a main difference between value investing and the “Keynesian beauty contest” is that popularity should have no effect on the decisions.
We will attempt below to share a description regarding how we would handle monies that are set aside for investment purposes. To be clear, this is not money needed in the short term (18 months or less), nor the midterm (in-between 19 months and 36 months). This money should be able to accept the risks associated with investing.
Here are examples of value-type investment strategies that we seek in order to carry out our form of value investing. The list is not intended to be exhaustive, nor exclusive.
- Merger Arbitrage: When a company purchases another company in the open market, there is a possibility that the market price is below the stated buy out price.
- Discounted closed end funds: Typically a closed end fund’s market price can trade below the net asset value of the underlying investments.
- Liquidations: A company’s stock or bond price will sometimes trade below what a conservative calculation of the liquidation value of the assets would yield.
- Deep covered calls: Sometimes the combination of buying a stock and writing a call below the current market price can offer a conservative amount of downside protection for the associated premium.
- Contrarian asset class: We believe that some asset classes can be relatively underpriced due to the emotional swings of the average investor.
- Transitions: At times a company’s stock price can trade below a conservative calculation of the discounted cash flows, due to the company going through some necessary transition.
- Wide moats: Some companies possess such a great competitive advantage that the market price can fall below a reasonable calculation of discounted future cash earnings.
In our implementation of “value investing,” we attempt to find close matches for the strategies described above. We also desire a blend of the strategies to diversify the risk drivers and concentrate on the best fit candidates we can find.
Do any problems occur in carrying this out? You betcha! Here are some of the risks we can explain. Again, the list is not meant to be exhaustive.
- Value traps: Our calculation of investment value can simply be wrong for various reasons.
- Time frame too long: Our estimation of how long it will take for the market to recognize the value we see can be too short. This may cause us to be unable or unwilling to hold onto the position long enough to realize the value.
- Creative destruction: Another competing company can take market share and profits away with a new product, service, or delivery method, etc.
- Larger value investor: A larger value investor maybe able to buy the entire company at a market price below our calculation of intrinsic value.
- Management malfeasance: The management of a company may not be truthful in its comments, actions, nor financial statements. We are not in a position to force managements.
- Management incompetence: The management of a company may simply be incapable of executing its strategy. We are not in a position to force managements.
- No exact match: In practice, it is not likely a company or situation will fit exactly to the simple descriptions above.
- Multiple category “match”: In practice companies can fit into more than one category, especially over multiple time frames.
- Selective strategies: It is not likely that all strategies will be used at all times.
- Unpredictability: We cannot predict market prices, nor duplicate past performance, nor offer any guarantees of some type of performance.
- Unique performance and implementation: Each account is unique and it will not match another account, nor a specific index. It may also contain more allocation toward one strategy and less to another than any other account, index, etc.
- Cognitive biases: We are all “blessed” with shortcuts for making quick decisions. Sometimes these heuristics can prove faulty in investing in a world that includes many varied uncertainties.
- Lack of confidence to buy: At times, we will not be confident enough of opportunities, to “fill the target allocations” and therefore may have a cash or similar position as one of our allocations.
- Lack of confidence to sell: At times due to withdrawals or a quickly rising market price, “our target allocations will be full or excessive,” and we will not be confident enough to adjust (sell) to meet targets or purchase a position we believe worthy otherwise (if we had enough cash). This is one of the reasons we recommend targeting at least 3 years of expected withdrawals outside of investments to begin.
- Overrides: We are subject to your stated investment allocation targets and any account restrictions.
- Taxable accounts: Some transactions will result in taxable events. We desire to be aware of them, yet not let the proverbial tax tail, to wag the investment dog.
In this way, we seek to avoid the “Keynesian beauty contest mentality,” which may cause us to fall into “wishful thinking” thus being swept up by the mob.
Our hope in writing and sharing these concepts with you is that we both learn something, and this learning will create a better alignment of our clients’ understandings with the implementation of our investment thoughts. In the long run, we believe both of those objectives can lead to better performance for you, individually and collectively.
See you next time.
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