It’s Friday, and that means a cup of tea and a ponder of the mix of urgent, important, frivilous and ironic perspectives available to anyone interested in the Australian sharemarket.

Musing on share market strategies

It is not possible to predict markets.

This reminder should be tattoo’d on the fingers of every person who elects to actively trade shares, so they must see it every time those fingers push the button to execute a trade.

We human beings are incredibly clever beings. We have an enormous capacity to deal with large data sets, divergent and convergent activity, and to make decisions that – in general terms – stand us in good stead. These decision making processes keep us safe from physical harm. Most of those decision processes are automatic, and they need to be, as our non-automatic thinking systems are often skewed by influences that we are not aware of. However, we are easily tricked into thinking that we are more clever than we actually are or that we have identified patterns and processes that others are not aware of. In terms of sharemarkets it means we need to be very careful of falling into the trap of thinking that we can predict markets because we simply can not.

The law of small numbers

i was reminded of the impact that this little beauty has while enjoying a trawl through Daniel Kahneman’s book “Thinking fast and slow“, which summarises years of research and study of human decision making. Kahneman jointly authored a paper “Belief in the Law of Small Numbers” in 1971 and later added to the field of psychology and economics through his work studying decision making and risk as it relates to money. There’s an interesting article on the law of small numbers as it relates to marketing on this link http://www.greenbookblog.org/2012/05/11/how-myths-are-formed-the-law-of-small-numbers-market-research/. Using Michael words, the law of small numbers points out that we human beings should be careful of assuming that our very limited personal experiences reflect anything more than a very small sample of possible outcomes.

For those interested in finding out a little bit more without having to read an entire tome of a book, there is an excellent article available, in which some financial people question Professor Kahneman on decision making as it relates to money. The professor’s answers are well worth a read. The article can be downloaded from the Social Science Research Network at this link http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2144471.

What this research tells us is that we must always be alert to the possibility that we or people we deal with, are assuming to know more than it is actually possible to know. This is especially true in something like trading shares or even the simple process of buying shares to eventually sell.

Musing on Funds Management

In a post-GFC world it has become quite standard to belittle the efforts of investment and superannuation strategy managers, with phrases like “i don’t need to pay someone else to lose me money, i can do a good job of that myself!” What is really being expressed though, is disappointment that paying for the expertise of professional money managers hasn’t necessarily helped in the final outcome, compared to just holding money in cash which is straightforward, cheap to do and entails only the smallest amount of risk.

There has always been a strong argument between those who believe that active managers “add value” and those who believe that with active managers you are just paying more money for no greater performance than you would obtain from simply buying “a bit of everthing” and having a portfolio of money that reflects the sharemarket as a whole. Research suggests that the bulk of return from a long term portfolio is obtained from which asset class you invest into rather than how you invest. That is, if you hold a portfolio of shares then over time your returns are likely to resemble the returns of the overall sharemarket – even if you try different investing strategies and techniques to manage those shares.

Buy everything versus buy selectively

Everyone has seen the sharemarket benchmarks – it used to be the All Ordinaries Index but is now more commonly the S&P/ASX 200 Index. We won’t cover indexes and index investment in detail here other than to say that you can now quite easily buy a single share that provides returns very similar to the index. Therefore, if you are happy with the long term performance expectation of the index then you could simply buy that one share and not concern yourself all that much with individual companies or sector comparisons or yield versus growth stories or all of that palava (remember this is NOT PERSONAL ADVICE – you must not act on anything contained in this note or on this site as it is simply opinion and musings of a general nature that cannot be used to direct individual investment decisions). In industry jargon, the return of the market as a whole is given the name “beta” which is simply the second letter of the Greek alpabet. When you or a professional fund manager attempt to buy and sell shares to get a return then the idea is that you are “chasing Alpha” or returns higher than the overall sharemarket itself. Otherwise, why are you taking the risk of making the wrong decisions and underperforming the sharemarket as a whole? Those benchmarks are all important in the funds management industry.

Is it possible to outperform the overall market itself?

Here is a link to a paper titled “Modern Fool’s Gold: Alpha in Recessions” prepared for the Journal of Investing  http://www.iinews.com/site/pdfs/JOI_fall2012_E&K.pdf. It is a bit academic but worth reading even if only for the first couple of pages and the final, which includes among other points the following conclusion:

“Using 20 years of monthly mutual fund data, we find active portfolio management fails to add value above the higher costs it imposes on investors. These findings are relevant to both expansions and recessions. However, the empirical results suggest that active portfolio managers, on average, do exhibit enough skill to offset fees in recessions. In other words, the after-expense average returns to active managers in recessions appear to be on an even footing with an index strategy when considering performance alone.”
 

 Paraphrased, i read that as “no matter how clever you are, the odds of your beating the overall market itself are rather small, and if you do, it is likely that you will incur extra costs that will remove most of the extra return you were only marginally likely to generate”.

So why is the funds management industry so huge? Why are there so many people spending so much time, effort and resource when the research suggests it isn’t likely that they will outperform the market? Is this just one big rip-off?

The trick to coming to grips with funds management is to understand a few core points:

• Not everyone is happy with “average”. The law of small numbers leads us to believe that we have a good chance of ourperforming, and therefore it is worth spending some money to make more money.
• Many investment managers operate in specialised market sectors. Here are just a few: 
  • Resources, small companies, industrials, international shares etc, etc.
  • Income earning securities such as hybrid notes
  • High turnover trading to rigid trading processes
• There is a lot of marketing material that suggests that outperformance is readily available.
• The Australian sharemarket is not as “efficient” as the US market where most of the research and studies are undertaken. Some research suggests the inefficiencies of the Australian market can lead to some managers outperforming, and a very small group doing so with some level of consistency.

Relative risk versus loss

The Kahneman extract link above spends some time covering this point. The funds management industry tends to measure performances over “rolling periods” and against the benchmark of the sharemarket index itself. This can easily lead to confusion or disenchantment. If a fund manager boasts of outperforming the market by 8% then that sounds good, doesn’t it? But what if the market itself posted a return of -20%? The “outperforming” fund manager has only shown a return of -12%. Does that really make people feel any better? This is a key area of difficulty in funds management. What expectations do you have of the investments that you make in investment products? How are you measuring their performances, and how are the managers of the products measuring their performances?

If i tell you that there is a 70% chance of an outcome, what thoughts cross your mind?

Let’s say we have a set of dice that are rigged, so that you have a 70% chance of coming up with a particular result. How would you act knowing this fact? If i asked you to put a $100 note on the table and then told you to roll those dice that are rigged in your favour, with the promise that i’ll pay you $150 if  your number comes up but i’ll take your money if it doesn’t – what would you do? Would you roll the dice or would you put that $100 note back in your pocket?

Naturally, i’ve rigged every aspect of this thought experiment. It is afterall, a Friday. However, this kind of thinking is important in helping you to understand your own position on risk and returns and uncertain outcomes. There are all sorts of “risk profiles” out there in the big, wide world but most rely on you and me having a pretty good understanding of the rules of statistics and uncertain outcomes. And i personally still feel i have a great deal to learn in this field even after decades of watching dollars in action. It’s an area that financial planners struggle with every day, and one that i’ll pick on quite a bit this year.

For those with nothing to do over the weekend, wander into a bookshop and buy a copy of “The Signal and The Noise” by Nate Silver. This is the baseball-loving, poker playing gambling maths prodigy who wrote a program that successfully predicted a massive swathe of US election results. In the book, he uses stories and histories to illustrate the ways in which even professional statisticians can fail to separate the important from the unimportant, bias from fact and interpretation from analysis. If you really would like to get a better handle on uncertain outcomes, this is a great book. Happy reading!

All predictions are guesses!

The point of this note is to remind everyone that the future is not predictable, and that financial planning is a profession that attempts to mix finite objectives with almost unlimited input variables. In doing so, the discussion on risks and possible outcomes is one that is often relegated to the “too hard/too boring” basket in favour of “appearing strong and knowledgeable” or simply following institutional marketing hype. It is my thought that this particular discussion on risks and possible outcomes is one of the most important that a person can ever have with their financial planner, and one that should take place with boring regularity.

i look forward to your thoughts…