Hi All,
I’m phoning it in this month as I was all ready to write a post about the rotation we believe may be occurring before our eyes (small caps playing catch up to large caps), but I’m just not quite convinced that this means large caps will go down. So rather than being precisely wrong, we’ve decided to try and be generally right and wait it out a bit.
Below is a tweet thread from Jim O’Shaughnessy. Jim is founder of O’Shaughnessy Asset Management, and a pioneer in quantitative investing (computer driven modeling). Now that computerized trading has become ubiquitous, he’s one of a large crowd, but most important to me are his opinions on the behavioral side of investing. His views most clearly mirror mine, and it’s a bit long-winded, but it’s important to realize how our emotions will always remain our greatest weakness and our greatest source of opportunity.
Happy reading everyone, and congrats to all the graduates out there!
– Adam
Markets change minute-by-minute. Human nature barely changes millennium-by-millennium. There’s your edge.
How To Arbitrage Human Nature: A thread
People want to believe the present is different than the past. Markets are now computerized, high-frequency and block traders dominate, the individual investor is gone and, in his/her place, sit a plethora of huge mutual funds and hedge funds to which he has given his money. Many have simply given up trying to earn alpha in the market and have given their money to index funds. Some people think these masters of money make decisions differently and believe that looking at how a strategy performed in the 1950′s or 1960′s offers little insight into how it will perform in the future. But while we humans passionately believe that our own current circumstances are somehow unique, not much has really changed since the unarguably brilliant Isaac Newton lost a fortune in the South Sea Trading Company bubble of 1720. Newton lamented that he could “calculate the motions of heavenly bodies but not the madness of men.” Herein lays the key to why basing investment decisions on long-term results is vital: the price of a stock is still determined by people.
If you chart price of the South Sea company’s stratospheric rise and then compare it with the NASDAQ in the 1990′s, you’ll see they are virtually identical. As long as people let fear, greed, hope and ignorance cloud their judgment, they will continue to misprice stocks and provide opportunities to those who rigorously use simple, time-tested strategies to pick stocks. Unless you believe that human nature will fundamentally change soon, using long-term studies of which stocks do well and which do poorly lets you arbitrage human nature. Newton lost his money because he let himself get caught up in the hoopla of the moment and invested in a colorful story rather than the dull facts. Names change. Industries change. Styles come in and out of fashion, but the underlying characteristics that identify a good or bad investment remain the same.
Each era has its own group of stocks that people flock to, usually those with the most intoxicating story. Investors of the twenties sent the Dow Jones Industrial Average up 497% between 1921 and 1929, buying into the “new era” industries such as radio and movie companies. In 1928 alone, gullible investors sent Radio Corporation from $85 to $420 per share, all based on the hope that this new marvel would revolutionize the world. In that same year, speculators sent Warner Brothers Corporation up 962 percent—from $13 to $138—based on their excitement about talking pictures and a new Al Jolson contract. The 1950s saw a similar fascination in new technologies, with Texas Instruments soaring from $16 to $194 between 1957 and 1959, with other companies like Haloid-Xerox, Fairchild Camera, Polaroid and IBM being beneficiaries of the speculative fever. Closer to home, remember all the dot.coms of the late 1990s that soared on little more than a PowerPoint presentation and a lot of sizzle? And, of course, now we have Bitcoin…
The point is simple. Far from being an anomaly, the euphoria of the late 20’s; 60’s and 90’s were predictable ends to a long bull markets, where the silliest investment strategies often do extraordinarily well, only to go on to crash and burn. A long view of returns is essential because only the fullness of time uncovers basic relationships that short-term gyrations conceal. It also lets us analyze how the market responds to a large number of events, such as inflation, stock market crashes, stagflation, recessions, wars and new discoveries. From the past the future flows. History never repeats exactly, but the same types of events continue to occur. Investors who had taken this essential message to heart in the last speculative bubble were the ones least hurt in the aftermath. They understand that today’s events and news are mostly noise, and that only longer periods of time deliver the much more accurate signal. As Pericles said, they “wait for the wisest of all counselors, time.”
The same is true after devastating bear markets. Investors behave as irrationally after protracted bear markets as they do after market manias, leaving the equity markets in droves, usually at or near the market’s bottom. By the time they gather enough courage to venture back into equities, a good portion of the recovery has often already happened. Investors who remained on the sidelines in 2009 left between 50 and 75 percent of gains on the table, making it very difficult for them to catch up with the market. We are always trying to second guess the market, but the facts are clear—Our emotions and biases are toxic to good long-term performance and we *must* get them under control so that rather than letting them control us, we take advantage of them and arbitrage human nature, the last sustainable edge.