More than you know

More than you know

Finding Financial Wisdom in Unconventional Places

By Michael J.Mauboussin

Michael J. Mauboussin is known throughout the financial world for his innovative approach to succeeding on Wall Street. In More Than You Know, Mauboussin shares his secret to becoming an insightful investor and provides invaluable tools to better understand the concepts of choice and risk.

I) Investment Philosophy

1. Process and Outcome in Investing

Judging solely on results is a serious deterrent to taking risks. the way. The single greatest error in the investment business is the failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price. You must consider both the probability and payoffs. You want the positive expected value on your side.

Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.
– David Sklansky, The Theory of Poker.


2. Focus on magnitude of correctness

Constantly thinking in expected-value terms requires discipline and is somewhat unnatural. You need focus. Professional gamblers do not play a multitude of games – they focus on a specific game and learn the ins and outs. Most investors must definte a circle of competence – areas of relative expertise.

Investors must evaluate a lot of situations and gather lots of information. For example, the CEO of Geico’s capital operations, Lou Simpson tries to read 5-8 hours a day and trades very infrequently. Dont appear very often in the market, until you are very sure. Even when you know what you are doing and play under ideal circumstances, the odds still favor you less than 10% of the time.

3. Theories, more important to base on circumstances

Much of investment theory is unsound because it is based on poor categorization. Example, investors who rely heavily on attributes based categories such as PE ratio. Based on a value investor’s theory, it is important for low-price-earnings-multiple investing. Buying the market when the P/E is low is not a valid theory for generating superior long term returns.

Legg Mason Value Trust’s Bill Miller, the only fund manager in the past 4 decades to beat the S&P 500 15 years in a row is a good case in point. His approach is decidedly circumstance based, yet he is often criticized for straying from an attribute -based mindset :

His portfolio has hardly reflected the stocks with a low price-to-book and price-to-earnings ratio you would expect to find in a value fund. In 1999, its price-to-book ratio was 178% higher than the value category average and its price-to-earnngs ratio was 45% higher than average.

4. Myopic Loss Aversion

The attractiveness of the risky asset depends on the time horizon of the investor. An investor who is prepared to wait a long time before evaluating the outcome of the investment as a gain or a loss will find the risky asset more attractive.


II) Psychology of Investing

Money manager, especially when feeling a loss of predictability and control, are drawn to short-term activity. They should take steps necessary to focus on the long term if they are to optimize long-term fund performance. Investors need to pay a great deal of attention to what influences their behavior example consistency and commitment, social validation and scarcity. It is important to figure out what the market already thinks.

When investors feel good about an investment idea, they deem the risks low and the returns high irrespective of more objective probabilities. And when they dislike an idea, the inverse is also good. Great investors aren’t too swayed by affect.

Imitation is one of the prime mechanisms for positive feedback. Momentum investing, for example, assumes that a stock that is rising will continue to rise. If enough investors follow a momentum strategy, the prophecy of a high price becomes self-fulfilling.  George Soros’s strategy was also to take advantage of these trends by either buying or shorting stocks.

Herding is when mnay investors make the same choice based on the observation of others, independent of their own knowledge. Markets do tend to have phases when one sentiment becomes dominant, thus resulting in booms (bullish markets) or busts (bearish markets). The key to successful contrarian investing is to focus on the folly of many, not the few.

It is also good to keep notes of why you make certain investment decisions. These notes will become a valuable source of objective feedback and can help sharpen future decision making.


III) Innovation and Competitive strategy

Wealth in the future is likely to follow those who create the useful ideas instead of those who execute those ideas. It is often difficult to know which businesses will succeed or fail. Investors are wise to look around for survicors at the end of the pruning process because a portfolio of surviving companies often presents an opportunity for attractive share holder returns.

Companies should develop long term decision rules that are flexible enough to allow managers to make the right decisions in the short term. In this way, the company is managing for the long run even when it has no information about what the future holds.

Investors need to assess the stocks of all companies vs expectations. This analysis is important for value investors. The classic value trap is to buy a cheap company that deserves to be cheap based on poor economic returns. Most stocks that are cheap are cheap for a reason. But buying a company that is cheap because of temporary downturn is potentially very attractive if the market does not anticipate the turnaround.


IV) Science and Complexity Theory

In well-defined systems, experts are useful because they can provide rules-based solutions. But when a system becomes complex, a collection of individuals often solves a problem better than an individual – even an expert. This means that the stock market is likely to be smarter than most people most of the time. Diversity is important.

Power laws indicate here are a lot of small occurences and very few large ones. In nature, there are a lot of ants but very few elephants. Similarly, we have many small companies and a modest number of large ones.It is hard for the largest companies to meaningfully outperform the market because they are such a large percentage of the market.

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