The Finance Book Club

Chapter 8 - The seven sins of fund management
This is a summary chapter where each topic is investigated in more detail and since I’m going to look at each one I will just list the sins here.

 

1. Sin 1: Forecasting (Pride)
   An enormous amount of evidence suggests that we simply cannot forecast.
2. Sin 2: The Illusion of Knowledge (Gluttony)
   Information is not necessarily knowledge.
3. Sin 3: Meeting Companies (Lust)
   We already know that people are easily fooled and susceptible to biases so why would meeting people in person make any difference?
4. Sin 4: Thinking You Can Outsmart Everyone Else (Envy)
   Overoptimism and overconfidence
5. Sin 5: Short Time Horizons and Overtrading (Avarice)
   Because so many investors end up confusing noise with news, and trying to outsmart each other, they end up with ridiculously short time horizons.
6. Sin 6: Believing Everything You Read (Sloth)
   We all love a story. Maybe too much.
7. Sin 7: Group-Based Decisions (Wrath)
   Even though psychologically we feel safer in herds, groups make the worst decisions.

Chapter 9 :The Folly of Forecasting: Ignore all Economists, Strategists, & Analysts

There is a lot of statistical and anecdotal evidence that predictions are hard, especially ones about the future.

Forecasting doesn’t seem to work:
Among equity strategists

Among bond forecasters

Among economists and analysts

and it’s not just in finance. Doctors are terrifyingly bad at predicting the ailments of patients based on symptoms compared to meteorologists estimating future weather based on current weather patterns.

My own research on signals services has failed to discover a single person or entity who is much better than 50% accurate . In fact I think one way to improve odds a little is to bet against popular forecasters.

So why do people continue to make and follow forecasts despite all the evidence showing that they’re useless? The short answer is ignorance and arrogance.

 

1. The most common biases are overconfidence and over optimism
2. people are very uncomfortable with uncertainty so they need any figure to anchor on
3. analysts are very good at telling us what has just happened but of little use in telling us what is going to happen in the future.
4. most forecasts simply extrapolate what has happened in recent history and expect it to continue to happen in the future. In other words they lag behind actual events.
5. this is why I’ve been so optimistic about cyclical analysis because it doesn’t just assume that future price action is going to mimic recent price action. However making use of this is dubious to say the least. Financial cycles seem to be too rough and chaotic to be of much use because the market is a pattern erasing machine.
6. People underestimate variance.
7. Experts are particularly overconfident
8. Analysts often respond by saying that individual target prices are the result of ‘irrational investors’ or ‘random chance’ whereas their earnings forecasts are credited to their ‘detailed sector knowledge’.
9. Forecasters basically don’t realize how overconfident they are and they protect their egos by ignoring the evidence pointing to their terrible success rates
   Attached Image (click to enlarge)

   
   

What should we do instead of forecasting? Montier advises using value-based investing strategies using trailing earnings and Graham-Dodd price-per-earnings but he does not go into any detail about these.

Understanding what is a Breakout and what it means.

I think it has been like this at least since Wyckoff identified his 'accumulation/distribution' zones.

Chapter 10 - What Value, Analysts?

You would suspect this chapter is about how analysts are not useful to a fund management firm but actually Montier supports analysis as long as it doesn't try to forecast but rather "[analyze] the present and [understand] what that means for the future rather than coming up with spurious anchors for investors." The curious reader, me, for example, would be interested in how this differs from 'forecasting' but Montier doesn't elaborate.

Instead, this chapter is about how nearly any (or actually any?) measure of valuation is equally useful to the prospective analyst.

1. Analyst's favorite measure of value is forward PE
2. However historical earnings are just as 'useful'
3. It seems to me this hinges on how useful 'useful' is?
4. Analyzing analyst recommendations show that they don't actually rate value as an input but instead prefer momentum growth. There's that word again.
   1. Analysts don't look at value but instead want "high long-term earnings growth forecasts."
   2. "Unfortunately, the evidence suggests that analysts haven’t got a clue about forecasting long-term growth".
   3. They like expensive stocks in terms of PE, with very low dividend yields, high price to sales, and high price to cash flow
   4. "analysts appear to be little more than momentum players." But what else is there?

   
   

5. The least popular valuation method is the dividend discount model but nearly every textbooks tells you that it is the best way to value stocks (what value, textbooks?)
6. Analysts tend to look at only 1-2 years data as inputs, making their trading horizons short-term, but stocks are supposed to be long-term claims on assets. This is probably a result of caving in to client pressures, which explains the shortening of holding periods in all markets
7. A study by Lancetti found no difference between using forward PE and trailing PE, so the value of analyst forecasts is questionable, well obviously, if we accept what we were told in chapter 9.
8. Since analysts are basically just looking at momentum, they are 'massively overpaid' because simple software can generate a list of momentum stocks.
   1. Analysts are probably not paid for their analysis so much as their stories

   
   

9. Momentum has been shown to work far better when it combines short-term winners with long-term losers (i.e. a trend reversal). However, analysts seem to prefer stocks that have done well both recently and over the longer term.
   1. [analysts] would be better off buying long-term losers that have recently become short-term winners, i.e. stocks that had witnessed a positive trend reversal.
   2. Chan and Kot (2002) have shown that this can be a very profitable strategy.
   3. The best performing strategy is the short-term winner long-term loser combination.

   
   

So, if nothing else there's something worth digging into.

But look, the chart actually seems to show that long-term losers, also losing in the short-term, are just as good candidates for future returns. So is this telling us the only thing that really matters is mean reversion? The losing-est stocks eventually have to rebound? But this would also be subject to survivor bias, since that list would only include the losing-est stocks that also didn't go belly up? I'd say so, without knowing more about the strategy.

Chapter 11 - Is More Info Better Info?

No. No it is not. Even if you can adequately analyze it, there are too many variables. People are terrible at multi-factor analysis and computers are only marginally better which is why quants haven't taken over the world (yet).

"The argument goes, if the information is useless it will be ignored. However, implicit within this viewpoint is an assumption that we are all supercomputers who can deal with the seemingly endless torrent of informational deluge. However, we aren’t idealized supercomputers."

 

1. 'mo info, 'mo overconfidence
2. more information can hamper decision-making
3. Figuring out what info is irrelevant makes forecasting even harder than it already is
4. What are the five most important elements in stock selection? Montier says he doesn't know and if he did he would have retired years ago.

Chapter 12 - Why Waste Your Time Listening to Company Management?
You shouldn't.

1. Info generated by companies is often noise
2. Corporate managers have no immunity from typical biases
3. Confirmation bias means most people only go looking for info that supports what they already believe
4. People tend to give too much credit to leadership; probably an innate bias.
5. People are not good at knowing who is lying to them.
   Stolen election, anybody?

Chapter 13 Who’s a Pretty Boy Then? Or Beauty Contests, Rationality and Greater Fools

1. most investors are gaming the market, using on average two steps of strategic thinking.
2. The game demonstrates the difficulty of ‘beating the gun’, and highlights the extreme risk that investors run in momentum-oriented markets.
3. Montier invents a toy version of the market game by asking investors to pick a number between 0 and 100, and the winner would be the player who picked the number closest to two-thirds of the average number chosen.

I would love to play this game with you right now, but I know I'll only get 2-3 responses, which is not enough. Montier got around 1000. Instead I'll cut to the chase.

1. The optimal (mathematical) strategy is to pick the lowest number possible, since if the other players are perfectly mathematically rational (and they know or assume everyone else is too), they'll also pick the lowest possible number. In that case the best response is '0' (zero).
2. However humans are far from mathematically rational, so the key is to be able to guess what the typical response will be, and then multiply that by 2/3.
3. A lot of respondents had already heard about this game and so there is a spike of responses around zero. This is the 'curse of knowledge' where once you know the answer it's hard to imagine everyone doesn't know it.
4. Most people use between 1-2 steps of strategic thinking
5. To beat them, therefore, you have to use third order thinking
   1. What does average opinion expect the average opinion to be?

6. You can beat this game using 'iterated thinking'
   
   

    

   1. Suppose everyone picks 100
   2. Then the dominant response is 67 because there is no number lower than 67 that is 2/3 of 100.
   3. Of course not everyone is going to guess 100
   4. Pick a lower number, say 50
   5. If everyone picks numbers 50 or higher then the dominant response is 33.
   6. You can keep going like this finding the response that dominates the others and it's always a lower number, until you get to zero

7. "As soon as we start to see that at least some of the market is not fully rational, then the problem becomes more and more complex."
8. "We know the efficient (right) answer should be 0, however as a rational investor our estimates have to include our guesstimates on how rational our
   competitors are!"

This is how Montier explains the results

1. The mean from a random draw is zero, so level zero players pick 50. (anyone who guessed over 50 is irrational).
2. Level 1 players guess 33, two-thirds of 50.
3. Level 2 players react to 33 which gives them 22. (I guessed 25 so I suppose that makes me a level 2 thinker. This is the most common modal level. Either that or I'm underestimating the cunning of the market and I raised my rational answer by too much.)
4. Level 3 players react to 22 and get 15.
5. The actual average response was 26, making 17 the best guess.
6. A majority of players who knew or suspected that zero was not a best answer because people are boundedly rational, still ended up picking an answer that was too low. Is this anchoring around the known answer or an overconfidence in human rationality?

Note that winning this 'game' requires you to be one step ahead of the mean but not more than that or you'll underestimate.

This also has associations with bubbles and busts. If everyone was rational, everyone would expect every bubble to burst today and so they would never materialize. All market activity depends on an innate 'failure of backward induction'. In other words, an assumption of market rationality, is irrational! Is this a variation of Soros' "reflexivity"?

I know some of you will think I'm off my rocker devoting so much time to this idea, but I actually think it's brilliant, and critical to understanding the main mind game that is played with investors in equity markets, and maybe all markets.

Look at what's happening in equity markets today.

Attached Image (click to enlarge)

The world is a mess.

1. News expects the economies of Britain, China, and the rest of Europe to implode, if they aren't already
2. There are new Covid fears as we enter the winter
3. Australian outlook is deteriorating
4. Russia/Ukraine uncertainty
5. Recession word tossed around everywhere

What's the market doing? It's going up! Why?

1. The average investor expects the market to go down (rational)
2. The second order thinker expects the average investor to expect the market to go down, so they are buying (what we see now)
3. The third order thinker expects the market to come crashing down just as soon as the first order thinkers think maybe the economic downturn is overplayed and/or their short trades become too painful.

Notice that this also produces the maximum amount of pain for everyone - trouncing the first order and second order gambits. My guess is there is a lot of money sitting on the sidelines waiting for the time to pounce.

edit: But it's not so simple as all that, because the third order thinker might be of the opinion that if the rest of the world is going into recession there is no better place to put money than in US market (T.I.N.A) in which case second order is thinking of the crash and first order is thinking this is the start of a recovery. Note that however you want to interpret it, this puts the most sophisticated investors trading the same direction as the most naive, but via a different thought process, which seems to support 'horseshoe theory'. I also wonder if these 3 groups (1st order, 2nd, 3rd or genius, midwit, dimwit) are represented in the average duration of trends/trading horizons?

Keep it up. I enjoy reading it . And we are all off our rockers being in this game so dont worry about it

jr , well color me stupid , but one may factor in the "fracutuals of how BUSINESS gets done and the measuring stick used , as in quarters , dosent have much to with "thinking" more to do with movers bottom line and what they actually use , starting with that would probably be good , does tend to get rid of a lot of the "thinking: problems most get taken up with
like all the indices , the old covid cowboy coming back around , nothing more nothing less , money aint quite so cheap to use now and hard to justify the "house" getting paid to borrow it atm , wink wink chuckle chucle tho , the boys will come up with something under handed , but it has to look good , like it is random and chaotic and fractual and and market related and all the other crap , far from it tho , its a fagazi game and it has been since day 1

I suppose the good news is that despite stupidity one can still be a first-rate trader because one will avoid the average “mid-wit” strategies that are dominated by third-order thinkers. Maybe?

I have remarked before that some of the smartest-seeming people online are also some of the ones who complain that successful trading is impossible for various reasons like market efficiency.

Chapter 14 - ADHD, Time Horizons and Underperformance

1. It’s a fact that the more often you check your investments the more likely you are to find a loss.
2. Even skilled investors can run for three years back to back underperforming the market
3. Skilled investors can also expect to underperform in every one out of three years.
4. Average holding time in the 1950s was around 10 years and now it’s dropped to around four years for fund managers.
5. Professional investment trading horizons have dropped from 11 years in the 1950s to just eight months now.
6. Being honest with clients about the limitations of short term trading is nearly impossible because nobody wants to hear it.
7. “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” -Keynes
8. I’m beginning to realize that John Maynard Keynes was famous for more than just his economic wisdom. He has a ton of great quotes.

Chapter 15 The Story is the Thing (or The Allure of Growth)

1. In this chapter Montier builds a case that stories, for which the human mind is hardwired, drive Investors into something called “the growth trap“.
2. Stock brokers sell dreams but deliver nightmares. So why do people listen to them?
3. The rational way to go about things is to gather all the evidence that we can in as unbiased a way as possible, and then evaluate it and then make a decision.
4. Instead what most people do is gather the evidence in a biased way, construct a story that fits the evidence and then make a decision based on the story. It’s called “explanation based decision making“.
5. Montier points to China as an example of a story that has misled investors. People who invested heavily in commodities expecting the growing economy of China to lead to higher prices because China consumes everything “will end up ruing their decision“. Did they though? It seems like this was good reasoning until it wasn’t.
6. Faster growing GDP economies have led to lower returns then slower GDP economies. But why? Montier claims it’s because investors overpay for the hope of growth. it seems to me that doesn’t really explain anything though? Is this principal really universalizable?

Chapter 16 - Scepticism is Rare (or Descartes vs Spinoza)

1. People believe the darndest things.
2. It seems like people are hardwired to need to believe things before they can understand them.
3. The chapter title refers to a disagreement between two philosophers.
   1. Descartes thought that understanding and belief were separate processes.
   2. Spinoza thought that they were the same process.
   3. Montier claims that the evidence supports Spinoza.

4. If this is true it’s highly disturbing. It would seem to suggest we cannot control our understanding.
5. There are two strategies to combat this though.
   1. We can analytically assess our beliefs.
   2. We can actively avoid the generators of false beliefs.
   3. it seems to me the second one is nearly impossible though because we would already have to know that the beliefs generated by a particular source were false in order to actively avoid them. Look at how many otherwise intelligent and rational people have fallen for the lies told by charismatic men like Putin and Trump. But heck if I’m being perfectly rational maybe I’m the one who’s been brainwashed and the lies are coming from Biden and NATO? If what this chapter is saying is true then I really don’t have any chance of getting this right except by analytically assessing my beliefs and trying to map the evidence to the conclusions. Which is a lot of work that my confirmation bias just doesn’t wanna do!

6. It gets worse though. Compounding this problem is the fact that when we are distracted our ability to properly assess an argument goes way down. In this era of handheld distraction machines we are probably living in the most historically distracted time in the history of humanity! Montier recommends putting away our cell phones when we need to exercise scepticism.
7. So I’ve taken his advice and after thinking about it I think I’m going to side with Descartes. This chapter is baloney! Vive le free will!

Chapter 17 - Are Two Heads Better Than One?
Most of the time, no.

 

1. Groups tend to reduce the variety of opinions in a discussion.
2. Groups reduce unique information because weak-willed participants abandon what they know in favour of consensus.
3. Groups are vulnerable to polarization (more extreme views) and groupthink (tunnel vision)
4. To offset these problems we can use secret ballots, devils advocates, and respect. Montier claims the last two are hard to find. I don’t think there is any shortage of contrarians on the Internet, respect on the other hand, definitely.
   

Curiously, groups are better at forecasting as long as a few strict conditions are observed.
1. People must be unaffected by others’ decisions (effectively their errors must be uncorrelated).
2. The probability of being correct must be independent of the probability of everyone else being correct.
3. The participants must be unaffected by their own vote possibly being decisive.

This clearly does not reflect the environment in financial markets and forums.

Fun fact: I was a big fan of Surowiecki‘s book when it came out and actually tried to launch a startup to make software that would use the Internet to allow organizations to make better decisions. As it turns out nobody thinks they need help making better decisions. Overconfidence bias! The company went nowhere but I was able to sell the domain name to a French company that makes stock options software.

Hi

" some of the smartest-seeming people online are also some of the ones who complain that successful trading is impossible for various reasons like market efficiency". -

I enjoy reading your "write-ups" - appreciate that you put in a lot of effort.

My own reading of books is a bit "slow" these days.

Trade well / Mos

Chapter 18 - The Tao of Investing

A welcome change of pace as the book shifts from focusing on the problem to the solution.

The goal is an investment strategy that is robust to behavioural bias

1. Managers are more likely to outperform if they
   1. understand exactly how they generate 'alpha'
   2. understand if their performance is luck or not
   3. know if their process needs to change over time

2. It's important to do something different from the vast majority of investors

Chapter 19 - Show Me the Alpha

1. Just because most fund managers fail to beat the market isn't proof that it's efficient
2. Stock-picking has declined in favour of 'closet indexing' (secretly following the indexes)
   1. Attached Image (click to enlarge)

      
      
      Stock-picking has declined 'massively' over 20 years.

3. Stock-picking generates alpha versus betting on sectors or indexing (really??)
   1. Attached Image (click to enlarge)

      
      
      The worst performer is a fund making sector bets and picking stocks passively. The poor performance of these funds explains why the indexes are able to outperform them says Montier.

4. Diversified stock-pickers tend to be large-cap value players
5. Concentrated stock-pickers tend to be small-cap value and growth
6. Closet indexers tend to be momentum players
7. "Active Share" measures the degree of overlap with the benchmark index. The higher the number the lower the overlap.
   1. "Imagine that the manager starts by investing $100 million in the index (S&P 500), thus having a pure index fund. Assume the manager only liked half the stocks, so he eliminates the other half from his portfolio, generating $50 million in cash, and then he invests that $50 million in those stocks he likes. This produces an active share of 50%. If he invests in only 50 stocks out of 500. . . his active share will be 90% (i.e. a 10% overlap with the index)."

8. The ideal fund appears to have high active share and high past performance
   1. Attached Image (click to enlarge)

      
      

9. Closet indexers can't beat the index because they're just shadowing it. This is not the same as market efficiency. If you're paying for active management and not really getting it, you're being fleeced.

Chapter 20 - Strange Brew
Montier advises abandoning indexing (!), focusing on absolute alpha, and more willingness to short.

 

1. He advises a return to balanced funds
2. Strategic allocation based on long-term valuation
3. Only 30% in equities
   1. Real bonds outperformed real equities over a 10-year horizon 18% of the time
   2. "Therefore, suggesting a 30% weight in equities over the long term, given the current state of valuations, doesn’t strike us as radical."
   3. A sensible precaution given how things went in 2008 but it looks bad from 2009-2019.

4. Capture short-term rallies in bear markets
5. He predicts the death of indexing, and thinks it is 'unrealistic' to anticipate 'any further multiple expansion' (trend?) in the long term.
   1. indexes are little more than momentum measures, as better performing stocks are added and worse ones removed
   2. So there is little reason to pay for management fees
   3. However now that momentum is 'over' it's more important to pick better managers
   4. This book was published in 2007 so he was right that the trend was ending, but the rest of it seems hyperbolic?

6. Montier says relative returns are only of use to a few fund managers.
   1. "It does me no good whatsoever to know that my pension fund has fallen 40% against a market that has fallen 50%. The only thing that matters to me is absolute returns."
   2. This will somehow also reduce the risk of bubbles arising?

7. Montier explains a new measure for evaluating performance consistency
   1. It's based on 'information ratio' which is the information coefficient (IC) x the square root of 'breadth'
   2. The IC measures the correlation between the forecasts made by a manager and actual outcomes
   3. Breadth is the product of the number of assets covered plus the number of independent decisions made
   4. Such a cumbersome measure of performance could only have been invented by an economist and the effort of applying it's formula could only be counterproductive!

8. On shorting
   1. Still perceived as immoral
   2. Jesse Livermore used to get death threats
   3. Shorting improves market efficiency
   4. It seems to me Montier doesn't supply enough evidence for this. Equities have only gone up historically. When they stop, investment isn't going to be top of mind for most folks.

9. Add breadth
   1. Diversify strategies
   2. Montier uses LTCM as an example of a fund that had just one strategy albeit diversified geographically

10. 'Truly Alternative' Investments
    1. Montier admits he doesn't know much about these, but one of them is timber. I guess timber prices have gone up to say the least.