" What we can learn from Paul the octopus? "

Dan Gardner is a prolific writer with profound insights! 

His latest book is Why Expert Predictions Fail-and Why We Believe Them Anyway.

Some words from the author’s website,

In 2008, as the price of oil surged above $140 a barrel, experts said it would soon hit $200; a few months later it plunged to $30. In 1967, they said the USSR would have one of the fastest-growing economies in the year 2000; in 2000, the USSR did not exist. In 1911, it was pronounced that there would be no more wars in Europe; we all know how that turned out. Face it; experts are about as accurate as dart-throwing monkeys.

Predictions & forecasts form a sizeable component of active investing i.e. relative to passive investing. Enclosed is link to a wonderful article titled What we can learn from Paul the octopus written by Dan Gardner.

The article points out that a few right calls or predictions or winning streak-whether it is a fund manager or an economist or Paul the octopus...doesn’t make any of them an oracle, an expert or a guru. One should consider the hand of luck and randomness!

The author points out to our unfortunate habit of paying attention to hits while ignoring misses.

I am reproducing these words from the article,

Consider Nouriel Roubini, the economist who shot to global gurudom after he correctly predicted the meltdown of 2008. Every time he is interviewed, every time he is introduced to an audience, Roubini's famous call is mentioned. What is never mentioned is that Roubini also called for a recession in the United States in 2004, 2005, 2006, and 2007. Or that after the crash of 2008 he said oil would stay below $40 a barrel throughout 2009 (it doubled in price). Or that he said stocks were going nowhere but down (they soared).

I'm not saying Roubini simply got lucky in 2008. He's a smart guy with lots of genuine insight. But he's no oracle.

Link to the article, the author gives some examples: successful fund managers, economists and of course Paul...no one is an oracle!

http://www.dangardner.ca/index.php/articles/item/32-what-we-can-learn-from-paul-the-octopus

" Active or Passive? "....an objective analysis by Vanguard.

Enclosed is a link to an objective analysis of ‘Active or Passive?’ done by John Ameriks on Vanguard Blog in September 2009!

Vanguard’s founder and former CEO John C. Bogle launched the first index mutual fund in 1976-which now happens to be one of the largest equity funds in the world.

According to me, the basic arguments posted on the blog are akin to the laws of gravity and hold good for all geographies and free financial markets.

Consider the following words; I have underlined the important sentences,

Zero-sum: You don’t need to believe in efficient markets, rational behaviour, economics, or the tooth fairy to establish that a portfolio that holds all the securities in a capitalization-weighted market index (i.e., an index weighted like the S&P 500 and other common indexes, but containing all the securities in the market) will, after costs, outperform the average dollar invested in the market if active management costs more than cap-weighted indexing, which it generally does.

You do have to believe in basic arithmetic. (And the index must be cap-weighted, as this wouldn’t necessarily be true for other indexing methods.) But the result is purely mathematical from there, and is based only on the definition of the word “average”—not on fancy/complicated theories that require any additional assumptions.

Importantly, this basic math applies regardless of the market, or the so-called efficiency of the market.

Further....

...that in inefficient markets (think small-cap stocks or emerging markets), you tend to get much wider dispersion in manager results. There are lots of home runs, and lots of strikeouts (or worse).

But it’s still the case that, regardless of which investors beat the average and which fall below, the performance of the average dollar in an inefficient market is equal to the performance of a cap-weighted index of that inefficient market...

Some more wisdom....

...given the amount of noise in the data, we very often just can’t say whether any outperformance or underperformance is due to luck or skill.

Sure, there are some managers/investors who will frequently end up on the upside of wild swings, but there are also those who frequently end up on the downside. In such an environment, it’s generally harder to distinguish who is really adding value or subtracting it, given the additional background noise.

My Observations:

Considering the fact that modern Indian financial markets are highly competitive due to the presence of a large number of professional active investors (who are paid to generate alpha-a short list would include numerous MF managers, Insurance managers, PMS managers, FII and hedge fund managers, treasury managers, pension managers, family offices, analysts, stock-pickers, advisors, and many more)-the zero-sum equation mentioned above kicks in leading to randomness of outcomes.

On account of intense competition, out and under performers are a result of randomness and unpredictability. Out performances are usually transient and known in hindsight.

By default if some active investors / managers beat the market by a wide margin-their equally brilliant, motivated and competitive counterparts will be hit badly!  To quote the blog, you tend to get much wider dispersion in manager results.

Therefore the realistic return from any market or asset class is the ‘market average’ return as measured by broad market cap-weighted indices that map a sizeable component of market capitalization! To my mind, buying the market portfolio (cap-weighted index) is a more logical method of investing in a country's enterprise / businesses-which is what equities as an asset class are all about.

http://www.vanguardblog.com/2009.09.25/active-or-passive.html#more-245

A famous fund manager and stock picker turns to indexing !

Jeffery Vinik, a famous fund manager and stock picker, turns to indexing after stock picking gains....read on...

http://www.bloomberg.com/news/2010-12-17/jeff-vinik-s-hedge-fund-turns-to-index-funds-after-stock-picking-gains.html

" Index Funds are Fabulous "-Meir Statman

Meir Statman of Santa Clara University is a professor of behavioural finance. Behavioural studies in finance have become a rage over the past few years-behavioural finance, in brief, tells us that market participants are not always rational!

Professor Statman says that ‘index funds are fabulous’ in a recent interview with Morningstar, titled, Knowing Others’ Mistakes Won’t Make You Rich.

In the interview, he also gives a few examples of cognitive errors that people tend to make, some excerpts,

“...there is a range of cognitive errors that people commit, and it's important for people to know that. For example, mutual fund companies tend to advertise their most successful funds, the ones that have five stars from Morningstar.

Well, investors are left thinking that it's very easy to get a very successful fund. They never advertise their one star funds, and so you have to be aware that because mutual fund companies do that it tilts your view as to the likelihood of success. And so you should tilt it back, and say wait a minute, this cannot happen.

 Hindsight is another one that is very important to guard the gains. It is very easy for all of us to say that in 2007 we knew for sure that the market is going to be terrible in 2008.

If you actually had people write down in pen what they thought in 2007 at the time you would find that they said maybe it will go down, but then maybe it will not go down until 2009 and so on.

But now when we get to be in 2010 they remember only that they knew that the market is going to go down, and that really is hindsight that is speaking. So these are two of more cognitive errors that get in the way.”

Link to the interview,

http://www.morningstar.co.uk/uk/news/article.aspx?lang=en-GB&articleid=93968&categoryid=13

I believe, Indian markets are getting increasingly competitive with an ever increasing number of professional participants-a short list-would include active investors such as: MF managers, PMS managers, Insurance scheme managers, FII and hedge fund managers, treasury managers, other institutional investors, analysts, stock-pickers and so on and so forth.

With the presence of numerous brilliant, competitive and highly motivated participants-it is not easy, for individual professionals to find and exploit mistakes / pricing anomalies-i.e. consistently.

Asset allocation to passive indexes (ETFs / funds) is important as markets become more competitive & efficient thus resulting in a reduction of pricing mistakes and anomalies!