" 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!

" A Dying Banker's Last Instructions "

Enclosed is a NY Times article dated 26^th November 2010, titled, A Dying Banker’s Last Instructions.

The article is about Gordon Murray-a former salesman at Goldman-who rose to become Managing Director at Lehman and CSFB. As he was diagnosed with brain cancer-he decided to pen a small book The Investment Answer.

The article mentions that Gordon Murray later in his career learnt about the failings of active portfolio management, which had taught him to erroneously believe It’s American to think that if you’re smart or work hard, then you can beat the markets.

Gordon Murray, later on in his career, is influenced by Dimensional-a passive mutual fund company, which teaches him, No one can predict the future with any regularity, so why would you think that active managers can beat their respective indexes over time?

http://www.nytimes.com/2010/11/27/your-money/27money.html

' The market ...it's crazy...but the fact it's crazy doesn't make you a psychiatrist '

Meir Statman of Santa Clara University is a Professor of Finance whose research focuses on behavioural studies.

Despite being a proponent of behavioural finance he believes that ordinary investors cannot get a better risk-adjusted return than they can in low-cost index funds!

Being a behavioural finance proponent he does not believe that markets are efficient-but that does not mean people should not Index, his brief explanation is as under,

Q: You pound the drum for index funds. Is that because you think the markets are efficient and therefore unbeatable over the long-term?

A: The market is not efficient. It's crazy, but the fact that it's crazy doesn't make you a psychiatrist. It's crazy like a wild animal. You wouldn't want to go against a wild lion because it's crazy. It's crazy in ways you cannot understand and cannot forecast.

People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.

Practically speaking, individual investors should treat the market as unbeatable and realize that when they try to beat it because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another.

Can professionals beat the market? His answer,

Q: Do you think pros can beat the market?

A: Yes, they can. But it's still a zero-sum game. If some people win, it means that some people lose relative to what they can get by being in an index fund.

My interpretation of the above for Indian investors / advisors,

·        Indian markets are competitive because they comprise of a large number of professional investors who are all attempting to generate alpha, a brief list includes: MF, PMS, insurance, treasury, FII and hedge fund managers, stock pickers, analysts both fundamental and technical and so on and so forth.

·        The constant analysis and activity of the above ensures that Mr Market knows more than individuals and hence it is difficult for individuals to beat it (outguess the market) consistently.

·        Therefore, ‘beating the market’ is a) more of a random outcome b) it is known in hindsight and c) past data is of little predictive value going forward.

·        I am tempted to repeat Meir Statman’s sage advice for Indian investors: People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it. Practically speaking, individual investors should treat the market as unbeatable...!

Link to the article,

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2010/11/16/BU991GCEF9.DTL&type=printable

' Buy and Hold is still a winner '....Burton Malkiel

Dr Burton Malkiel is the economics professor at Princeton and author of a best-seller A Random Walk Down Wall Street. If my memory serves me right it has run into nine editions till date and remains an all time investment classic.

In a recent WSJ article, titled ‘Buy and Hold is still a winner-’ Professor Malkiel reinforces the timeless wisdom of a buy and hold investment strategy using passive indexing i.e. even during the turbulent first decade of the 21^st century.

The lessons from his analysis, in principle, are applicable to Indian investors also: it is rather difficult to outguess and beat the markets consistently!

Some outstanding words (in italics) from the article,

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.

I am reproducing a sample of ‘market timing’ from the article.

Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

The logic of passive indexing, in brief,

Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns.

http://online.wsj.com/article/SB10001424052748703848204575608623469465624.html