December 2020
Money flows vs Market concentration
Hedge funds vs Indexing
Market Lingo translations
Double-Digit Gains in 2020! (they still underperformed)
Fortune Tellers
Years from now when we think back to 2020 - or when your optometrist says 20-20 for that matter - we all will remember the global pandemic. What we Likely will not remember are the wide-ranging forecasts from so-called market experts, confidently “helping” investors navigate the market turmoil.
By nature we are loss-averse, which is the psychology that makes losses feel more painful than equally-sized gains - perhaps twice as painful. The fear of loss often hinders our willingness to take calculated risks that can capture even-larger risk-adjusted rewards. Compounding this effect is that fund managers usually have short-term reporting requirements and other perverse incentives that lead them into underperforming loss-averse management.
Now consider erroneous forecasts from market experts. In Statistics there are Type I errors and Type II errors.
Type I errors are “false positives”, in which an affirmative statement is made that is incorrect. Examples include a positive test for cancer in a patient who does not actually have cancer, when a fire alarm sounds but there is no fire, or when a doctor tells a woman she is pregnant when actually she is not pregnant.
Type II errors are “false negatives”, in which an affirmative statement is not made but should have been. Examples include a negative test for cancer in a patient that has cancer, when no fire alarm sounds in a real fire, or when a doctor tells a woman she is not pregnant when actually she is pregnant.
Type I errors can also be considered “errors of commission” in which someone chooses to take an action that turned out to be incorrect, such as when a manager buys a security that goes down or shorts a security that goes up. Likewise, Type II errors can be considered “errors of omission” in which someone fails to act but should have, such as when a manager does not pull the trigger on buying a security that then outperforms, or when a manager holds onto a security that then declines.
Managers have strong incentives to err on the side of caution by forecasting more severe losses than are Likely to materialize.
Since this is the year of COVID-19, the distinction between errors of commission and errors of omission is particularly revealing in the context of vaccines. Here’s Parental Decision-Making on Childhood Vaccination:
For parents, vaccinating their children could mean that parents have to witness their child's discomfort and have to face potential side effects. At the same time, not vaccinating may lead to contracting vaccine-preventable diseases, potential prosecution in certain countries, enrollment refusal in some schools, disrupting herd immunity, etc.
Parents who resist vaccinating a child may be acting out of a preference for Type II errors of omission, rather than the Type I error of commission in making the active decision to vaccinate their child then have to live with their self-imposed turmoil if the vaccine causes significant harm to their child.
So which type of error is worse? Let’s revisit the pregnancy example, summarized humorously in this graphic:
Okay okay, now let’s translate this two-way table into investment management:
Most managers prefer Type II errors of omission, rather than being actively wrong with Type I errors of commission. Missed opportunities are much easier to explain to investors than actively losing their money! Managers have strong incentives to err on the side of caution by forecasting more severe losses than are Likely to materialize. So when it comes to market experts making forecasts, the strategy is clear: predict losses that few people will remember when markets rise, but assert your expertise and prudent risk management when markets fall as predicted.
In this way, forecasts are systematically skewed toward undue negativity. Together with clickbait warnings of extreme losses (like this gem from June 23, 2020 Dr. Doom Predicts Another Decade of Depression), these phenomena play right into our cognitive biases and directly contribute to long-term systematic underperformance.
In his 1992 letter to shareholders Warren Buffett summed it up this way:
“We have long felt that the only value of stock forecasters is to make fortune tellers look good.”
—Warren Buffett
Let’s remember this forecasting wisdom.
Stock Picking Hindsight is 20-20
Here’s CNBC’s Eric Rosenbaum in Here's how much 5% invested in Tesla could have made for S&P 500 index fund investor:
The index fund has thoroughly disrupted the role of active stock pickers in the market, but in an era of accelerating disruptive business models across sectors of the economy, stocks like Tesla remind investors that they still need to make some conviction bets to generate above-average returns.
In this article, Nick Colas from DataTrek Research makes the following argument [summary mine]:
Indexing takes a long time to get results. That’s boring.
Indexing is overweight boring companies and underweight the high-flying IPO disruptors.
Stock picking provides the possibility of outperforming the index.
In the past decade, the S&P’s above-average returns relative to global stocks is due to just a few disruptive tech stocks.
Investors should right-size their stock picks with a 5% conviction carveout on disruptive stocks. Finding a home run like Tesla will make their portfolios outperform, whereas striking out will lag the index by only a small margin and is worth the tradeoff.
Stock picking is a losing game! Stock picking has a terrible track record, and it's getting worse. Providing the possibility of outperformance is easy. Providing the Likelyhood of outperformance is much harder. The stock picking possibility is the Hail Mary heave giving a team the unlikely hope of a touchdown to eke out an improbable win. Under those last-minute circumstances when all that matters is outperforming once, sure, the Hail Mary is the optimal strategy. But when it’s early in the 1st quarter and teams have a wide range of more successful long-term strategies in the playbook - as it is with the infinite repeated game of investing - throwing Hail Marys repeatedly each drive throughout the game is an obviously losing long-term strategy.
Stock picking is a losing game! Right-sizing with 5% is much better than 100%, slightly better than 10%… and worse than 0%.
Stock picking is a losing game! Tesla looks great in hindsight. But a repeated strategy that relies on continually finding Teslas is not Likely to succeed in the long run. The repeated game will have many more flops whose collective losses will Likely exceed the gains of the winners.
Stock picking is a losing game! Annie Duke’s latest book Thinking in Bets details what she calls Resulting, also known as Outcome Bias, which is judging the quality of a decision by the outcome rather than the decision-making process. Especially with highly uncertain contexts like investing, luck is rarely credited in explaining profitable outcomes. Hitting a home run with Tesla, then promoting that home-run-hitting strategy based on the results for future stock picking, is classic Resulting.
I’ll stop now.
Robinhood Gamification
Robinhood has perhaps become the go-to platform for new, small-dollar investors who are not profitable to the larger brokers. Commission-free trading, slick interface, and a dose of human psychology have found demand. Throw in pandemic lock-downs that lead stuck-at-home folks to seek entertainment (gambling?) in the stock market - what Matt Levine aptly calls the Boredom Market Hypothesis - and we’ve got a story!
Now Massachusetts is coming after Robinhood to protect vulnerable new investors from losses, Robinhood Accused of 'Gamification' of Trading by Massachusetts Regulator.
Yes, Robinhood needs more complete disclosures and warnings. Yes, Robinhood should increase margin requirements to throttle high-risk trading. Yes, Robinhood should ensure users are educated about margin calls, and should make those margin calls when warranted.
But come on Massachusetts, let ‘em trade.
ONE MORE THING…
The money flows rebuttal to the market concentration critique: Rotation is the lifeline of the bull market, says Ritholtz's Josh Brown
More bad news for hedge funds competing with indexing: Hedge funds had their best month since 2009. They’re still not keeping up with the stock market
Which Market Lingo translations are your favorites? My nominee: “We are not correlated” = We are underperforming while the market keeps going up. Technically Speaking: Navigating Market Lingo In 2021
Double-Digit Gains in 2020! (they still underperformed the S&P 500): Stock-picking hedge funds land investors double-digit gains in 2020
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