Should an investor still be looking for that pot of gold at the end of the rainbow, I'll end this paper by framing that hope with a dose of reality. Even as professionals (in fact, perhaps more so), we are at risk of overestimating our ability to predict the future, because as humans we have a tendency to overestimate our competence, knowledge, and experience and our ability to control outcomes. We tend to overestimate the information we have (which creates a knowledge illusion) and the accuracy of our estimates and our abilities (which create control and experience illusions).
I know how tempting it is to look for "the answer" to miserable markets, particularly as we suffer rom the lost decade. So I'll end my thoughts with a number of vignettes to remind you how angerous it is to ignore the behavioral risk of overconfidence as you compete against the house and other Tiger Woods's in the global investment markets.
In 1938, John Durand wrote Timing: When to Buy and Sell in Today's Markets, one of the early classics in active investment management. He also wrote How To Secure Continuous Security Profits in Modern Markets, in which he opined: "As this is written, one of the reatest bull markets in history is in progress. People have been saying for several years that prices and brokers' loans are too high; yet they go on increasing. ... People who explore the high at which gilt edged common stocks are now selling apparently fail to grasp he fundamental distinction between investments yielding a fixed income and investments
in the equities of growing companies. Nothing short of an industrial depression ... can revent common stock equities in well-managed and favorable circumstanced companies rom increasing in value, and hence in market price." This advice was penned September 928.
In March 1998, Brad Barber and Terrance Odean, two respected behavioral finance academics, published a paper often referred to as "the cost of a good idea." Based on the rading records of 66,465 households with accounts from 1991 to 1996, the researchers compared the performance of the stocks investors sold to the performance of the stocks hey bought with the proceeds of the sale. They found that those that traded most (i.e., whose investors with the most "good ideas") earned an annual return of 11.4%, while the market returned 17.9%. The average household earned an annual return of 16.4%. Their
conclusion? "Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth."
If you remember the "New Era," you may remember the money manager Robert Markman. In March 1999, he wrote, "The asset allocation zealots are mindlessly over-diversifying based on past performance. Ironically, it is the asset allocation zealots, in their rush to mindlessly diversify, who are projecting dangerously from past performance." In April he wrote "Bubble? What bubble? An all-time high often means the market is going higher. A lot of people talk about this all-time high as if it's a market top. ... This market high is a reflection of a strong economy. We oftentimes get hung up on these numbers and lose sight of the real direction of the market. The economy is strong. The economy is broad. The economy is deep. All the data coming in is positive. This is no bubble. This market is different from the market top of the '60s. This market is different from the market of the early '70s. This market is certainly different from Japan. A lot of people are pulling out the old Japanese bubble stuff, saying it'll happen here. Let's keep in mind in the late '80s, when the Japanese market was truly a bubble, the ground of the Imperial Palace in Tokyo had a greater market value than all the real estate in the state of California. That's a bubble! This is the future-changing right in front of us. What we have are some pretty high P/Es that are based on expectations of future growth. Those who can't understand this market don't understand the role of technology in our economy and how it's changing right before our eyes." [over the next few years the market fell about 35%]
I know you've all seen the charts: "If you missed the x best days," your return would have only been x%. That obviously begs the question: Why would someone miss those few best days? The answer is, the market moves up just as quickly as it moves down. According to one recent study, 70% of the best days in the market occurred within two weeks of a worst day (14 out of 20 days) and 100% of the best days occurred within six months of a worst day (20 out of 20 days).
How about other famous market gurus? Harry Dent? Elaine Garzarelli? Robert Prector?
Consider, more recently, Stephen Feinberg, co-founder of Cerberus Capital Management. Cerberus bought 51% of GMAC in 2006 for $14 billion, and 80% of Chrysler for $7.4 billion.
Or Sam Zell, the chairman of Equity International. Zell, who has made billions as a real-estate mogul, paid $8.2 billion for the Tribune Co., owner of several metropolitan newspapers and the Chicago Cubs. Tribune declared bankruptcy.
You can also think of Leon Black, the CEO of Apollo Management. Black's private-equity firm bought Linens 'n Things in 2006 for $1.3 billion with a plan to revive the ailing retailer and sell it for a profit. Instead, the company declared bankruptcy. In 2007, Apollo paid $6.6 billion for Realogy-the parent of Coldwell Banker and Century 21 real estate brokerages-just as the housing boom was inverting.
Or consider these other gurus:
- Bill Miller, manager, Legg Mason Value Trust mutual fund; enough said.
- Richard Fuld, former CEO, Lehman Brothers; ditto.
- Joseph Lewis, British currency speculator. This reclusive billionaire thought investment bank Bear Stearns was a bargain as its share price plummeted from a peak of $170 in 2007 and early 2008.
- David Bonderman, founder and principal of private-equity firm TPG. Bonderman has made a fortune buying distressed companies like Continental Airlines (1993) and Petco (2000), and turning them into profit machines. That's what he hoped to do with Washington Mutual. Bonderman's entire $1.35 billion evaporated.
- Stephen Schwarzman, CEO, Blackstone Group. Schwarzman saw a bright future for private equity when his famed firm went public in June 2007. But the share price subsequently plunged 80% percent.
- T. Boone Pickens, CEO of hedge fund BP Capital. The Texas oilman has made billions guessing right about the future of energy-until this year, when he failed to foresee the sudden drop in oil prices from record highs. In September 2008, he predicted that oil prices would be at about $120 a barrel by the end of 2008.
Finally, remember that in predicting the future, the key is not simply getting a single prediction correct; it's getting all of the interacting consequences correct. Ask yourself, just two years ago, could you have confidently predicted that we would elect our first African-American president in 2008? Would you have imagined that Citigroup would trade for a time under $1 or that General Electric would trade for a time under $6 or that Bear Stearns and Lehman Brothers would virtually vanish? That Chrysler and GM would file bankruptcy or that a graduating class of law students would be unable to get jobs? Or that high-end MBAs would be unemployable? And would you have guessed that we would have a fall of more than 50% in the broad stock indexes or that it would subsequently be up almost 30% in less than one month? Or that oil would triple in price and then fall by more than $100 a barrel? Some gurus might have seen parts of this pattern, but all of it? Again, life is far too complex to be predicted with any consistency. The moral? E&K's investment philosophy, although not static, is founded on decades of financial research and practical experience. We believe that profitable long term investing is based on buyand-manage with a consistent exposure to the market, allocations based on forward looking expectations, formalized rebalancing, careful attention to the management of expenses and taxes, all based on the unique circumstances of each client.