World Beta Blog

I was chatting with Professor Tetlock earlier and he passed along this interesting opportunity.  It looks like fun plus you can make up to $600.

To join, go to http://www.goodjudgment.info

Dear Colleague,

We are writing with an unusual but, we hope, intriguing request.  We are in the process of recruiting knowledgeable people to participate in a quite unprecedented study of forecasting sponsored by the Intelligence Advanced Research Projects Activity (“IARPA”) and focused on a wide range of political, economic and military trends around the globe. The goal of this unclassified project is to explore the effectiveness of techniques such as prediction markets, probability elicitation, training, incentives and aggregation that the research literature suggests offer some hope of helping forecasters see further and more reliably into the future.

To join, go to http://www.goodjudgment.info.  You do not need to read anymore of this message, but, if you are curious, further details follow.

***

There are several teams recruiting participants. Ours builds on Phil Tetlock’s work described in his book Expert Political Judgment; his co-PIs are Barb Mellers and Don Moore, with an advisory board that includes Daniel Kahneman, Robert Jervis, Scott Armstrong, Michael Mauboussin, Carl Spetzler and Justin Wolfers. It involves a multi-disciplinary effort to understand how people use the knowledge they have to develop expectations about the future and what sorts of processes and strategies lead to success.

We need to recruit as many as 2500 people who have a serious interest in and knowledge about world affairs, politics, and global economic matters and are interested in testing their own forecasting and reasoning skills. So please consider visiting the project web-site at http://www.goodjudgment.info.  You will find what you need to register there and more information about the project.

We are committed to maintaining high standards for admission to this special program. And we would greatly welcome your participation if you are so inclined (please be advised that the minimum time commitment would be several hours in passing training exercises, grappling with forecasting problems, and updating your forecasting response to new evidence throughout the year).

The primary motivation for participating should be Socratic: self-knowledge. But we can also offer a token honorarium of $150 to each participant for completing each year in the forecasting tournaments. And, although all participants will be given key anonymity, the winners of the forecasting tournaments will know who they are and will be free to go public if they so wish.

Of course, we understand if you yourself do not have the time to engage in an exercise of this sort. But we would be very grateful if you are willing to pass this request on to colleagues and readers of your work who might be interested in participating in this program and who would be likely to qualify for admission.

We can promise the following: this will be an intellectually stimulating experience (indeed, should you be bored, you should drop out); participants will have the opportunity to work with state-of-the-art techniques (training and incentive systems) designed to augment accuracy; and participants will receive feedback on how well calibrated (among other things) their subjective probability judgments are in relation to others for various categories of problems.

In short, we think it will be fun. If we were not running it, we would volunteer ourselves.

Many thanks for considering this, and for passing this invitation on to others who might also be interested.

Philip Tetlock, Psychology and the Wharton School, University of Pennsylvania

Barb Mellers, Psychology and the Wharton School, University of Pennsylvania

Don Moore, The Haas School, University of California, Berkeley

With the news that Apple is now the largest company by market cap in the US hitting the wire, analysts should take a look at this older post of ours summarizing Arnott’s research.

Arnott’s monthly letter is a must read.  In the 6/2010 issue, titled “Too Big To Succeed” he examines how the largest market cap company in each sector performs relative to its peers.

(We did some older posts on the subject of the largest company by market cap overall.  The original study was featured in the book “Mosaic: Perspectives on Investing” by Pabrai.)

From Arnott’s letter:

“We find the leader in any sector underperforms the average stock in its own sector by 3.5% in the next year … and the next year … and the next year. As Table 1 shows, the damage doesn’t really slow down for at least a decade, as the top dog in each sector lags its own sector by 3.3% per year for the next decade!

From these results, one might conclude that an investor could do rather well by investing in the Russell 1000, minus its 12 sector leaders. Better still, perhaps we should exclude all of the companies that have been sector leaders any time in the past decade because the performance drag for the top dogs tends to persist for a decade or more. These stocks typically comprise about one-fourth of the Russell 1000! If these stocks suffer a 300–400 bps shortfall in most years, one could outperform the index by nearly 100 bps per annum merely by leaving the top dogs out, cancelling the corrosive influence of competitors, populists, and pundits.”

Now, Arnott runs billions on indexes that are not market cap weighted, but the arguement is certainly persuasive.  He also co-wrote the very good book The Fundamental Index: A Better Way to Invest.

Below are the 9 sector SPDRs and their top holding in each:

“The Commanding General is well aware the forecasts are no good.  However, he needs them for planning purposes.”

- Kenneth Arrow, Nobel Laureate Economist…recalling the response he and colleagues received during the Second World War when they demonstrated that the military’s long-term weather forecasts were useless. (via Future Babble)

Virtually every day there are pundits and gurus on the airwaves, internet, and print making predictions.  At the beginning of 2011 a few of these gurus made some pronouncements as to the future returns of the US stock market.   Laszlo Biryini contended that the S&P 500 (currently trading at 1300 as of this writing – sorry, wrote this about a week ago) would rise to 2854 by 2013, or a 120% gain from current levels.  Robert Prechter, on the other hand, said he thought the Dow would decline 90% by 2017, which would imply that the S&P 500 trades down to around 130.

So there you have it, opposing gurus who believe that stocks will either rise or decline by 30% annualized over the next number of years.  (To complicate the matter even further, you have Shiller estimating the S&P 500 to gain about 10% total by 2020 which splits the two gurus in half.)

Interestingly enough, if you combine the current S&P 500 level (1300, PE of 23) with the lowest (5) and highest historical values (45) for the Shiller cyclically adjusted price earnings ratio (CAPE) you get to values similar to the forecasts at both ends (300 and 2600).  I think the most interesting but unlikely forecast is all three being correct over various timeframes!

The only difference between the S&P500 at 300 (an 80% decline) and the S&P500 at 2600 (a near double) is opinion, namely, what you think those underlying stocks are worth.  Now, we could certainly go on and on making well-thought out arguments as to why either value is justified (low/high interest rates, profit margins, productivity, mean reversion, discounted cash flows, etc.), but at the end of the day it is simple human beliefs on the value of stocks that drive their short term price levels.  As the late, great Kurt Vonnegut opined in his book Galapagos, circa 1985:

“The thing was, though: When James Wait got there, a worldwide financial crisis, a sudden revision of human opinions as to the value of money and stocks and bonds and mortgages and so on, bits of paper, had ruined the tourist business not only in Ecuador, but practically everywhere…Ecuador, after all, like the Galapagos Islands, was mostly lava and ash, and so could not begin to feed its nine million people. It was bankrupt, and so could no longer buy food from countries with plenty of topsoil, so the seaport of Guayaquil was idle, and the people were beginning to starve to death…Neighboring Peru and Columbia were bankrupt, too…Mexico and Chile and Brazil and Argentina were likewise bankrupt – and Indonesia and the Philippines and Pakistan and India and Thailand and and Italy and Ireland and Belgium and Turkey. Whole nations were suddenly in the same situation as the San Mateo, unable to buy with their paper money and coins, or their written promises to pay later, even the barest essentials. ..They were suddenly saying to people with nothing but paper representations of wealth, “Wake up, you idiots! Whatever made you think paper was so valuable?”

The financial crisis was simply the latest in a series of murderous twentieth century catastrophes which had originated entirely in human brains. From the violence people were doing to themselves and each other, and to all other living things, for that matter, a visitor from another planet might have assumed that the environment had gone haywire, and that people were in such a frenzy because Nature was about to kill them all.

But the planet a million years ago was as moist and nourishing as it is today – and unique, in that respect, in the entire Milky Way. All that had changed was people’s opinion of the place.”

How does an investment manager reconcile all of the various prognostications he hears on a daily basis?

Simple – ignore them.

Now I am not recommending to completely ignore the basis behind the arguments, as many new approaches and research projects have been originated by ideas presented in print and on TV.  But in general, one should ignore the forecasts of so called experts as they are likely to be about as accurate as a monkey throwing darts against a wall or a coin flip.  There is enormous amount of research to back up the inability of experts to make solid predictions.

One such researcher on expert predictions is Philip Tetlock, a professor of management at the Wharton School at UPenn . He started tracking experts and their forecasts and predictions a quarter century ago, and he has compiled over 300 professionals and academics that have made over 80,000 forecasts. (Here is Tetlock’s home page as well as a sample book chapter. Daniel Drezner has two excellent posts on the book, here and here, and a review from The New Yorker.)

He examined both the outcomes of their predictions as well as their processes – i.e. how they reacted to being wrong and how they dealt with contrary evidence.  In general they offered no benefit over a random prediction, and ironically enough, the more famous the expert, the less accurate the predictions were.    The experts with the least confidence made the best predictions.

Tetlock states:

 “Isaiah Berlin borrowed from a Greek poet, “The fox knows many things, but the hedgehog knows one big thing”? The better forecasters were like Berlin’s foxes: self-critical, eclectic thinkers who were willing to update their beliefs when faced with contrary evidence, were doubtful of grand schemes and were rather modest about their predictive ability. The less successful forecasters were like hedgehogs: They tended to have one big, beautiful idea that they loved to stretch, sometimes to the breaking point. They tended to be articulate and very persuasive as to why their idea explained everything. The media often love hedgehogs. “

BECOMING A BETTER INVESTOR

The characteristics enabling one to appear on TV and become a famous pundit are not the same as the characteristics of being a successful trader or money manager.  Here is a passage from Future Babble on how to be a successful pundit, as illustrated by the charismatic overpopulation doomsdayer Paul Ehrlich:

“Be articulate, enthusiastic, and authoritative.  Be likable.  See things through a single analytical lens and craft an explanatory story that is simple, clear, conclusive, and compelling.  Do not doubt yourself.  Do not acknowledge mistakes.  And never, ever say, “I don’t know.”

People unsure about the future want to hear from confident experts who tell a good story, and Paul Ehrlich was among the very best.  The fact that his predictions were mostly wrong didn’t change that in the slightest.”

Now notice the difference in thinking with one of the greatest hedge fund managers ever, George Soros, “I think that my conceptual framework, which basically emphasizes the importance of misconceptions, makes me extremely critical of my own decisions.”  I know that I am bound to be wrong, and therefore more likely to correct my own mistakes.”

Most of the greatest traders and money managers I know think in terms of all sorts of possibilities and probabilities of various scenarios.

Likewise, this follows in line with the old Maynard Keynes expression, “When the facts change I change my mind.   What do you do sir?”

Indeed, the title of one of my favorite investment books is “Being Right or Making Money” by Ned Davis.  The title alone summarizes almost everything an investor needs to know about investing – do you care more about being correct, or do you care more about increasing your wealth?

Additional Reading

Being Wrong: Adventures in the Margin of Error by Kathryn Schultz

Why We Make Mistakes: How We Look Without Seeing, Forget Things in Seconds, and Are All Pretty Sure We Are Way Above Average by Joseph Hallinan

Mistakes Were Made (But Not by Me): Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts by Carol Tavris and Elliot Aronson

How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life by Cornell psychologist Thomas Gilovich

Expert Political Judgment:  How Good Is It?  How Can We Know?  By Philip Tetlock

I wrote a month ago that the endowments and real money funds would face a high hurdle this past year (ending June 30th), and it looks like at least the initial numbers are pretty good.

60/40:  18.33%

Ivy allocation from book:  24.27%

Bloomberg:  ” Endowments and foundations gained an average of 20 percent in the year ended June 30, their best performance in 14 years, according to consultant Wilshire Associates Inc.”

This seems to be the question many people are asking in today’s markets.  Most commentators and media focus only on equities (even though the bond market is bigger than the stock market). While bonds have had a fantastic run (the long bond is up about 14% YTD), equities are down around 5% (although with current vol that # could be anywhere by the time this gets published).

Many investors are also nervous and wringing their hands about the day to day volatility.  While most of my systems and approaches are on a much longer timeframe (weeks to months), it is interesting to see how markets have responded to similar down days such as yesterday.  I looked at all -5% down days in the US back to the 1920s as well as all -5% days in Japan to the 1950s.

Below is a table of the average, median, max, and min summaries for T +1 (ie today), T + 2 (Monday), T+ 3 (Tuesday), and the 7-day and 14-day total returns.  While you can see that there is a little bit of outperformance for buying after these down days (which represent about 1% of all days as mentioned in my last post), there is such wide variability (plus or minus 20% in two weeks) that it is impossible to forecast with conviction what may happen in the ensuing days even though that short term outperformance annualizes to about 30-50%.  That is some solid alpha, but you are taking on the risk of a much worse outcome as well.  (We’ve replicated this for 15 countries with fairly similar results.)

As always, have a plan and be prepared going in to every market situation while realizing all of the possible outcomes, both good and bad as well as the strengths and weaknesses of any approach.  Especially so that you are not asking yourself, “What do I do now?”

It is always good to look at CEFs during bear markets and sharp market volatility.

Here is a nice website that lets you screen based on discounts and premiums:  CEF Connect.

If you get to Rule #1 you know there are some that I disagree with, but overall some nice advice from Contrarian Investment Strategies by Dreman.

Rule 1: Do not use market-timing or technical analysis. These techniques can only cost you money.

Rule 2: Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in­-depth profits.

Rule 3: Do not make an investment decision based on correlations. All correla­tions in the market, whether real or illusory, will shift and soon disappear.

Rule 4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

Rule 5: There are no highly predictable industries in which you can count on an­alysts’ forecasts. Relying on these estimates will lead to trouble.

Rule 6: Analysts’ forecasts are usually optimistic. Make the appropriate down­ward adjustment to your earnings estimate.

Rule 7: Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

Rule 8: It is impossible, in a dynamic economy with constantly changing polit­ical, economic, industrial, and competitive conditions, to use the past accurately to estimate the future. The past gives some frame of reference but cannot be exact.

Rule 9: Be realistic about the downside of an investment, recognizing our hu­man tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

Rule 10: Take advantage of the high rate of analyst forecast error by simply in­vesting in out-of-favor stocks.

Rule 11: Positive and negative surprises affect “best” and “worst” stocks in a di­ametrically opposite manner.

Rule 12: (A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites. (B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites. (C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks. (D) The effect of an earnings surprise continues for an extended pe­riod of time.

Rule 13: Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

Rule 14: Buy solid companies currently cut of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

Rule 15: Don’t speculate on highly priced concept stocks to make above-average returns. The blue chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or woman.

Rule 16: Avoid unnecessary trading. The costs can significantly lower your re­turns over time. Low price-to-value strategies provide well above mar­ket returns for years, and are an excellent means of eliminating excessive transaction costs.

Rule 17: Buy only contrarian stocks because of their superior performance char­acteristics.

Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more indus­tries (if your assets are of sufficient size).

Rule 19: Buy medium-or large-sized stocks listed on the New York Stock Ex­change, or only larger companies on Nasdaq or the American Stock Ex­change.

Rule 20: Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

Rule 21: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

Rule 22: Look beyond obvious similarities between a current investment situa­tion and one that appears equivalent in the past. Consider other impor­tant factors that may result in a markedly different outcome.

Rule 23: Don’t be influenced by the short-term (3 or five year) record of a money manager, bro­ker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.

Rule 24: Don’t rely solely on the “case rate.” Take into account the “base rate“­ – the prior probabilities of profit or loss.

Rule 25: Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

Rule 26: Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

Rule 27: The push toward an average rate of return is a fundamental principle of competitive markets.

Rule 28: It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.

Rule 29: Political and financial crises lead investors to sell stocks. This is pre­cisely the wrong reaction. Buy during a panic, don’t sell.

Rule 30: In a crisis, carefully analyze the reasons put forward to support lower: stock prices-more often than not they will disintegrate under scrutiny.

Rule 31: (A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker. (B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

Rule 32: Volatility is not risk. Avoid investment advice based on volatility.

Rule 33: Small-cap investing: Buy companies that are strong financially (nor­mally no more than 60% debt in the capital structure for a manufacturing firm).

Rule 34: Small-cap investing: Buy companies with increasing and well-protected dividends that also provide an above-market yield.

Rule 35: Small-cap investing: Pick companies with above-average earnings growth rates.

Rule 36: Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.

Rule 37: Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.

Rule 38: Small-company trading: Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.

Rule 39: When making a trade in small, illiquid stocks, consider not only com­missions, but also the bid /ask spread to see how large your total cost will be.

Rule 40: Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.

Rule 41: A given in markets is that perceptions change rapidly.

Normal market returns are extreme.  Listening to the media and following the comments on Twitter one would think the world is ending every 1% move in stocks and bonds.  Makets are volatile, and that is “normal”.

Outliers have a big impact on performance, and below are charts of the Worst/Best days since 1928 in the US stock market.  As you can see, you should have about two or three days every year that are around -4 to -5% (as well as +4 to +5%).  And every few years you will have some -9 or -10% days (as well as +9 or +10%).  Since volatility tends to cluster, and that tends to happen after markets have begun declining, you usually see the most volatile days when markets are below long term moving averages.  On average about 70% of the best AND worst days occur below long term moving averages simply because markets become more volatile.

We have a few new papers coming out over the next few months, and below are some of the teaser headlines:

Learning to Love Investment Bubbles: What if Newton was a Trendfollower?

Where the Black Swans Hide

S&P 300, S&P 2600

Total Yield:  Building a Better Dividend

Last quotes from Future Babble I promise:

“I can forecast confidently that it will vary.  After that, I can gossip with you.  But that’s all it is, because there are too many factors which go in to the dynamics of the pricing of oil.”

-Lord John Browne, the legendary former chief executive officer of British Petroleum, worked all his life in the oil business, and he is convinced the price of oil is fundamentally unpredictable.

“Those who claim to foresee the future are lying, even if by chance they are later proved right.”

-Arabic saying