The Four Pillars of Investing: Lessons for Building a Winning Portfolio_8 ppt

charac-In the book’s last section, we’ll talk about portfolio rebalancing—theprocess of maintaining a constant allocation; this is a technique whichautomatically commands you to sell whe

bubble and subsequent collapse would likely have been much lessviolent.

A similar reaction occurred in the United States in the wake of the

1929 crash that should give pause to many involved in the most recentspeculative excess At the center of this titanic story was a brilliantattorney of Sicilian origin, Ferdinand Pecora Just before the marketbottom in 1932, with embittered investors everywhere demandinginvestigation of Wall Street’s chicanery, the Senate authorized aBanking and Currency Committee It promptly hired Pecora, then aNew York City assistant district attorney, as its counsel In the follow-ing year, he skillfully guided the committee, and via it the public,through an investigation of the sordid mass of manipulation and fraudthat characterized the era The high and mighty of Wall Street werepolitely but devastatingly interrogated by Pecora, right up to J.P “Jack”Morgan, scion of the House of Morgan and a formidable figure in hisown right

But the real drama centered around New York Stock ExchangePresident Richard Whitney Tall, cool, and aristocratic, he symbolizedthe “Old Guard” at the stock exchange, who sought to keep it the pri-vate preserve of the member firms, free of government regulation

In the drama of the October 1929 crash, Whitney was the closest thingWall Street had to a popular hero At the height of the bloodshed onBlack Thursday—October 25, 1929—he strode to the U.S Steel post andmade the most famous single trade in the history of finance: a purchase

of 10,000 shares of U.S Steel at 205, even though at that point it wastrading well below that price This single-handedly stopped the panic.But Dick Whitney was a flawed hero His arrogance in front of thecommittee alienated both the legislators and the public He was also alousy investor, with a weakness for cockamamie schemes and aninability to cut his losses He wound up deeply in debt and began bor-rowing heavily, first from his brother (a Morgan partner), then from theMorgan Bank itself, and finally from other banks, friends, and evencasual acquaintances In order to secure bank loans, he pledged bondsbelonging to the exchange’s Gratuity Fund—its charity pool foremployees This final act would be his downfall

Under almost any other circumstances, he would not have beentreated harshly for this transgression But Whitney had found himself

at the wrong place at the wrong time In 1935, he went to Sing Sing

He was not the only titan of finance who found himself a guest of thestate, however, and many of the most prominent players of the 1920smet even more ignominious ends

The moral for the actors in the recent Internet drama is obvious.When enough investors find themselves shorn, scapegoats will be

sought Minor offenses, which in normal times would not attractnotice, suddenly acquire a much greater legal significance The nextPecora Committee drama already seems to be shaping up in the form

of congressional inquiries into the Enron disaster and brokerage lyst recommendations It is likely that we are just seeing the beginning

ana-of renewed government interest in the investment industry

On the positive side, four major pieces of legislation came out of thePecora hearings Unlike the post-bubble English experience, the com-mittee’s effect was positive; three new laws were introduced that stillshape our modern market structure The Securities Act of 1933 madethe issuance of stocks and bonds a more open and fair process TheSecurities Act of 1934 regulated stock and bond trading and estab-lished the SEC The Investment Company Act of 1940, passed in reac-tion to the investment trust debacle, allowed the development of themodern mutual fund industry And finally, the Glass-Steagall Act sep-arated commercial and investment banking This last statute hasrecently been repealed Sooner or later, we will likely painfully relearnthe reasons for its passage almost seven decades ago

This legislative ensemble made the U.S securities markets the mosttightly regulated in the world If you seek an area where rigorous gov-ernment oversight contributes to the public good, you need look nofurther The result is the planet’s most transparent and equitable finan-cial markets If there is one industry where the U.S has lapped thefield, it is financial services, for which we can thank Ferdinand Pecoraand the rogues he pursued

How to Handle the Panic

What is the investor to do during the inevitable crashes that terize the capital markets? At a minimum, you should not panic andsell out—simply stand pat You should have a firm asset allocation pol-icy in place What separates the professional from the amateur are twothings: First, the knowledge that brutal bear markets are a fact of lifeand that there is no way to avoid their effects And second, that whentimes get tough, the former stays the course; the latter abandons theblueprints, or, more often than not, has no blueprints at all

charac-In the book’s last section, we’ll talk about portfolio rebalancing—theprocess of maintaining a constant allocation; this is a technique whichautomatically commands you to sell when the market is euphoric andprices are high, and to buy when the market is morose and prices arelow

Ideally, when prices fall dramatically, you should go even furtherand actually increase your percentage equity allocation, which would

Bottoms: The Agony and the Opportunity 161

require buying yet more stocks This requires nerves of steel and runsthe risk that you may exhaust your cash long before the market final-

ly touches bottom I don’t recommend this course of action to all butthe hardiest and experienced of souls If you decide to go this route,

you should increase your stock allocation only by very small

amounts—say by 5% after a fall of 25% in prices—so as to avoid ning out of cash and risking complete demoralization in the event of

run-a 1930s-style berun-ar mrun-arket

Bubbles and Busts: Summing Up

In the last two chapters, I hope that I’ve accomplished four things.First, I hope I’ve told a good yarn An appreciation of manias andcrashes should be part of every educated person’s body of historicalknowledge It informs us, as almost no other subject can, about thepsychology of peoples and nations And most importantly, it is yet onemore demonstration that there is really nothing new in this world In

the famous words of Alphonse Karr, Plus ça change, plus c’est la même

chose: The more things change, the more they stay the same.

Second, I hope I have shown you that from time to time, marketscan indeed become either irrationally exuberant or moroselydepressed During the good times, it is important to remember thatthings can go to hell in a hand basket with brutal dispatch And just

as important, to remember in times of market pessimism that thingsalmost always turn around

Third, it is fatuous to believe that the boom/bust cycle has beenabolished The market is no more capable of eliminating its extremebehavior than the tiger is of changing its stripes As University ofChicago economics professor Dick Thaler points out, all finance isbehavioral Investors will forever be captives of the emotions andresponses bred into their brains over the eons As this book is beingwritten, most readers should have no trouble believing that irrationalexuberance happens It is less obvious, but equally true, that the sort

of pessimism seen in the markets 25 and 70 years ago is a near tainty at some point in the future as well

cer-And last, the most profitable thing we can learn from the history ofbooms and busts is that at times of great optimism, future returns arelowest; when things look bleakest, future returns are highest Sincerisk and return are just different sides of the same coin, it cannot beany other way

P ILLAR T HREE The Psychology of Investing

The Analyst’s Couch

The biggest obstacle to your investment success is staring out at youfrom your mirror Human nature overflows with behavioral traits thatwill rob you faster than an unlucky nighttime turn in Central Park

We discovered in Chapter 5 that raw brainpower alone is not cient for investment success, as demonstrated by Sir Isaac Newton, one

suffi-of the most notable victims suffi-of the South Sea Bubble We have no torical record of William Shakespeare’s investment returns, but I’mwilling to bet that, given his keen eye for human foibles, his returnswere far better than Sir Isaac’s

his-In Chapter 7, we identify the biggest culprits I guarantee you’ll ognize most of these as the face in the looking glass In Chapter 8,we’ll devise strategies for dealing with them

Dick Thaler Misses a Basketball Game

The major premise of economics is that investors are rational and willalways behave in their own self-interest There’s only one problem Itisn’t true Investors, like everyone else, are most often the hapless cap-tives of human nature As Benjamin Graham said, we are our ownworst enemies But until very recently, financial economists ignoredthe financial havoc wreaked by human beings on themselves

Thirty years ago, a young finance academic by the name of RichardThaler and a friend were contemplating driving across Rochester, NewYork, in a blinding snowstorm to see a basketball game They wiselyelected not to His companion remarked, “But if we had bought thetickets already, we’d go.” To which Thaler replied, “True—and inter-esting.” Interesting because according to economic theory, whether ornot the tickets have already been purchased should not influence thedecision to brave a snowstorm to see a ball game

Thaler began collecting such anomalies and nearly single-handedlyfounded the discipline of behavioral finance—the study of how humannature forces us to make irrational economic choices (Conventionalfinance, on the other hand, assumes that investors make only rationalchoices.) Thaler has even extended his research to basketball itself.Why, he wonders, do players usually go for the two-point shot whendown by two points with seconds remaining? The two-point percent-age is about 50%, meaning that your chance of winning is only 25%,since making the goal only serves to throw the game into overtime Athree-point shot wins the game and has a better success rate—about33%

At about the same time in the early 1970s that Thaler and his friendwere deciding whether or not to brave the snowstorm, two Israeli psy-chologists, Daniel Kahneman and Amos Tversky, were studying theimperfections in the human decision-making process in a far sunnierclime They published a landmark paper in the prestigious journal

Science, in which they outlined the basic errors made by humans in

estimating probabilities A typical riddle: “Steve is very shy and drawn, invariably helpful, but with little interest in people, or in theworld of reality ” Is he a librarian or mechanic? Most people wouldlabel him a librarian Not so: there are far more mechanics than librar-ians in the world, and plenty of mechanics are shy It is therefore morelikely that Steve is a mechanic But people inevitably get it wrong.The Kahneman-Tversky paper is a classic, but it is unfortunatelycouched in an increasingly complex series of mind-twisting examples.Its relevance to investing is not immediately obvious But Thaler andhis followers were able to extend Kahneman and Tversky’s work toeconomics, founding the field of behavioral finance (Thaler himselfdislikes the label He asks, “Is there any other kind of finance?”)This chapter will describe the most costly investment behaviors It islikely that at one time or another, you have suffered from every singleone

with-Don’t Get Trampled by the Herd

Human beings are supremely social animals We enjoy associatingwith others, and we particularly love sharing our common interests Ingeneral, this is a good thing on multiple levels—economic, psycho-logical, educational, and political But in investing, it’s downright dan-gerous

This is because our interests, beliefs, and behaviors are subject tofashion How else can we explain why men wore their hair short inthe 1950s and long in the 1970s? Why bomb shelters were all the rage

in the early 1960s, then fell into disuse in later decades, when thenumber of thermonuclear weapons was exponentially greater? Whythe pendulum between political liberalism and conservatism swingsback and forth to the same kind of generational metronome as stocksand bonds?

The problem is that stocks and bonds are not like hula hoops orbeehive hairdos—they cannot be manufactured rapidly enough tokeep up with demand—so their prices rise and fall with fashion Thinkabout what happens when everyone has decided that, as happened inthe 1970s and 1990s, large growth companies like Disney, Microsoft,and Coca-Cola were the best companies to own Their prices got bid

to stratospheric levels, reducing their future return This kind of pricerise can go to absurd lengths before a few brave souls pull out theircalculators, run the numbers, and inform the populace that the emper-

or has no clothes

For this reason, the conventional investment wisdom is usuallywrong If everyone believes that stocks are the best investment, whatthat tells you is that everyone already owns them This, in turn, meanstwo things First, that because everyone has bought them, prices are

high and future returns, low And second, and more important, that

there is no one else left to buy these stocks For it is only when there is

an untapped reservoir of future buyers that prices can rise

Everyone Can’t Be Above Average

In a piece on investor preconceptions in the September 14, 1998, issue

of The Wall Street Journal, writer Greg Ip examined the change in

investor attitudes following the market decline in the summer of 1998

He tabulated the change in investor expectations as follows:

The first thing that leaps out of this table is that the average investorthinks that he will best the market by about 2% While some investorsmay accomplish this, it is, of course, mathematically impossible for theaverage investor to do so As we’ve already discussed, the averageinvestor must, of necessity, obtain the market return, minus expensesand transaction costs Even the most casual observer of human natureshould not be surprised by this paradox—people tend to be overcon-fident

Overconfidence likely has some survival advantage in a state ofnature, but not in the world of finance Consider the following:

• In one study, 81% of new business owners thought that they had

a good chance of succeeding, but that only 39% of their peers did

• In another study, 82% of young U.S drivers considered selves in the top 30% of their group in terms of safety (In self-doubting Sweden, not unsurprisingly, the percentage is lower.)The factors associated with overconfidence are intriguing The morecomplex the task, the more inappropriately overconfident we are

them-Expected Returns Jun 1998 Sept 1998

Next 12 months, own portfolio 15.20% 12.90%

Next 12 months, market overall 13.40% 10.50%

Misbehavior 167

“Calibration” of one’s efforts is also a factor The longer the “feedbackloop,” or the time-delay, between our actions and the results, thegreater our overconfidence For example, meteorologists, bridge play-ers, and emergency room physicians are generally well-calibratedbecause of the brief time span separating their actions and their results.Most investors are not.

Overconfidence is probably the most important of financial ioral errors, and it comes in different flavors The first is the illusionthat you can successfully pick stocks by following a few simple rules

behav-or subscribing to an advisbehav-ory service such as Value Line About once

a week, someone emails me selection criteria for picking stocks, ally involving industry leaders, P/E ratios, dividend yields, and/orearnings growth, which the sender is certain will provide market-beat-ing results

usu-Right now, if I wanted to, with a few keystrokes I could screen adatabase of the more than 7,000 publicly traded U.S companiesaccording to hundreds of different characteristics, or even my owncustomized criteria There are dozens of inexpensive, commerciallyavailable software programs capable of this, and they reside on thehard drives of hundreds of thousands of small and institutionalinvestors, each and every one of whom is busily seeking market-beat-ing techniques Do you really think that you’re smarter and faster thanall of them?

On top of that, there are tens of thousands of professional investorsusing the kind of software, hardware, data, technical support, andunderlying research that you and I can only dream of When you buy

and sell stock, you’re most likely trading with them You have as much

chance of consistently beating these folks as you have of starting atwide receiver for the Broncos

The same goes for picking mutual funds I hope that by now I’vedissuaded you from believing that selecting funds on the basis of pastperformance is of any value Picking mutual funds is a highly seduc-tive activity because it’s easy to find ones that have outperformed forseveral years or more by dumb luck alone In a taxable account, this

is especially devastating, because each time you switch ponies youtake a capital gains haircut

There are some who believe that by using more qualitative criteria,such as through careful evaluation and interviewing of fund heads,they can select successful money managers I recently heard from anadvisor who explained to me how, by interviewing dozens of fundmanagers yearly and going to Berkshire shareholder meetings to listen

to Warren Buffet, he was able to outperform the market for bothdomestic and foreign stocks The only problem was that his bond, real

estate, and commodities managers were so bad that his overall folio results were far below that of an indexed approach Take anoth-

port-er close look at Figure 3-4 If the nation’s largest pension plans, eachmanaging tens of billions of dollars, can’t pick successful money man-agers, what chance do you think you have?

Most investors also believe that they can time the market, or worse,that by listening to the right guru, they will be able to I have a fanta-

sy in which one morning I slip into the Manhattan headquarters of themajor brokerage firms and drop truth serum into their drinking water.That day, on news programs all over the country, dozens of analystsand market strategists, when asked for their prediction of market direc-tion, answer, “How the hell should I know? I learned long ago that mypredictions weren’t worth a darn; you know this as well as I The onlyreason that we’re both here doing this is because we have mouths tofeed, and there are still chumps who will swallow this stuff!”

At any one moment, by sheer luck alone, there will be severalstrategists and fund managers who will be right on the money In

1987, it was Elaine Garzarelli who successfully predicted the crash.Articulate, well-dressed, and flamboyant, she got far more mediaattention than she deserved Needless to say, this was the kiss ofdeath Her predictive accuracy soon plummeted Adding insult toinjury, her brokerage house put her in charge of a high-profile fundthat subsequently performed so badly that it was quietly killed off sev-eral years later

The most recent guru-of-the-month was Abby Joseph Cohen, who

is low-key, self-effacing, and, for a market strategist, fairly scholarly.(Her employer, Goldman Sachs, which emerged from the depths ofignominy in 1929 to become the most respected name in investmentbanking, makes a habit of hiring only those with dazzling mathskills.) From 1995 to 1999, she was in the market’s sweet spot, rec-ommending a diet high in big growth and tech companies.Unfortunately, she didn’t see the bubble that was obvious to mostother observers, and for the past two years, she’s been picking theegg off her face

Remember, even a stopped clock is right twice a day And there areplenty of stopped clocks in Wall Street’s canyons; some of them willalways have just shot a spectacular bull’s-eye purely by accident.There are really two behavioral errors operating in the overconfi-dence playground The first is the “compartmentalization” of successand failure We tend to remember those activities, or areas of our port-folios, in which we succeeded and forget about those areas where wedidn’t, as did the advisor I mentioned above The second is that it’s farmore agreeable to ascribe success to skill than to luck

Misbehavior 169

The Immediate Past Is Out to Get You

The next major error that investors make is the assumption that theimmediate past is predictive of the long-term future Take a look at thedata from the table at the beginning of the chapter and note that inSeptember 1998, after prices had fallen by a considerable amount,

investors’ estimates of stock returns were lower than they were in June.

This is highly irrational Consider the following question: On January

1, you buy a gold coin for $300 In the ensuing month the price ofgold falls, and your friend then buys an identical coin for $250 Tenyears later, you both sell your coins at the same time Who has earnedthe higher return? Most investors would choose the correct answer—your friend, having bought his coin for $50 less, will make $50 more(or at worst, lose $50 less) than you Viewed in this context, it is aston-ishing that any rational investor would infer lower expected returnsfrom falling stock prices The reason for this is what the behavioral sci-entists call “recency”; we tend to overemphasize more recent data andignore older data, even if it is more comprehensive

Until the year 2000, with large growth stocks on a tear, it was verydifficult to convince investors not to expect 20% equity returns overthe long term Blame recency Make the recent data spectacular and/orunpleasant, and it will completely blot out the more important, ifabstract, data

What makes recency such a killer is the fact that asset classes have aslight tendency to “mean-revert” over periods longer than three years.Mean reversion means that periods of relatively good performance tend

to be followed by periods of relatively poor performance The reversealso occurs; periods of relatively poor performance tend to be followed

by periods of relatively good performance Unfortunately, this is not asure thing Not by any means But it makes buying the hot asset class

of the past several years bad odds

Let’s look what happens when you fall victim to recency In Table7-1, I’ve picked six asset classes—U.S large and small stocks, as well

as U.K., continental European, Japanese, and Pacific Rim stocks—andanalyzed their performance at five-year intervals during the periodfrom 1970 to 1999

From 1970 to 1974, the top performer was Japan; but in the nextperiod, from 1975 to 1979, it ranked fourth In those years, the bestperformer was U.S small stocks, which actually did best from 1980 to

1984 But during the next period, from 1985 to 1989, it ranked last Thebest performer from 1985 to 1989 was again Japanese stocks, but from

1990 to 1994 it ranked last In that period, the best performer wasPacific Rim stocks, which ranked next to last from 1995 to 1999 The

best asset class in the late 1990s was U.S large-cap stocks, and, if thepast two years is any indication, it seems likely to be near the bottom

of the heap next time around

We’ve previously discussed how the recency illusion applies to gle asset classes For example, from 1996 to 2000, the return of

sin-Japanese stocks was an annualized loss of 4.54%, but over the 31 years

from 1970 to 2000, it was 12.33% Both inside and outside Japan,investors have gotten very discouraged with its stock market in recentyears But which of these two values do you suppose is a more accu-rate indicator of its expected future return?

Likewise, the 1996 to 2000 return for the S&P 500 was 18.35%, butthe very long-term data show a return of about 10% Again, which ofthese two numbers do you think is the better indicator?

Entertain Me

If indexing works so well, why do so few investors take advantage ofit? Because it’s so boring As we discussed in Chapter 3, at the sametime that you’re ensuring yourself decent returns and minimizing thechances of dying poor, you’re also giving up the chance of striking itrich It doesn’t get much duller than this

In fact, one of the most deadly investment traits is the need forexcitement Gambling may be the second-most enjoyable human activ-ity Why else do people throng to Las Vegas and Atlantic City whenthey know that, on average, they’ll return lighter in the wallet?

Humans routinely exchange large amounts of money for excitement.One of the most consistent findings in behavioral finance is that peo-ple gravitate towards low-probability/high-payoff bets For example,it’s well known among professional horse race bettors that it is mucheasier to make money on favorites than on long shots The reason isthat the amateurs tend to prefer long shots, making the odds for the

Misbehavior 171

Table 7-1 Subsequent Performance of Prior Best-Performing Asset Classes

Rank (1 to 6) in Time Period Best Asset Class Next Five-Year Period 1970–1974 Japan 4