Investing with the Slowskys: Appreciating the Value of Expertise, Analysis, and Judgment
For do-it-yourselfers, frugal consumers, and efficiency seekers, the proliferation of the internet, smart mobile devices, and high speed connectivity has been a remarkable boon that has more than offset many economic headwinds. We can pull up a how-to video in youtube in seconds (and for free) rather than calling a contractor for a minor repair, we can buy ebooks at a fraction of the price of hard copies, and we save all kinds of physical trips with online applications, emails, video calls, etc.
Investors have realized their own bonanza with free online news, price data, and research that used to cost investment firms tens of thousands of dollars. As the cost of information has declined, its consumption has exploded to create an ever-more frenetic, information intensive society. We see evidence of this everywhere including in communications advice to limit messages to "a few bullet points" and to use "punchy, catchy language." While information resources have done a great deal to improve convenience and to keep investors better informed, there is one big thing they haven't done and cannot do: improve long-term investment performance.
That free information cannot improve investment performance may seem counterintuitive, but it actually reveals a key characteristic of reasonably efficient markets: When information is free and easy to acquire, you only have what everyone else has -- and it gets discounted into stock prices almost instantaneously. This challenge begs the larger question of how to outperform markets that are mostly efficient and was addressed beautifully in well-worn, but still relevant, research by Jack Treynor and Michael Mauboussin.
Treynor laid solid intellectual foundations for the challenge in his 1975 piece, "Long term investing". He tells us, "When one talks about market efficiency, it is important to distinguish between ideas whose implications are obvious and consequently travel quickly and ideas that require reflection, judgment, and special expertise for their evaluation and consequently travel slowly. The second kind of idea -- rather than the obvious, hence quickly discounted insight relating to 'long-term' business developments -- is the only meaningful basis for 'long-term investing'."
So a direct answer to the challenge of how to outperform is to acknowledge that data points, news bits, and other items "whose implications are obvious" do not provide a meaningful basis for long-term investing. Deeper analysis is required. But there is also a more subtle implication from Treynor's insights: opportunities for outperformance arise when significant portions of market participants make the same error or act in the same way.
In particular, Treynor articulates the importance of the assumption of independence in regards to market efficiency: "As the key to the averaging process underlying an accurate consensus is the assumption of independence, if all -- or even a substantial fraction -- of these investors make the same error, the independence assumption is violated and the consensus can diverge significantly from true value. The market then ceases to be efficient in the sense of pricing available information correctly.
Mauboussin also picks up on this thought. According to Mauboussin, markets fail because, "Most simply, investor heterogeneity breaks down and everyone acts in unison, leading to excessive optimism (greed) or pessimism (fear)." So what really matters for markets functioning well is for a diverse group of investors to each make decisions independently. Although diversity breakdowns don't occur frequently, when they do, Mauboussin notes that they "provide investors with significant opportunities to earn excess rates of return."
Interestingly, a fair bit of evidence suggests that we may be in the midst of just such a diversity breakdown. For one, it is no secret that many institutional incentives exist that work in opposition to investors' best interests. Mauboussin highlights some of these: "Current incentives encourage agent behavior that is not always consistent with maximizing long-term shareholder returns (Bradford Cornell and Roll, 2005). In recent decades many large investment firms have emphasized marketing (often at the expense of the investment process), increased the number of funds they offer (selling what's hot), and boosted the number of stocks they hold in order to minimize tracking error versus the benchmark."
He notes further, "But perhaps the most significant incentive-caused behavior, and most relevant for a discussion of how to beat the market, is the reduction in investment time horizons. According to Bogle (2005), average equity portfolio turnover rose from 20% in the mid-1960s to 112% in 2004. And fund managers aren't the only ones with shorter time horizons; Bogle documents that mutual fund owners redeem shares at a rate four times higher than a few decades ago." While this data is not completely fresh, the trends have not changed and in the case of exchange trade funds (ETFs), are far worse.
If these conditions weren't already enough to warrant concern, recent industry trends suggest the risk of diversity breakdown has been increasing. The 2104 Investment Company Factbook describes, for example, that "The growth of individual retirement accounts (IRAs) and defined contribution (DC) plans, particularly 401(k) plans, explains some of households' increased reliance on investment companies during the past two decades." In other words, progressively greater chunks of money have been flowing to institutions that have the same set of biases.
Unfortunately, there's more. The Fed's policies since the financial crisis have likely made these challenges to market diversity even worse. With investment firms already fairly uniformly predisposed towards remaining fully invested in order to preserve near term revenues, the Fed's policies of keeping interest rates near zero and explicitly targeting higher asset prices has made it even harder for investment firms to buck the trend. Further, any efforts on the part of money managers to independently manage risk over the last several years have been severely punished by the effects of new iterations of quantitative easing and other extraordinary monetary policy tools. In summary, the last several years of market activity have created a nearly perfect storm of short termism.
While the magnitude of diversity break down can be fairly debated, it is difficult to refute that investor heterogeneity has diminished. After all, there is no doubt that institutional investors have like incentives that cause similar behaviors and that those same institutional investors comprise a "substantial fraction" of the investor base from which it is sufficient to undermine an "accurate consensus". Jeremy Grantham recently made a less than thinly veiled reference to these directional forces in a Financial Times article when he noted that "If you're a naturally conservative investor and still alive, you're doing pretty well."
What should investors take away from all of this? The most immediate implication is that there is substantial evidence that U.S. stock markets are experiencing the kind of diversity breakdown by which "consensus can diverge significantly from true value." Industry structure, trends, and monetary policy have all combined to erode market diversity in a way that can cause significant losses -- and significant gains. It could well be that having a truly independent view is one of the greatest strengths an investor can have right now.
Second, and in a more general sense, investors should be extremely skeptical as to the investment value of news bits and data items. In an important sense, these results should not be surprising. As Mauboussin notes, "Time horizon is a crucial consideration in any probabilistic field. In these systems, short-term results show mostly noise -- the noise-to-signal ratio is very high. But over time, the signal reveals itself, and the noise-to-signal ratio drops. Short-term investors dwell mostly in the world of noise."
Such tidbits may certainly be helpful in other ways, but investors should not be fooled into believing they are useful for long-term investing. Only deep research and analysis can help out on that front. Given this important and time-honored insight, it is interesting and ironic that the breakdown in investor diversity is moving in the direction of more noise and less signal. Sources of "slow traveling ideas" that can maintain a truly independent perspective will prove investors' best antidote to institutional biases and short-termism.
In conclusion, for many years, Comcast aired a commercial for its internet service that featured a couple of turtles named the Slowskys who were averse to anything that was fast. Although this portrayal was obviously a parody, it illustrates a perfectly appropriate maxim for investing: "Slow traveling ideas are a long-term investor's best bet for delivering superior results".