Seeing investors reality Charles Ellis, PhD, CFA Founder of - - PowerPoint PPT Presentation

Seeing investors’ reality

Charles Ellis, PhD, CFA

Founder of Greenwich Associates and best-selling author

The wish of Robert Burns O wad some pow’r the giftie gie us To see oursels as others see us It wad frae monie a blunder free us An’ foolish notion

Citizens of Lake Wobegone! 80/20 rules apply to us on rating ourselves . . . Good listener Sense of humor Skill as driver Good friend Skill in dancing Skill in investing

Endowment effect: It’s mine! Give 1/3 of a group beer mugs and later ask for a fair price for a mug: 1/3 to sell their mug $7.12 1/3 to buy a mug $2.87 1/3 to “arbitrate” $3.12 Ownership does matter

Cabdrivers’ lesson Seldom empty

Rainy day

Often empty

Sunny day

Optimal smart hours? More (getting’s good)

Rainy day

Less (go home and play)

Sunny day

Actual hours? Why? Make “enough” every day More (getting’s good) Less than usual

Rainy day

Less (go home and play) More than usual

Sunny day

Optimists’ characteristics

• Overestimate skills
• Suffer illusion of control
• Underestimate odds of bad events

Exaggerate ability to forecast Scottish parliament’s new building cost 1997 £40m 1999 £109m 2000 £195m 2001 £241m 2002 £295m 2003 £376m 2004 £431m Repeating now with tram from center city to Edinburgh airport

Experts are fallible Examine 80,000 expert estimates versus trend:

More Same Less

How to beat the experts

1/3 1/3 1/3

More Same Less

Beware of illusion of skill

People can maintain unshakable faith in any proposition when supported by co-believers.

~Daniel Kahneman

“ ”

Hindsight bias (and outcome bias) We evaluate decisions on the outcome, not on the quality of the decision

• Obama and Navy SEALs
• Carter and Iran rescue
• Doctors and operations

Investments of all kinds

True or false Very intelligent women tend to marry men who are not as intelligent?

True or False?

? ?

Success = talent & luck Great success = talent & luck Kahneman’s favorite equation

talent luck

&

a lot more a little more

We ignore base rate Interest rate

12%

Dot-com peak U.S. Treasuries at record lows

To improve forecasts

• Identify appropriate reference class
• Gather relevant data
• Project “base rate”
• Accept “base rate” unless compelling reason

Even then, let “base rate” dominate

Framing effect Which operation would you prefer . . . Survival rate

95%

Mortality rate

5%

Confirmation bias is strong We seek and recall information that confirms our prior beliefs

• Fox TV
• The New York Times
• Rolling Stone

Halo effect is strong. If Jack says so, we’re inclined to: Accept, believe, and repeat

We ignore data we don’t see

• Professional hockey players are born

in January and February

• NINJA mortgages
• We don’t fully appreciate the undeniable

power of regression to mean or base rates

Common error Flight instructors stopped praising good landings and focused on chastising poor landings —for the wrong “reasons”

Common errors We are, on average, wrong on both decisions and select managers having “good” run

Praise

managers after “bad” run

Fire

Common errors

• Higher price = higher value
• Past performance predicts
• We forget that sample size is inversely

correlated with sample variability

Does blink work?

Let’s try A:

8 · 7 · 6 · 5 · 4 · 3 · 2 · 1 = ?

Let’s try B:

1 · 2 · 3 · 4 · 5 · 6 · 7 · 8 = ?

Test results

Let’s try A:

8 · 7 · 6 · 5 · 4 · 3 · 2 · 1 = 2,250

Let’s try B:

1 · 2 · 3 · 4 · 5 · 6 · 7 · 8 = 512 Actual = 40,320

What will come next?

H T H T H H H T T H T H H T T T T T T

Which is more likely?

B B B G G G G G G G B G B B G G G B

First impressions matter a lot

• BSO auditions
• Warren Harding
• Romance

Accessibility is powerful

70%

• f candidates with faces that look

“competent” get hired

The long term is not where life is lived. Utility trumps wealth Emotions do matter Emotions are driven by change

“

~Daniel Kahneman

”

Failures to accept defeat

• Continuing to fight on in war
• Staying in failed marriage
• Staying with failed manager
• Holding failed investment

Common errors We overrely on experts Experts are overconfident

Before active’s glory days

• Committee decisions—made monthly
• Utilities, industrials, buy and hold
• Dividends and bonds for income
• Money-center banks and insurance companies
• Graham and Dodd, Hickman on bonds,

E.L. Smith, Phil Fisher

• Business school courses??

Active’s glory days begin

• Quotron just introduced
• In-depth research new
• DLJ, Baker Weeks, Spencer Trask, etc.
• Performance measurement new
• CFAs beginning; CHA jokes
• Investment counsel firms
• Portfolio manager as king
• The Money Game

Changes of note over past 50 years

• 3M 5B
• 0 5B+
• 10% 95%
• 0% 100%
• 10 300
• 0 100,000 CFAs
• Reg D
• MBAs and PhDs
• Internet, Bloomberg, IT, algorithms
• 40¢ 3¢
• Turnover 20% to 100% +

Disagreeable data Mutual funds underperform

• 60% over “typical” year
• 70% over 10 years
• 80% over 20 years (beware data)

Losers lose almost twice as much as winners win

Disagreeable data II Institutional investors underperform

• 75% about average
• 25% below average
• 0.1% above average

Past performance: Poor predictor Which one decile predicts: 1st ? 2nd ? 3rd ? 4th ? 5th ? 6th ? 7th ? 8th ? 9th ? The bottom decile!

What do professionals do?

• Emphasize recent results . . . if “good”
• Sell recent past “performance”
• Time-weighted… not dollar-weighted
• Overemphasize “performance” in ads, etc.
• Ignore risk
• Incubate and delete, incubate, and delete
• Flood system with data
• Not focus on clients’ real needs
• Increase fees

Fees over 50 years

300%

Results: Industry economics transformed

Up from 0%–0.1% to 0.3%–0.5%

Institutional fees

Up from 0.25% to 1%

• r more

Mutual fund fees

400%

Fees: Perception versus “deception”

• 1% of assets
• 15% of returns (of 7%)
• 100% of incremental returns?

Loser’s games

• Tennis
• Las Vegas
• Politics
• War
• “Performance” investing

Case for indexing

• Higher returns
• Lower risk
• More reliable
• Lower cost
• KISS
• Easier to change portfolio structure
• Free to focus on important decisions

Old arguments

• Why settle for “just average”?
• Indexing is just an experiment
• Real men don’t eat quiche!
• Index funds are un-American!

Passive’s big mistake Wrong name! In the rest of your life and work, would you rather be described as:

Active or Passive?

Names do matter

• Tony Curtis versus Bernard Schwartz
• Dorothy Lamour versus Mary Slaton
• Rita Hayworth versus Margarita Cansino
• Ralph Lauren versus Ralph Lifshitz

Passive leads to another active

• Every fund has more important decisions:
• Spending policy
• Liquidity policy
• Communications policy
• Investment committee design
• Strategic portfolio structure
• Sustainability

Investing triangle

MKT INV MGR

Old concept

INV MKT MGR

New concept

INV MGR MKT

Important information

The views expressed in the presentation are the speaker's own and may not reflect the views of Vanguard.