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Enter the Dragon 2012

August 4, 2012 1 comment

This article was first published in B Beyond 2012/1 (page 88) by BB Publications – a niche publisher catering for the global HNW and UHNW community. http://bbpublications.org/

The S&P 500 index ended 2011 relatively unchanged despite a year of high volatility driven by the European Sovereign Debt Crisis and the pertinent risk of double dip recession. During the year, the markets witnessed the major impacts of the Arab Spring, the Japanese earthquake, the downgrading of the US credit rating and the risk of a Eurozone country defaulting on its debt obligations – none of which were ‘predicted’ by Wall Street analysts at the beginning of the year.

The future is much harder to predict than Wall Street would have us believe. As Nassim Taleb remarked: “To prophesize, don’t add anything to the future; just figure out and eliminate what will not survive.” This Popperian view, that all investment hypotheses are provisionally accepted until proven wrong, may not seem comforting to investors.  Nonetheless, it has not stopped the influx of money flowing into hedge funds.

Hedge funds on average lost 4.83% in 2011 despite amassing a record $2.04 trillion in total capital under management during the first quarter of 2011. The industry – which caters to wealthy and institutional investors chasing higher returns for bigger fees – appears to be licking its wounds as fund managers finished the year in the red. The hedge fund industry – which prides itself on outperforming the market – has failed to live up to expectations and delivered one of their worst annual performances last year. As 2012 – the year of the Water Dragon according to Chinese Zodiac – rolls on, can the industry reverse its fortune?

Renewed optimism in Europe’s ability to solve its debt problems and the U.S. economic recovery has led analysts to expect a brighter 2012 with hedge funds gearing up on riskier bets. The question then remains: Why are the so-called ‘Wall Street analysts’ invariably wrong?

Despite their relatively poor record in making financial predictions, it seems to be a staple publication for analysts each year. From a non-deterministic worldview, the future is unpredictable; therefore, a successful investment manager should be able to change his views as events that either confirm or refute his investment hypothesis unfold. Making a public prognostication in the form of a financial prediction begins a very slippery slope towards intellectual materialism. Subsequently changing one’s view would be tantamount to admitting that the former was, in fact, erroneous. Making erroneous financial calls reflects badly on an investment manager. This agency problem may manifest itself when the manager seeks out confirmatory evidence for his earlier thesis and subconsciously filters out contradictory evidence. Such intellectual materialism is a highway to financial ruins. Perhaps money managers should refrain from making explicit public commentary on financial markets for this very reason. It frees them from the shackles of having to defend their views and allows an unfettered approach towards investing. This separation is exemplified further in the financial service industry’s highly regulated relationship with its research divisions, requiring a Chinese wall between public and private functions.

So then, why are analysts’ predictions invariably wrong? To borrow from quantum physics’ Totalitarian Principle which states “everything not forbidden is compulsory” – it is not possible to envisage or even model the future states of all permissible events that can occur and affect the markets. This is akin to the adage commonly referred to as Murphy’s Law that is typically stated: “anything that can go wrong will go wrong”. The job of a money manager is therefore not just to react to such events but to be perceptive. George Soros famously remarked that “it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”. As the collective action of investors translates to the ebb and flow of the financial markets, the investment manager’s job is to remain one step ahead of the crowd. There is no point in being right one year in advance as the financial markets can remain irrational longer than one can remain solvent.

The hedge fund industry’s performance for 2011 is an egregious example of ‘smart money’ getting it wrong. The industry as a whole underperformed the broader market. This is an industry that hires the best and the brightest minds armed with MBAs and often wielding PhDs from the top business schools in the world. Compensation in this industry is second to none. Hedge funds understood what politicians have long understood – that there is no shame in buying success. The industry goes to great length to justify its compensation and management fees. Can this be one of the reasons as to why the asset management industry continues to churn out financial predications, the majority of which are often not worth the paper they are printed on? After all, the industry that pours millions into its research departments ought to be seen as making informed investment decisions based on well-researched ideas. A simple flick through previous years’ financial predictions and their propensity to come to pass will reveal dismal statistics. Nonetheless, the media’s deep-seated fascination for financial predications continues to contribute to the proliferation of analyst recommendations aimed at investors.

Ask any economist or analyst how precise their estimates are, their response will be that such predictions help guide decision-making in investments more satisfactorily than it would be otherwise. That however inaccurately or irresponsibly their predictions may help shape investment decision, it does so better than astrology. However mindless the culture of prophesying, it is more attractive than disremembering. And however deceptive the idea of an analyst’s estimate, it is more believable than that of a coin toss.

As for my financial predictions for 2012, it will take a leaf out of Chinese astrology. The year of the Water Dragon may bring more economic trouble in the year ahead. According to Chinese Feng Shui, the economy is very much affected by the five elements in Chinese astrology (wood, fire, earth, metal and water). In the Chinese calendar, the fire element will generate optimism and happiness. Therefore, if the financial market represents the collective optimism of investors, it should rally with the fire element.  The water element is the opposite and it represents fear in the five-element system. Happy 2012 – the year of the Water Dragon!

 

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Categories: Economics, Finance, Investing Tags: , ,

The Four Most Dangerous Words in Investing

June 26, 2011 Leave a comment

First published on BBeyond Magazine blog – an ultra niche publisher that caters exclusively for the global UNHW market and community: http://bbpublications.org/BBblogs/the-four-most-dangerous-words-in-investing/

“The four most dangerous words in investing are ‘This time it’s different.’”

– Sir John Templeton (29 November 1912 – 8 July 2008)

In 2005, the late Sir John Templeton penned a memo, which wasn’t discovered until after his passing in 2008.  It was eerily pithy, almost ‘prophetic’  as the first two words were bolded in its original text and begins as follows:

Financial Chaos – probably in many nations in the next five years. The word chaos is chosen to express likelihood of reduced profit margin at the same time as acceleration in cost of living.”

Sir John had already correctly predicted the Dot-com crash and his predictions of a housing bubble (that will eventually burst) and subsequent stock market fall all came to pass. However, those with views similar to Sir John back in 2005 would generally have found their concerns of the housing market pooh-poohed by the proponents of securitization as the US housing market has ‘never experienced’ a simultaneous nationwide fall.

Time and again, investors have always used the words “this time it’s different” or many of its variants to justify our actions when we rush headlong into a bubble. Caught up in the euphoria of a bull run, we post-rationalize our thoughts and seek out ‘evidence’ to support our hypotheses. Much like when we suddenly decide to purchase a car of certain make and color, we tend to notice it a lot more often on the road. As our paper wealth increases, we use that as justification, or worse, as ‘proof’, that our earlier convictions were indeed ‘correct’. Perhaps it is cognitive dissonance – not too dissimilar to a smoker who is perfectly cognizant of the health risks yet continues to feed his habit by inhaling from the cancer stick. Psychologists have shown that we have a tendency to underestimate the risk of an activity when we ourselves are engaged in it. We also have a penchant to indulge in intellectual materialism where we treat our ideas like possessions. We find it difficult to admit we were ‘wrong’ in light of new contradictory information and as a result, we hang on to our ideas for far too long. Perhaps this could be a reason why economic bubbles continue to persist despite ever more efficient markets.

Hindsight is a beautiful thing or, as I always say, “hindsight vision is always 20/20”. From the tulips mania in 1600s and the South Sea bubble in 1720, to the Housing bubble in the 2000s – it was never a bubble in foresight, only in hindsight. To quote the ‘greatest stock operator’ that ever lived:

“There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.” – Jesse Livermore

The whole premise of efficient markets lies in the fact that overvalued stocks should theoretically attract short sellers to bring it back in line. Arbitrageurs should keep the markets in check. However, as Yogi Berra once said “in theory there is no difference between practice and theory, in practice there is” and as we now accept, the markets are not always rational. In fact, I would go as far as to argue that rationality itself is an arbitrary concept.

Keynes once remarked that “The markets can remain irrational longer than you can remain solvent.”  Even the best investors have painfully discovered that being early and right is the same as being wrong.

Michael Burry of Scion Capital faced an investor revolt when he bet too early on the recent subprime mortgage crisis.  The housing bubble continued to inflate before his predictions came true and the investors that stuck with him made a tidy profit.  Scion ultimately returned almost 500% (net of fees and expenses) from November 2000 until June 2008 whilst the S&P returned just over 2% over the same period.

Even the likes of George Soros, his once right-hand man Stanley Druckenmiller of the Quantum Fund and Julian Roberston were not spared from the ‘irrationality’ of the markets. Titans of the industry and legends in their own right, each man has paid dearly for being ‘right too early’ at one point or another in their careers. If being right too early equals being wrong, does being ‘wrong’ too early equal being ‘right’? Is it homogeneous and symmetrical? (More on this later.)

Julian Roberston’s Tiger Fund paid the ‘ultimate price’. Robertson correctly called the tech bubble in the late ’90s but had to unwind the legendary fund in March 2000  ̶  just before the NASDAQ tanked. Since there was no hope of bucking the trend as momentum traders continued to ride the wave, hedge funds mostly jumped on for the ride. Only the bravest or perhaps the foolhardiest would even dare consider trading against this mania.

Perhaps the bravest of all was Julian Robertson, who suffered heavy losses when everyone else surfing the wave was making extraordinary profits. Faced with a flood of redemption requests from investors as the bubble drove the price of tech stocks to dizzying heights, Robertson, who famously refused to partake in the Internet craze, just couldn’t hang on long enough. He had repeatedly warned the ‘day of reckoning would come’ when Internet companies that had never turned a profit continue to skyrocket against a backdrop of collapsing stocks elsewhere.

In March 2000, Robertson decided he had had enough of waiting and closed down the battered Tiger Fund. At around the same time, the NASDAQ crested to mark the beginning of the end for the tech bubble. But for Robertson and his Tiger Fund, the end just could not have come soon enough. The ‘day of reckoning’ did come on 13 March 2000 when the sell off began, but for Robertson it was too late. The market had remained irrational longer than he could stay solvent. Over the next 20 months, the NASDAQ fell from 5038 to a bottom of 1114. At its peak, Tiger had well over $20 billion in assets under management and Robertson was second to none when it came to stock picking.

Back in 1867 John Stuart Mills noted “Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive work”. The same lesson could still be applied to the Stock Market Crash of 2000-2002, which wiped off $5 trillion in the market value of companies.

Perhaps it is no wonder that Sir Isaac Newton famously said “I can calculate the motions of heavenly bodies, but not the madness of people” when the genius himself got caught up in the South Sea bubble and reportedly lost £20,000 (equivalent to £3 million today).

Earlier, I argued that rationality itself is an arbitrary concept and posed the question “If being right too early equals being wrong, does being ‘wrong’ too early equal being ‘right’?” Think about it: if everyone in the world suddenly became ‘irrational’, would that not make you the irrational one (at least from a medical standpoint)? If rationality is defined by consensus, then by implication rationality is a moving target. Hence, when the market is acting ‘irrationally exuberant’, do you try to remain ‘rational’ and short the market (like Robertson did)? Or do you act ‘rationally’ by jumping on for the ride to profit from it (like Druckenmiller eventually did)?

George Soros famously said “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”. I would venture as far as saying when it comes to the markets, there is no such thing as ‘wrong’ or ‘right’. There are strategies that are profitable, and strategies that blow you up. That’s it.

Fortunately, in finance, economists have another term called ‘profit-maximizing’, which is often used interchangeably with ‘rational expectations’. However, as investors we may not always have the luxury or liberty to consider etymological and philosophical questions when our portfolio is haemorrhaging money. If it walks like a duck, quacks like a duck and looks like a duck, for all intents and purposes, it is a duck!

 

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