Agenda:
1. Inversion Thinking
2. Defensive Investor Strategy Performance (up 41.8% in last 12 months)
3. All Seasons Strategy Performance (up 2.5% in last 12 months)
Many good value investors have written about Charlie Munger's use of an approach called inversion thinking. I'd like to briefly discuss inversion thinking in this quarter's newsletter, as well as why I believe that inversion thinking makes a strong case for quantitative investing. Tren Griffin, a Munger biographer, describes this problem-solving approach much more eloquently than I can:
Charlie Munger has adopted an approach to solving problems that is the reverse of the approach that many people use in life. Inversion and thinking backwards are two descriptions of this method. As an illustrative example, one great way to be happy is to avoid things that make you miserable.
Munger even jokes that he wants to know where he will die so he can just not go there. -25iq
I'll attempt to leverage Munger's philosophy to explain how to make wise investments. If you want to make money investing (grow long-term wealth), and you use inversion thinking, start by asking how you would destroy long-term wealth. The next time you decide you would like to destroy your wealth, I would recommend the following:
· Pay high fees and/or commissions
· Buy expensive or speculative assets
· Trade frequently
· Use leverage
· Make emotional decisions about buying or selling assets
If you have read my previous newsletters these suggestions won't come as a surprise (I often recommend the opposite). At this time, I’d like to focus on making emotional decisions. Before we can improve our decision making, we first must understand that we are prone to making poor investing discussions. One typical decision-making deficiency is illustrated in the Greenblatt study. The study identified a group of stocks that outperform the market over time and gave investors two options:
1. To choose when they buy and sell stocks on the list (self-managed)
2. To have a formula determine when to buy and sell stocks on the list (this quantitative approach was described in the study as "professionally managed")
The self-managed account allows clients to choose which stocks to buy and sell from a list of approved Magic Formula stocks. Investors were given guidelines for when to trade the stocks, but were ultimately able to decide when to make those trades. Investors selecting the professionally managed accounts had their trades automated. The firm bought and sold Magic Formula stocks at fixed, preset intervals. During the two year period in Greenblatt's study, both types of account were able to select only from the approved list of Magic Formula stocks.
If investors in the study made rational decisions about the appropriate times to buy and sell stock, I would expect them to outperform the market significantly (because they were given a basket of stocks that outperformed the market).
…What happened? The self-managed accounts, where clients could choose their own stocks from the preapproved list and then exercise discretion about the timing of the trades, slightly underperformed the market. An aggregation of all self-managed accounts for the two-year period showed a cumulative return of 59.4 percent after all expenses, against the 62.7 outperformance of the S&P 500 over the same period. The aggregated professionally managed accounts returned 84.1 percent after all expenses over the same two years, beating the self-managed accounts by almost 25 percent (and the S&P by well over 20 percent) (emphasis mine). For a two-year periods a huge difference. It's especially so since both the self-managed accounts and the professionally managed accounts chose investments from list of stocks and followed the same basic plan. People who self-managed their accounts took a winning system and used their judgment to eliminate all the outperformance and then some (emphasis mine). Greenblatt has a few suggestions about what caused the underperformance, and they are related behavioral biases. - From "Quantitative Value" by Wesley Gary and Tobias Carlisle
The investor's "best judgment" was the difference between outperforming and underperforming the S&P 500. Most investors show similar underperformance in "self-managed" accounts because of emotional decision making when buying and selling stock (causing them to buy high / sell low). We can leverage inversion thinking to solve this problem: if self-management and emotional decision-making are the problem, using a systematic approach is an ideal solution. Depending on your investing approach, implementation of a systematic or quantitative approach might vary:
1. For an index investor – it probably means buying at predefined intervals (every two-weeks, monthly, etc.)
2. For a disciplined value investor – it likely means buying when a stock is significantly below fair value and selling when the stock reaches fair value
3. For a less disciplined value investor – it likely means buying stocks that are significantly below fair value and selling after a defined period of time (one year, three years, etc.)
Is your "best judgment" the cause behind your investment’s underperformance? It's worth some thought. If so, consider adding a quantitative element to your investing approach.
If you are interested in additional reading on the subject check out the following links: on Munger; on Quantitative Investing.
My Benjamin Graham inspired fund has outperformed the S&P 500.
In the last 12 months, it is up 43.2% (through December 21, 2016).
Defensive Investor Notes: My personal favorite investment strategy uses Benjamin Graham’s (Warren Buffett’s mentor and professor at Columbia Business School) guidance to identify companies with a strong cash position, low debt, and stable dividends paid over many years that are trading at bargain prices. Similar techniques have yielded annual returns of approximately 18% since 2001.
My more conservative "All Seasons" inspired fund is up 2.5% in the last 12 months (through December, 21 2016).
Notes on the All Seasons Strategy: I use this strategy for cash management (and to minimize draw-downs). It is intended to reduce volatility without significantly reducing upside. From 1973 - 2012 the max draw-down of this approach was only 14.4% (http://mebfaber.com/2013/07/31/asset-allocation-strategies-2/), yet the compound annual return was a very solid 9.5%. One additional note- this strategy is 70% bonds, which have been in a bull market for 30+ years (this overlaps with the back-testing period). In my opinion, it is unlikely to perform as well in the next 30 years as it has in the last 30 years.