In my two previous posts, I discussed Atul Gawande, author of The Checklist Manifesto, and his contention that simple checklists can make an incredibly complex processes like surgery or flying an airplane safer and more effective. While reading his book, I was happy to see that Gawande also has something to say about checklists and investing.

In chapter 8, Gawande states that regimentation - sticking to a disciplined, repeatable process - can offer many benefits beyond the area of medicine, and he cites finance as an example. While researching his book, he talked with a number of portfolio managers who employ checklists; hedge fund manager Mohnish Pabrai's comments were especially interesting.

Pabrai is from India. He was trained as an engineer and then built a successful technology company before starting his investment firm where he manages a 500 million dollar fund. Gawande says Pabrai ought to know a thing or two about being dispassionate and unemotional about decision-making given his background. But when it comes to investing, Pabrai actually has to fight to control his emotions.

"No matter how objective he tried to be ...he found his brain working against him, latching on to evidence that confirmed his initial hunch and dismissing the signs of the downside. It's what the brain does." Gawande wrote. Readers of The Naked Portfolio Manager know this phenomenon as "confirmation bias," as discussed in chapters 7 and 8 of my book.

Or in a bear market he can go into "fear mode" and start seeing risks where they don't exist. "You see people around you losing their shirts, and you overestimate the danger."

Another portfolio manager that Gawande intervied, Guy Spier, also talked about "greed mode." That means the investor sees an exciting investment and starts to think about the hundreds of millions of dollars he can make. Spier calls it "cocaine brain."

I have personally experienced cocaine brain myself. (I am speaking metaphorically here. I have never used illegal drugs of any sort in my life). I remember in 1999 I was using a judgment-based portfolio approach that relied heavily on chart reading. I bought several stocks that climbed many points over my buy price immediately after I bought them. I experienced a tremendous rush of adrenaline and began to feel as if I could make money at will. Still, a little voice inside me kept saying, "This can't be so easy." Then the bear market came along and fortunately I realized that naked investing strategies were a much better approach.

While I agree with Gawande that a checklist can be an effective tool for judgment-based portfolio managers to reduce the risk of making emotional decisions, remember that the best tool to avoid emotional errors is rules-based investing, a.k.a. naked strategies. I think Gawande really caught Speir and Parabai with their guards down and got them to speak candidly about how emotions effect their judgment. All the more reason to use naked strategies!

Did you know the Model 299 "Flying Fortress" was the most advanced airplane Boeing ever made? It could fly faster and almost twice as far as the other bombers of its day - and carry more bombs too. It had an imposing 103-foot wing span, and it's four-engine instead of the usual two design made it an impressive sight for the United States Army.

On October 30, 1935 at Wright Air Field in Dayton, Ohio, a small group of Army brass gathered to watch the Model 299's test flight. It was supposed to be a mere formality. Major Ployer Hill, one of the Army's most experienced test pilots,  roared down the tarmac and lifted the plane into the air, rising to about three hundred feet. Seconds later, the plane abruptly turned sideways and crashed into a fiery explosion, killing Major Hill and one other crew member.

The investigation later revealed that the cause of the crash was pilot error. The Flying Fortress was substantially more complex than previous airplanes. It required the pilot attend to four engines, each with a separate fuel-oil mix, retractable landing gear, wing flaps, and electric trim tabs that needed to be adjusted to maintain air speed. All of this had to be monitored while regulating the pitch of the propellers with hydraulic controls.

The Army opted for a less capable plane designed by Martin and Douglas. Military historian Phillip Meilinger explained that many thought the 299 was just "too much airplane" for one person to fly.

Still, some of the top Army brass thought the plane was flyable. So they came up with an interesting plan, and it didn't involve longer or more extensive pilot training. It was a very simple set of rules to be followed in a disciplined, repeatable fashion. Essentially, it was a naked strategy, although the Army called it a checklist. And with this strategy in place, the incredibly complex aircraft became much easier to fly. Test pilots logged almost two million miles without an incident.

Later, the US Army gave the Boeing 299 a new name. They called it the B-17. They ultimately bought over 12,000 of them, while the airplane played an integral role in the Allies victory over Nazi Germany.

This is another one of the stories that Atul Gawande retells in his book, The Checklist Manifesto. It's a terrific example of how a disciplined, repeatable process can take something incredibly complex - like flying a highly sophisticated airplane - and reduce it to a series of simply steps that can be successfully performed by an ordinary pilot. The same goes for investing; naked strategies apply a simple set of disciplined, repeatable rules to portfolio management, making it easy for everyday investors to do.

I just finished up reading a fascinating book by Atul Gawande called The Checklist Manifesto. Gawande is a well-known surgeon who was asked by the World Health Organization to help make surgery safer for their 193 member nations.

The problem seemed staggering. How could you come up with a program to make surgery safer in 193 different countries? These countries have different economic systems, different cultures, and different educational systems. To improve surgery worldwide would take a massive expenditure of resources and involve tens of thousands of people, wouldn't it?

Actually, no.

Gawande's surprising answer to the problem was a checklist. By formulating a set of official standards for safe surgical care and publishing them under the World Health Organization's name, he felt he could reduce many of the errors that surgeons make. 

According to Gawande, surgery has four big risk factors: bleeding, infection, unsafe anesthesia, and what he calls "the unexpected." For the first three, Gawande says science and medicine have given us some straightforward and valuable preventative measures. Unfortunately, surgeons sometimes miss these simple things. For example, a 2005 study of the Children's Hospital in Columbus, Ohio determined that over one-third of the time, appendectomy patients failed to get the right antibiotic at the right time. Gawande said if you give the antibiotic too soon, it can wear off before surgery, and if you give it too late it won't work at all.

While giving the antibiotic at the right time may seem like a simple notion, Gawande points out that many simple requisites can easily be overlooked. And it is these oversights that cause major complications.

Are there parallels between surgery and traditional portfolio management? Gawande suggests there are. While on the surface, both seem incredibly complicated, Gawande suggests much of surgery is a series of simple tasks. Isn't this what naked investing is about too?

I will have much more to say about this wonderful book in future posts.

One of my New Year's resolutions is to lose some weight. So I started a strict diet on January 1st. I go to Dunkin' Donuts each morning and eat four jelly-filled doughnuts for breakfast. Mid-morning, I stop by Starbucks and get a Vanilla Crème Frappuccino. By lunch time, I'm really hungry so I go to McDonald's and get two Big Macs, a super-sized order of fries, and a large Coke. This will usually hold me over until dinner, when I go to see the Colonel and get a bucket of extra crispy fried chicken. And then I'll top it off with a stop at Cold Stone Creamery, and get Founder's Favorite ice cream.

To my surprise, I recently learned the above food purveyors don't care if I gain weight by eating at their establishments. In fact, they're more interested in me spending money than hitting my weight goal.

...Of course, I really don't eat like this. I used the fast food industry as a metaphor for so much of what passes for investment advice published by the financial tabloids. While McDonald's does have healthy salads and Cold Stone has sinless ice cream and non-fat smoothies, both of these businesses are primarily concerned with making a profit, not producing low-fat, nutritious meals. And the financial media is no different.

What financial magazine editors and television producers try to do is produce a product that people want to buy. That's why you see so many magazine covers with fund managers who have great investment records. Reading about hot funds, stocks, or sectors has never worked for investors trying to make money though, but it is a great way to sell magazines to those who aren't savvy about financial matters.

Just like a dieter cannot count on a fast food restauranteur to help them meet their goals, an investor cannot count on the financial tabloids to make them wealthy. The restauranteur and publisher have different objectives in mind when it comes to dieters and investors, and they're typically contrary to what is healthy for you, physically and financially, whatever the case may be.

Empirically based, naked strategies are created to achieve a financial objective and are not influenced by circulation, advertising, or fashion.

Full disclosure: I do own two Cold Stone Creameries. You can get a delicious, low-fat shake that I call the "Bob Special" at Cold Stone if you ask the crew members to mix sinless ice cream with milk and strawberries in a blender. Have them throw in a little chocolate malt too if you like...

Labels: investment choices, investment diet

According to The Wall Street Journal, the CGM Focus Fund was the best performing mutual fund in the last decade. In a time when the Standard and Poor's 500 lost money, the CGM Focus Fund turned in a stellar return, averaging 18% per year. So why did most of the fund's shareholders lose money?

The problem is a matter of timing. The fund produced an amazing return of 80% in 2007. The financial media went wild. Fortune magazine called fund manager Ken Heebner America's hottest investor . His picture adorned the cover of Kiplinger's Personnel Finance magazine. Investor's Business Daily crowed about the fund's stellar performance as well. Yet, The Wall Street Journal said the fund sucked in almost three billion dollars in new assets in 2008, but then proceeded to produce a disastrous return, losing nearly half its value.

Page 72 of The Naked Portfolio Manager talks about the difference between time-weighted returns and dollar-weighted returns. When a fund is as volatile as the CFM Fund is, it can produce eye-popping, time-weighted returns in excess of 18% per year while still losing money for its average shareholder.

This is yet another example of the availability error discussed on pages 38 and 39 of The Naked Portfolio Manager. My new e-book, available for download now, discusses an allocation strategy that might prove helpful if you're thinking about investing in funds that have this type of volatility.

Labels: CGM Focus, Fortune Magazine, Kiplingers

With this blog, I have emphasized over and over again that by ignoring the stock market forecasters and prognosticators and simply following a set of empirically based rules in a disciplined manner, you can meaningfully improve your investment results. Here's an experiment you can do with your own computer to see the results of naked strategies for yourself.

One very simple thing you can do to enhance your return is rebalance your portfolio at regularly scheduled intervals. To test this, select up to ten stocks and then select a time period to test. Go to Google Finance Historical Stock Prices and download excel spreadsheets with the historical stock prices and the time period you have chosen. Then you can copy and past those historical prices into this spreadsheet that Professor Tom Scott of Sweet Briar College (I'm helping guide his "Principles of Investing" class apply rules-based investing strategies) was kind enough to share with us.

The spreadsheet compares the difference in return between a buy-and-hold portfolio with no rebalancing and a portfolio that is rebalanced at regularly scheduled intervals. You can download weekly data, monthly data, or yearly data and enter it into the spreadsheet. The calculation assumes that you rebalance your portfolio back to an equal weighting for each security at the end of each time period.

In most cases, you'll find that the rebalanced portfolio does better than the buy-and-hold. Depending on the volatility of the stocks you select, the difference can in some cases be 2% or more per year.

Now stop and think about this. We're comparing two strategies for investing for the exact same stocks. Yet one strategy results in meaningful differences in return. How is that?

Stocks are constantly oscillating on a range. When you rebalance, what happens is you sell stocks that are trading in the high part of the range and buy stocks that are in the low part of their range.

Now remember, no strategy works all the time for all stocks. It's possible to find time periods and stocks where systematic rebalancing does not produce better results than the buy-and-hold. And you of course need to consider the effects of taxes and trading costs. But if you do this experiment enough times, I think you'll agree that over time, you can add significant value by rebalancing at regularly scheduled intervals in a disciplined manner.

Labels: Sweet Briar

I think I set Wintergreen's record for the fastest time to becoming a homeowner this year.

I first visited the green and white slopes of Wintergreen on December 31st when my friend Patrick Morin invited me to a New Year's Eve Party there. I met some really great people and pretty much fell in love with the place.

The next weekend, I brought my whole family up to the mountain for a visit. While my oldest children snowboarded, I watched my six-year-old - on skis for the first time - ski circles around me. When I suggested we might buy a townhouse at Wintergreen, my thirteen-year-old son exclaimed that was "the best idea I ever had"!

The next weekend I met with real estate agent Brian Chase, and after being assured we were at the absolute bottom of the real estate market, I made an offer on a lovely home in Trillium. If all goes well, we close on Thursday of this week.

As the newest Wintergreen homeowner, long time resident and race team booster Janice Smeallie invited me to a party this weekend, which includes a silent auction to benefit the Wintergreen Alpine Race Team. The team has a supportive group of parents behind them who raise funds to help pay for the young athletes' training and coaching. The team competes against others in the Southern Alpine Racing Association. To show my appreciation for the invite and to support the community, I decided to donate two autographed copies of The Naked Portfolio Manager and to take the winning bidders to The Tobacco Company for an illuminating discussion of rules-based investing. A complete list of items that are going to be auctioned will be available here this Thursday, so check back then and make a bid. Go Wintergreen Racing!

Labels: Wintgreen