How Do You Describe Two Years Worth of Work in 60 Seconds?
QUICKLY!
I was really honored to be interviewed by the Richmond Times-Dispatch'sMetro Business section for their piece entitled "Sixty Seconds with..." which profiles local business and professional leaders. I had sixty seconds, of course, to give the central message of "The Naked Portfolio Manager." Take a look at the interview; it will only take a minute.
I recently spent some time at my local Barnes and Noble looking at the shelves of investment books. I found many of the titles to be comical (even funnier than "The Naked Portfolio Manager," if you can believe that!). There was a consistent theme with each book that I thought was dangerous though. Let's look at some of the titles:
1. "Fire Your Stock Analyst: Analyze Stocks of Your Own"
2. "The 100 Best Stocks You Can Buy"
3. "(You) Invest Like a Shark"
4. "(You) Day Trade Online"
5. "(You) Get Rich with Options"
[With the last three titles, I have added the word "you" in parenthesis.] Two things are implied when you purchase these titles. Number one: The information each book offers is useful to you for the purposes of making investment decisions. Number two: You, the investor, can apply this information effectively to improve your investment results. With this analysis, I will ignore the first assumption and concentrate on the second.
On page 54 of "The Naked Portfolio Manager," I write about a study conducted by a scientist named Hillel Einhorn about three pathologists. The pathologists were asked to look at a series of slides and evaluate nine specific risk factors affecting Hodkinson's disease patients. All of the slides were of deceased patients. The question that Einhorn was studying was whether the pathologists could use their analysis of the nine risk factors to determine the patients' life expectancy with any degree of accuracy.
Einhorn found that the pathologists were able to accurately assess the nine risk factors, but were not able to use those risk factors to make accurate predictions about life expectancy. Using their risk assesments, Einhorn developed a model that was reasonably accurate in predicting how long the patients survived after the biopsies were taken.
How does this apply to the aforementioned investment tomes? Even if the information in the books is useful, there's no guarantee that the average investor, who is subject to emotional decision-making (picking stocks based on emotion), will be able to use the information effectively. The great thing about "naked strategies," which eliminates human error, is that you don't need specialized knowledge or expertise to apply them. Brilliant men have created the model for you. I have listed several of these models in the book and given references as to where you can find more models. All you need to do is follow them. That's one of the things that sets the information in "The Naked Portfolio Manager" a part from other books.
How Many Variables Do You Need To Create A Good Naked Strategy?
As I wrote in one of my last blog posts, "naked strategies" are quite simply highly efficient, cost-effective methods of coming to a decision quickly. These methods help investors avoid many of the delays that are frequently part of the decision-making process, such as the delays that occur when human decision-makers apply their judgment.
Comparing naked portfolio managers to traditional portfolio managers, the latter often uses far more information than is used in the naked model. People assume that humans judges are more reliable and sometimes even more cost-effective in their investment decision-making because they use a lot more information. Yet ironically, naked strategies often outperform human managers despite using far less information.
There are many examples of this out side the area or portfolio managment. Orley Ashenfelter, a Princeton professor, developed a model for predicting the value of wine futures based on just two variables (rainfall and temperature). That model proved much more reliable than the decision-making of wine speculators, who had the same data available to them plus the benefit of using the old "swish and spit" method. Another example: The Goldman chest pain decision aide used to make triage decisions for patients uses just four variables, yet it made more reliable triage decisions than the cardiologists and emergency room doctors at Cook County Hospital in Chicago who had far more information. Greenblatt's Magic Formula, which I discuss in The Naked Portfolio Manager, uses just two inputs, yet has produced impressive results relative to market averages.
One would think that with more information, human judges would be able to out-predict models, but the evidence clearly indicates this is not the case. The problem that human judges have is that when you have lots of information, it's sometimes difficult to determine what data is extremely important and what is almost irrelevant. With naked decision-making strategies, on the other hand, the method's construction tells you what data is truly important.
Good models focus on only the most important criteria necessary for making the decision. Models with a huge number of factors often dilute the value of the most important variables by averaging them with inputs of lesser value.
Decision-Making Best Practice #20: If a model has a very large number of inputs, it usually means that the model's creator has not done a very good job of identifying the most important inputs. Be very skeptical of these models.
I really find ABC's new reality TV show "Shark Tank" amusing. If you're not familiar with it, it's produced by Mark Burnett, who is also the producer of a number of hit shows including "Survivor" and "The Apprentice." On the show, five self-made millionaires (the sharks) hear presentations from entrepreneurs who need money to grow their business. The idea that self-made millionaires would decide to invest hundreds of thousands of dollars in a person they just met - based on a two minute interview, no less - seems a little ridiculous. But for the entrepreneurs on the show who need the money, it is indeed very serious.
If the shark "bites" and makes an offer, the entrepreneurs have to make a decision almost immediately. This is what makes the show so interesting; you can see all types of decision biases on display.
In last Sunday's episode, commitment bias was on full display. Paul Watts, one of the entrepreneur contestants, had a graffiti removal business that was grossing $230,000 per year. He wanted to franchise the business but had no experience in that area. Two of the shark judges, Kevin, the venture capitalist, and Robert, the technology guru, were willing to give Paul $350,000 for 75% of the business. It seemed to me this was a great deal for Paul - he would get two new partners that could help him sell franchises, plus get a large cash payment. Yet he turned the offer down flat.
Dan Claffey, owner of Coffee Brand Gifts (a business in which he puts names associated with coffee on novelty items like teddy bears), claimed he had invested $400,000 of his own money in his business, but he had no sales to show for it. He wanted a $400,000 investment for 40% of his company. The sharks told him he had a worthless patent. Yet the fact that he had spent so much of his own money without any sales did not seem to deter him at all. Continuing on a erroneous path because of sunk costs is a common decision-making error. Claffey apparently will continue to pursue a flawed business strategy rather than stop and cut his losses.
Gina Catroneo, however, had to be the night's biggest victim of commitment bias. Her company Souls Calling sells products with a positive message, like umbrellas (rather, "inspirellas") featuring greeting card-like words of inspriation and sandals that literally stamp happy words in the sand when you walk. She wanted $150,000 for 25% of her company, but her sales were less than $20,000 per year. She said she had invested over $100,000 of her own money into the business, but the sharks told her she needed to get a job and forget the fantasy. Still, she hung on. At the exit interview, she said as long as people needed happy thoughts, Souls Calling would be there to meet the need. Like I said, the show was amusing.
Decision-Making Best Practice #17:Yogi Berra once said, "You can observe a lot just by watching." Even though "Shark Tank" seems contrived, you really can learn a lot about decision-making by paying close attention.
Bob's noteworthy success in the investment field is based upon his in-depth knowledge of decision-making, which he applies in a disciplined, rule-based approach: the application of Statistical Prediction Methods.
