Investing is not as hard as we think A polite assassination of the - PowerPoint PPT Presentation

Investing is not as hard as we think A polite assassination of the behavioural shortcomings of our competition Value Investing Speaker Series LBS Investment Management Club February 2019

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About Tollymore T O L L Y M O R E I N V E S T M E N T P A R T N E R S Tollymore's objective is to compound clients' capital over the long term by investing in a concentrated portfolio of undervalued high-quality businesses. Patience and independent thought are cornerstones of our investment philosophy. Tollymore seeks to improve the lives of investors through exceptional long- term investment returns. M A R K W A L K E R , A C A , M A N A G I N G P A R T N E R A N D P O R T F O L I O M A N A G E R Mark Walker is the Managing Partner of Tollymore Investment Partners. Prior to founding Tollymore Mark was a global equity investor for Seven Pillars Capital Management, a long-term global value investing firm based in London. Mark joined Seven Pillars from RWC Partners, where he was part of a two-person team managing a newly launched, long term global equity fund. Prior to that Mark worked as an investment research analyst for Goldman Sachs and Redburn Partners. He is a qualified chartered accountant, and graduated from Edinburgh University with a First Class MA Honours degree in Economics, graduating first in his class. 3

Investing IS hard “ It’ s not suppos e d to be e as y. Anybody w h o finds it e asy is s tupid” . Ch arlie Munge r • Active trading harms aggregate investment results (Journal of Finance) • Over the last 15 years only one in 13 large-cap managers, only one in 19 mid-cap managers, and one in 23 small-cap managers were able to outperform their benchmark index. (SPIVA) • Investors underperform both the passive and active funds in which they are invested (Morningstar surveys) 4

But we know it’s hard A frame w ork to s tay th e c ours e in pe riods of se lf -doubt We know investing is hard. We are here because we think we can make a difference. • Spending time with reflective thoughtful and talented peers can lead to imposter • syndrome! We need a broader context in which to judge our prospects for long term success. • My sell side experience exposed me to the incentives and actions of the institutional • money management industry. The following is a collection of eight observations from that experience. • For each behavioural constraint I’ll discuss my personal impressions as well as “the • outside view”, why this may be antithetical to sound investing practice, and how we can set ourselves up to avoid and exploit these behavioural errors. 5

(1) Pursuit of informational edge O bse rv ations Corporate access perceived as a source of edge for the largest managers. • Corporate access led investment processes. • Large complex financial models, broad knowledge vs. deep understanding. • Lack of calibration of investment processes to forecasting errors. • W h at’ s th e proble m? Information gathering increased confidence but not accuracy. • Exposure to sales pitches. • Misdirected intellectual effort/intellectual dishonesty. • 6

(1) Pursuit of informational edge Th e outside v ie w Overconfidence can have profound consequences, inflating investors' valuation of their • investments, leading physicians to gravitate too quickly to a diagnosis, and making people intolerant of dissenting views. Numerous studies suggest that confidence and accuracy are not highly related. E.g. College • football experts were asked to predict game outcomes (Organizational Behavior and Human Decision Processes), professional horse handicappers predicting horse races (Paul Slovic). In subsequent rounds of the game the experts were given additional information and asked to rank their confidence. The additional information did not improve the accuracy of their predictions but did increased the confidence in their bets. The problem with this as it relates to investing is that the extra confidence causes us to • increase the size of our bets without a corresponding increase in our capacity to predict outcomes, causing us to lose money. 7

(1) Pursuit of informational edge Th e outside v ie w Overloading our cognitive capacities • with more information can actually lead to worse decision making. In one study 60% of participants chose the objectively best car when given four attributes, vs. a 20% success rate when given 12 attributes (Dijksterhuis). 8

(1) Pursuit of informational edge How to av oid/ e xploit Awareness of exposure to sales pitches. • Corporate access position in an investment process. • Strive for simplicity and conduct deep work on the handful of value drivers. • Large opportunity set and focused portfolio to find the biggest gaps between price • and (wide) value range. Consider the merits of equal weighted portfolios if overconfidence is likely to cause us • to increase bet size. 9

(2) Pursuit of analytical edge O bse rv ations Specialists vs. generalists. • Sector teams and incentives directed to picking winners and losers. • Self-perceived expertise fosters hubris and certainty. • Absence of probabilistic thinking. • Unreceptive to disconfirming evidence or dissenting opinions. • Conviction differences in analysts vs. PMs • Intellectually closed and believe that ideas, IQ and research = edge. • Authority bias: Hierarchical structures. • Synonymity of titles and progress. • Committee led decision making. • Investment managers feel the need to sound smart, a major barrier to epistemic • humility. “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.” (Mark Twain (mis?)quote) 10

(2) Pursuit of analytical edge W h at’ s th e proble m? The need to justify fees creates pressure to: • Conceal rather than acknowledge ignorance, and • Build large teams and create perception of deep intellectual expertise. This • expertise increases the perceived validity of one’s own opinions and makes one less receptive to ‘non - experts’. Deep perceived expertise promotes trust in intuition and lowers the inclination for hard System II work. This also geometrically increases complexity of organisations, introduces group • think, authority bias, loss aversion by slowing down decision making – are we acting decisively when the odds are in our favour? Large teams dilute decision-making accountability, leading to mis-assignment of • skill and stupidity vs. luck and therefore hubris. Smarter people are worse at combatting behavioural biases (Kahan motivated • reasoning trap – numerically literate people fit the data to their pre-existing views on gun control). 11

(2) Pursuit of analytical edge Th e outside v ie w Greater accuracy is attributed to the opinions of authority figures ( Milgrim’s effort to • understand why moral humans commit atrocities – half of subjects administered fatal electric shocks in conflict with personal conscious). The preference for orderly social systems trains us from birth to obey authority; • deference to authority is mindless. Mental flexibility, introspection, and the ability to properly calibrate evidence are at • the core of rational thinking and are largely absent on IQ tests. Typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience (Mauboussin). Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. HiPPO (highest paid person’s opinion) is a barrier to data/evidence based decision • making. Peer acquiescence further entrenches the HiPPO’s confidence. 12