Seeing investors reality Charles Ellis, PhD, CFA Founder of - PowerPoint PPT Presentation

Seeing investors’ reality Charles Ellis, PhD, CFA Founder of Greenwich Associates and best-selling author FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 1

The wish of Robert Burns O wad some pow’r the giftie gie us To see oursels as others see us It wad frae monie a blunder free us An’ foolish notion FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 2

Citizens of Lake Wobegone! 80/20 rules apply to us on rating ourselves . . . Good listener Sense of humor Skill as driver Good friend Skill in dancing Skill in investing FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 3

Endowment effect: It’s mine! Give 1/3 of a group beer mugs and later ask for a fair price for a mug: 1/3 to sell their mug $7.12 1/3 to buy a mug $2.87 1/3 to “arbitrate” $3.12 Ownership does matter FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 4

Cabdrivers’ lesson Rainy day Sunny day Seldom empty Often empty FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 5

Optimal smart hours? Rainy day Sunny day More (getting’s good) Less (go home and play) FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 6

Actual hours? Rainy day Sunny day More (getting’s good) Less (go home and play) Less than usual More than usual Why? Make “enough” every day FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 7

Optimists’ characteristics • Overestimate skills • Suffer illusion of control • Underestimate odds of bad events FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 8

Exaggerate ability to forecast Scottish parliament’s new building cost 1997 £40m 1999 £109m 2000 £195m 2001 £241m 2002 £295m 2003 £376m 2004 £431m Repeating now with tram from center city to Edinburgh airport FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 9

Experts are fallible Examine 80,000 expert estimates versus trend: More Same Less FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 10

How to beat the experts 1/3 More 1/3 Same 1/3 Less FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 11

Beware of illusion of skill “ People can maintain unshakable faith in any proposition when ” supported by co-believers. ~Daniel Kahneman FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 12

Hindsight bias (and outcome bias) We evaluate decisions on the outcome, not on the quality of the decision • Obama and Navy SEALs • Carter and Iran rescue • Doctors and operations Investments of all kinds FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 13

True or false Very intelligent women tend to marry men who are not as intelligent? True or False? FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 14

Kahneman’s favorite equation Success = talent & luck a lot more talent luck & a little more ? ? Great success = talent & luck FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 15

We ignore base rate 12% Interest rate Dot-com U.S. Treasuries peak at record lows FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 16

To improve forecasts • Identify appropriate reference class • Gather relevant data • Project “base rate” • Accept “base rate” unless compelling reason Even then, let “base rate” dominate FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 17

Framing effect Which operation would you prefer . . . 95% 5% Survival rate Mortality rate FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 18

Confirmation bias is strong We seek and recall information that confirms our prior beliefs • Fox TV • The New York Times • Rolling Stone Halo effect is strong. If Jack says so, we’re inclined to: Accept, believe, and repeat FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 19

We ignore data we don’t see • Professional hockey players are born in January and February • NINJA mortgages • We don’t fully appreciate the undeniable power of regression to mean or base rates FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 20

Common error Flight instructors stopped praising good landings and focused on chastising poor landings —for the wrong “reasons” FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 21

Common errors Praise Fire and select managers managers after having “good” run “bad” run We are, on average, wrong on both decisions FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 22

Common errors • Higher price = higher value • Past performance predicts • We forget that sample size is inversely correlated with sample variability FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 23

Does blink work? Let’s try A: 8 · 7 · 6 · 5 · 4 · 3 · 2 · 1 = ? Let’s try B: 1 · 2 · 3 · 4 · 5 · 6 · 7 · 8 = ? FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 24

Test results Let’s try A: 8 · 7 · 6 · 5 · 4 · 3 · 2 · 1 = 2,250 Let’s try B: 1 · 2 · 3 · 4 · 5 · 6 · 7 · 8 = 512 Actual = 40,320 FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 25

What will come next? H T H T H H H T T H T H H T T T T T T FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 26

Which is more likely? B B B G G G G G G G G G B G B B G B FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 27

First impressions matter a lot • BSO auditions • Warren Harding • Romance FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 28

Accessibility is powerful of candidates with faces that look 70% “competent” get hired FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 29

Utility trumps wealth “ The long term is not ” where life is lived. ~Daniel Kahneman Emotions do matter Emotions are driven by change FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 30

Failures to accept defeat • Continuing to fight on in war • Staying in failed marriage • Staying with failed manager • Holding failed investment FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 31

Common errors We overrely on experts Experts are overconfident FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 32

Before active’s glory days • Committee decisions—made monthly • Utilities, industrials, buy and hold • Dividends and bonds for income • Money-center banks and insurance companies • Graham and Dodd, Hickman on bonds, E.L. Smith, Phil Fisher • Business school courses?? FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 33

Active’s glory days begin • Quotron just introduced • In-depth research new • DLJ, Baker Weeks, Spencer Trask, etc. • Performance measurement new • CFAs beginning; CHA jokes • Investment counsel firms • Portfolio manager as king • The Money Game FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 34

Changes of note over past 50 years • 3M 5B • 0 5B+ • 10% 95% • 0% 100% • 10 300 • 0 100,000 CFAs • Reg D • MBAs and PhDs • Internet, Bloomberg, IT, algorithms • 40¢ 3¢ • Turnover 20% to 100% + FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 35

Disagreeable data Mutual funds underperform • 60% over “typical” year • 70% over 10 years • 80% over 20 years (beware data) Losers lose almost twice as much as winners win FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 36

Disagreeable data II Institutional investors underperform • 75% about average • 25% below average • 0.1% above average FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 37

Past performance: Poor predictor Which one decile predicts: 1 st ? 2 nd ? 3 rd ? 4 th ? 5 th ? 6 th ? 7 th ? 8 th ? 9 th ? The bottom decile! FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 38

What do professionals do? • Emphasize recent results . . . if “good” • Sell recent past “performance” • Time-weighted… not dollar-weighted • Overemphasize “performance” in ads, etc. • Ignore risk • Incubate and delete, incubate, and delete • Flood system with data • Not focus on clients’ real needs • Increase fees FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 39

Fees over 50 years Institutional fees Mutual fund fees Up from 0%–0.1% to Up from 0.25% to 1% 0.3%–0.5% or more 300% 400% Results: Industry economics transformed FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 40

Fees: Perception versus “deception” • 1% of assets • 15% of returns (of 7%) • 100% of incremental returns? FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 41

Loser’s games • Tennis • Las Vegas • Politics • War • “Performance” investing FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 42

Case for indexing • Higher returns • Lower risk • More reliable • Lower cost • KISS • Easier to change portfolio structure • Free to focus on important decisions FOR FINANCIAL ADVISORS ONLY. NOT FOR PUBLIC DISTRIBUTION. 43