On bankers winning beauty contests
Posted on April 28, 2008 by Richard Beddard
Filed Under Investing |
Your article reminds me of James Montier’s idea that investment performance is not based on what is true and not based on what you believe to be true but is based on what the majority of other people believe to be true…
James Montier*1 nicked the idea from John Maynard Keynes.
Keynes compared professional investing in the stockmarket to a newspaper beauty contest (I suppose it would be on Facebook these days) in which the contestants pick the six prettiest faces. The winner is the person who makes the closest selection compared to the average for all contestants.
So the challenge isn’t to pick the faces you think are prettiest, or even the faces you think average opinion says are prettiest, but the faces you anticipate average opinion expects the average opinion to choose or some iteration beyond that!
In other words, professional investors are more interested in gaming the market than buying shares in sound companies with good prospects.
The point they both make, though, is this game of speculation is risky. It means buying popular but expensive stocks and selling before they become unpopular - or ‘the greater fool theory’ (there will always be someone prepared to pay more “for the bad, or depreciating, half crown” as Keynes said).
While that’s the way the game is played, Mr Montier says its very hard to win. So when you say “investment performance”, I hope you don’t mean “good long-term investment performance”, because I’m sure Mr Montier, and Mr Keynes, wouldn’t agree.
I was thinking of the recent out-performance by banks and trying to work out why it is happening.
I confess, I didn’t realise banks were beating the market.
Banks may be a good investment simply because people believe that they will not be allowed to fail by the governments.
In addition they are able to access a lot of extra liquidity in exchange for their safest assets. It is highly unlikely they will reduce the cost of mortgages using this liquidity (which is a good money spinner for them) and much more likely that they will use it to invest in the stock market in better performing assets.
The US job data is still quite strong and corporate earnings is still strong enough to support the jobs. This may reflect a similar situation in the UK. Jobs mean that people can continue to repay their mortgages.
Even if the Banks have to cut their dividends in half later in the year, they will still yield a reasonable amount.
If the number of write-downs turns out to be too high (because people can keep paying their mortgage) then the banks will be able to undo those write-downs later in the year.
All in all, it seems a fairly safe investment.
That may be what investors think. Or what they think, other investors think…
But there’s plenty of punditry around to the contrary. You know; the American economy is already in a recession that will precipitate a global slowdown, prices are rising, it will take years not months for bad debt to work its way out of economies, and there will be more write-downs to come. Governments will intervene to save banks, but:
- Events at Northern Rock and Bear Stearns show they’re not interested in bailing-out investors, and…
- Would they be able to prevent a number of banks going down simultaneously?
It’s fun to debate, but I don’t think such speculation helps - most of it should be written off quicker than a brace of sub-prime mortgages.
The alternative is not to look at banks as participants in a beauty contest, but dispassionately as business for sale at a price (if you’ve been following this discussion, you know I don’t think they’re cheap enough).
Finally, if you do not invest in equities now then you are going to be absolutely hammered by the massive global inflation which is going to hit us over the next few years with all these extra dollars and pounds in the system.
We’re back in the speculation game again there, but I agree, as long as capitalism isn’t doomed, equities are a good long-term investment (and if capitalism is about to end, there are probably other things that require our attention more urgently than our share portfolios).
The question is, which equities? The ones that are winning the popularity contest now? Or the ones that aren’t even in it? It’s one of the great divides in investing; do you follow the herd or seek comfort in obscurity?
This is the story so now you have to try and pick it apart to see where it all goes wrong
Well, I tried! What do you think Robin (or anybody else)?
Footnotes:
- See Chapter 13. ‘Who’s a Pretty Boy Then? Or Beauty Contests, Rationality and Greater Fools’, in Behavioural Investing by James Montier (reviewed here, on sale here).
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11 Responses to “On bankers winning beauty contests”
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Hi Richard,
I am flattered that you have dedicated an entire blog entry to my comment. I am impressed that you came up with your response so quickly!
To pick up on one point, I actually think that Montier’s book is all about people who ‘game’ the market. Suppose we think of market participants (note I do not use the term ‘investor’) as three basic types.
1) Those who have not got a clue what is going on (but sometimes think they do)
2) Those who should know what is going on but still get it wrong anyway (e.g. economists)
3) Those who make sure they know what is going on and generally get it right
James Montier’s book is mainly concerned with category (1) and (2) people. He talks about strategy’s (such as momentum investing and value investing) to try to take advantage of the way people behave. Momentum investors are purely investing in the way people behave and value investors are successful because the way people behave cause companies to become undervalued.
I am squarely in category (1) but I am trying to use momentum investing to move up to category (3). However I might end up being category (2) by following this route.
Good value investors are squarely in category (3) but so are any people who comfortably meet their long term financial objectives.
Regarding banks, I do not know if they are a good investment or not. I also do not know if the stock market will end the year up or down. However, I do not think fundamentals will have much to do with the result in the short term. In the long term, by the time fundamentals kick in, things will have moved on in any case.
Right now I have a pure total return portfolio but I realise that this is not an investment style I am comfortable with so I going to start to move back into equities over the coming months. I will keep a core holding of total return investments however (just in case I end up in category (2) at the end of the day).
Hi Robin. Phew! I don’t know where to start. I don’t think I’m going to be as quick off the mark with a full reply to your reply!
I agree with this:
>Momentum investors are purely investing in the way people behave and value investors are successful because the way people behave cause companies to become undervalued.
But I think in picking momentum investing you’re picking the hard route to exploiting behaviour - not something Montier recommends (I’ll try to dig out the relevant chapter).
Hi Richard,
Let me know if you find the chapter. I will review it. However in principle, as momentum investing is mechanical, it is not that difficult to do (the main effort is working out the method in the first place and sticking to it). It just might not work very well
The question is, should I spend the next 10 years tweaking the algorithm or learning how to value companies. I know what your answer will be!
Yes I will - I work at home on Fridays so that’s often when I do book research as that’s where most of the books are! However, here is an interview with Eugen Fama, the father of Efficient Market Hypothesis who seems to have spent a large part of his subsequent career finding anomalies in the theory - chief among them momentum. It sheds some light on lure, and the problems of momentum investing:
http://www.minneapolisfed.org/pubs/region/07-12/fama.cfm
Region: Let me ask you about momentum. You’ve said that it’s the strongest challenge to the hypothesis of market efficiency. Can you elaborate on that?
Fama: There’s evidence that if you rank stocks every month based on their last year of returns, the very extreme winners tend to win for a few more months and the losers tend to lose for a few more months.
That seems to be true in U.S. data beginning around 1950. We don’t have foreign data going back that far, but it tends to be there in major foreign markets except for Japan. It doesn’t tend to be there in the U.S. data for the ’30s and ’40s. So there’s some chance that it is just a chance result. There are so many people looking for anomalies in the data, that may just be the biggest one that they’ve found. Maybe it won’t be there in the future. We don’t know yet.
Region: Is there an opportunity to make money there?
Fama: Well, there isn’t much of an opportunity to make money, because as I said, you do this every month. And if you rank and trade stocks every month, the turnover of these portfolios is enormous.
Region: The costs will eat up the profits.
Fama: Right. The costs will kill you. So the people who have written these papers have said, basically, “This is interesting, but forget about trading on it.” But it’s still interesting.
Hi Richard,
As usual, you find a very interesting article to read.
The issue of costs (fees, taxes and the switching day) is, of course, a factor that has to form part of your overall trading strategy when using momentum.
I cannot, in all honesty, say that I account for it all correctly or even close to correctly.
Last year, after all costs, my method returned 10%.
This year because I did not feel the method was reliable, I moved into a hand-built total return portfolio and my YTD has been -3% (after costs).
Had I continued to use the method without changes my YTD would have been 0% (after costs) (mainly attributable to the unexpected rally last month).
If the method had returned -2% (after costs), that would have still been in line with expectations.
Therefore momentum would still have worked even at this difficult time.
I cannot comment on the method that Fama talks about for using momentum. Using 12 month data is only accounting for the behaviour of one type of category (1) investor. I personally feel things are a little more complicated than that and my own method uses a more complex model. I suspect that the infamous quant hedge funds use much more complex models than anything I could come up with.
Hi Robin, bit rushed today so I thought I might just point you in the direction of some interesting reading in Montier’s book Behavioural Finance and make an observation.
First the observation - on more complex models. It’s interesting because most of the research is on relatively simple models, presumably because its easier to get the data and test but also perhaps because if you have too many variables it makes it difficult to work out which hare having the effect! Yet many of us use more complex criteria in real life. Does that add value - obviously we think so.
Second the reading. ‘Momentum - critique’ is actually listed in the index and there are quite a few references to it. Quickly flicking through I think this would be a profitable programme of reading. He’s not as critical as you’d expect in a critique. However it’s clear that momentum is a short-term, and therefore expensive, strategy.
Finally I do use a momentum screen to find hot stocks for iBall primarily - just for a bit of variety. That’s how I dug up ASOS, which is up 86% and is the top iBall performer! Of course I didn’t put any money in it myself
More recently Dechra Pharmaceuticals and Abcam were also momentum picks.
Beauty contest trends result in problems for investors to decide which stocks to invest. Investment is a complex problem, especially nowadays.
In your previous blog entry you mentioned value investors would buy at a low p/e or deposits to market value ratio. What effect (if any) would the imminent dilution of the share price mean? Granted the market cap won’t change.
Hi Justin, thanks for your comment. Good point. Other things being equal, arnings per share will fall as there are more shares in issue thereby making the company look even less attractive on a p/e basis (because the price divided by the smaller earnings per share will be higher). There’s a good article on the implications here: http://www.efinancialnews.com/investmentbanking/corparatenews/content/2450492135
Hi Richard,
Thanks for pointing out that index reference. It is a useful lookup into the sections I am particularly interested in.
On a final note, my total costs for momentum investing are now only about 2% per annum as the cost of buying funds is now 0% for most funds.
Therefore it all comes down to whether momentum investing is effective or not. This is very difficult to say as, over the last two years, my portfolio has suffered huge negative swings but it is still ahead overall and, until I messed things up this year (by exiting the strategy), I had been in the top 20% of my benchmark over the year.
If we do go into a persistent systemic downturn then my strategy will suffer relative to cash. However I do not think I will ever be able to call the top or bottom of this market so I would rather stay in equities and trust the long term out-performance.
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