the research puzzle

the research puzzle http://researchpuzzle.com a blog by tom brakke Wed, 01 Sep 2010 20:16:47 +0000 http://wordpress.org/?v=2.8.3 en pitching horseshoes http://researchpuzzle.com/blog/2010/09/01/pitching-horseshoes/ http://researchpuzzle.com/blog/2010/09/01/pitching-horseshoes/#comments Wed, 01 Sep 2010 19:55:31 +0000 tom brakke http://researchpuzzle.com/blog/?p=990
As with most any game, among the players of horseshoes there are various levels of interest, involvement, obsession, and expertise. That's true for those navigating the markets as well.

There are those who play to go along with the crowd, without a particular plan or much if any preparation. To use the horseshoe analogy, they may laughingly throw the horseshoes around when others do, but if you are in the vicinity you'd best keep your eyes open, since a horseshoe could come flying your way at any time. In reality, they might be better off trying to take advantage of the luck that supposedly accrues to someone who holds a horseshoe, since luck is really what they are counting upon anyway.

Then there are those amateurs who enjoy the sport of it all and have developed some skill. Their rules of scoring may reflect the old adage that "close only counts in horseshoes and hand grenades." They just have to be a bit better than Uncle Joe to win, although in a bigger gathering they'll need to step up their game even more to generate a victory against those who have been at it for awhile. They typically can't take the time to get as good as they'd like, but they are good enough to beat anyone in the park on a given day.

But there are those who operate by another standard altogether: What's their percentage of ringers? Toss after toss, how consistently good are they? If you get over seventy percent ringers, you're world class. How much practice and what kind of skills does it take to get there?

And what is required to be the very best? The New York Times did a profile of Alan Francis,[1] not only the best horseshoe pitcher around (ever), but "perhaps the most dominant athlete in any sport in the country." His ringer percentage often hits ninety percent. Certainly he must have the innate skills it takes to be successful, but I was struck by the fact that he also approaches the game differently than almost anyone else. He figures that less than one percent of top competitors use his particular way of tossing, the "three-quarter reverse." Had he started out trying to be like everyone else, Francis might be just that today.

In attempting to navigate the markets, which kind of player are you? Which kind do you aspire to be? What are you willing to do to get there?

[1] The New York Times : Francis is a purchasing manager when he's not pitching horseshoes.: http://www.nytimes.com/2010/07/21/sports/21horseshoe.html]]> a street named desire http://researchpuzzle.com/blog/2010/08/30/a-street-named-desire/ http://researchpuzzle.com/blog/2010/08/30/a-street-named-desire/#comments Mon, 30 Aug 2010 20:02:47 +0000 tom brakke http://researchpuzzle.com/blog/?p=985 A Streetcar Named Desire, Tennessee Williams' classic play, Blanche DuBois has been forced to leave her once-stately Mississippi home, now lost to foreclosure. She makes her way to her sister's modest dwelling in New Orleans, the last stretch by way of a streetcar with that fateful name, still gripped by her delusions of grandeur and not prepared at all for what is to come.

As the story unfolds, the layers of desire and events of the past are laid bare, and the façades come tumbling down. The arc of the tragedy encompasses generations, with years of unwinding having been played out in slow motion before the few months of cathartic action in the play.

It is a dramatic use of poetic license to say that it seems like the business of investments is on a similar journey, but the similarities are there. Decades of good times fostered beliefs that in a harsh light don't seem as beautiful as they once did: efficient markets, modern portfolio theory, buy-and-hold investing, faith in the Fed and the Great Moderation, deregulation, the wizards of Wall Street, and on and on.

Like Blanche clinging to the plantation house and what it represented, investors, investment professionals, and investment firms are hanging onto memories of the way things were. An edifice was created, but can -- or should -- it be sustained?

To be sure, employment is down in certain parts of the business, but the slice of our economy dedicated to managing, massaging, and manipulating other people's money remains substantial. And the infrastructure to make it happen, with some notable exceptions, remains in place. Is it possible that we'll see the business (with or without the markets doing so in tandem) correct enough that we'll see big drops in the number of funds and ETFs, of asset managers, of those sitting for the CFA exams, of industry employment, and of financial advisors, who after a punk decade still seem as ubiquitous as California real estate agents in 2006?

Will changes in the flow of information be a powerful force of disintermediation, ripping up the old business models of the markets?

And, most importantly, what will happen to the attitudes that shaped a generation of money decisions? Blanche lost Belle Rive, her beloved home place, but that was just a prelude to the climactic loss of beliefs that had defined her. Similarly, we need to get back to square one, a journey started in the wake of the financial crisis, but not yet completed.

When we get there, I hope that:

We have rid ourselves of the unrealistic assumptions about markets which have formed the foundation of much investment advice. They fostered unwarranted expectations, helped shape an avoidance of thrift by individuals, and contributed to dreadful decisions by fiduciaries responsible for the oversight of pension plans and other pools of money.

We have found along the way a skepticism that can cut through the layers of obfuscation that have characterized our financial give-and-take. Buyers of investment products should know the fees and exposures that come with a purchase, and be presented with a faithful picture of the potential for loss as well as gain. It's amazing the degree to which the business has been dedicated to obscuring those things.

We have recognized the strangulation of investment creativity that has resulted from an undue focus on short-term results and the reliance on relative performance comparisons that are counterproductive.

The recent struggles of the industry have been modest in the aggregate in comparison to the times that preceded them, but a lurking shadow remains on its doorstep. If it does not rework and reform itself, there will be a date with destiny down the road, like Blanche and her ways coming face to face with Stanley Kowalski and his.]]> combo platters http://researchpuzzle.com/blog/2010/08/04/combo-platters/ http://researchpuzzle.com/blog/2010/08/04/combo-platters/#comments Wed, 04 Aug 2010 19:38:15 +0000 tom brakke http://researchpuzzle.com/blog/?p=734
While some investors assiduously avoid forecasting, it is a critical piece in many investment strategies, and a posting from The Capital Spectator looked at the worth of "combination forecasts."[1] No matter how good an indicator is and how reliable it appears to be in aiding forecasting, "that any one predictor fails at times is unsurprising." The bottom line: "In effect, investors should diversify the sources of their forecasts."

When it comes to investing, much research has been focused on identifiable anomalies and trying to capture them. Lots of books have been sold by authors who advocate exploiting them and multitudes of investors have jumped on them over time (arbitraging some away in the process). What would happen if investors diversified across the anomalies? CXO Advisory Group reviewed[2] a paper by Erik Hjalmarsson, and their summary of his findings is that "evidence from nearly six decades of data indicates that diversifying across stock return anomalies consistently beats individual anomalies and the broad stock market."

The Psy-Fi Blog picked up on that paper as well,[3] and linked to another one by Zhijian Huang that looks at what might happen if you tried to regularly jump to the best-performing anomaly. (CXO had reviewed the paper too and said, "Anomalies appear to have their own kind of momentum.") So that's now a third way: sticking to your guns, combining approaches, or jumping from one thing to another. Perhaps this line from Psy-Fi applies to all three: "Sometimes it’s not enough to have a good strategy, you also need to understand why it’s a good strategy in order to profit in the long term."

Or do you? Maybe it's as simple as following the momentum without thinking too much about it. Abnormal Returns looked at "the momentum paradox,"[4] noting that it could be that the "ambiguity in definition and causation is in fact the strength of momentum investing." It certainly seems to rule the day in many market environments, but is it enough on its own? The posting says that even "the most ardent of momentum investors" use it in combination with "other more placid strategies." And, sure enough, CXO is on the case there too, with a review[5] of a paper called, "Technical, Fundamental, and Combined Information for Separating Winners from Losers." The evidence as cited shows that the additional information generated from other investment approaches can improve a momentum strategy.

As a generalist, all of this makes sense to me, but the investment business is made up of specialists by and large. It's very hard to get some people to use other sources and traditions, and often is counterproductive to try. And, while it sounds good in theory, in practice it can be quite challenging to execute. An earlier email exchange with David Merkel on a related topic reminded me of that. He cited Peter Lynch as one who carved out parts of his portfolio for approaches that worked differently than his natural diet of GARP, and Merkel said Lynch was "canny in integrating styles that would otherwise conflict." But others, he noted, have not been as good: "When done well, it is a thing of beauty, when done poorly, it is a recipe for mediocrity at best."

So, no panacea, but the body of evidence suggests that the next time you go to the market diner, you might want to order a combo platter. It's possible that indigestion may result, but it could very well be that you'll find a mix of flavors that suits you well.

[1] The Capital Spectator : James Picerno has been blogging about investments since 2003.: http://www.capitalspectator.com/archives/2010/03/combination_for.html
[2] CXO Advisory Group : This site provides consistently worthwhile reviews of the academic literature.: http://www.cxoadvisory.com/big-ideas/diversifying-across-equity-anomalies/
[3] The Psy-Fi Blog : I like its subhead, "A Sideways Look at Psychology and Finance.": http://www.psyfitec.com/2010/06/exploiting-anomalies.html
[4] Abnormal Returns : Among its many other accolades, AR was named the inaugural site of the week on research puzzle pix.: http://classic.abnormalreturns.com/the-momentum-paradox/
[5] CXO Advisory : The authors of the paper are Cheng-Few Lee and Wei-Kang Shih.: http://www.cxoadvisory.com/fundamental-valuation/amplifying-momentum-with-volume-and-accounting-indicators/]]> conceptual categories http://researchpuzzle.com/blog/2010/07/29/conceptual-categories/ http://researchpuzzle.com/blog/2010/07/29/conceptual-categories/#comments Thu, 29 Jul 2010 13:56:18 +0000 tom brakke http://researchpuzzle.com/blog/?p=932

So, what are your categories? How long have you had them?

Maybe they are asset classes or sectors or industries or themes or tax-impact buckets or some combination thereof. Maybe you have an advanced system whereby the exposures of packaged products like funds are disaggregated into the proper line items. Maybe the economic impact of the optionality of various instruments is factored in and maybe you have even moved on to the next generation of risk classifications before everyone else. Or maybe your construct is as simple as could be imagined.

In any case, at the root of your approach is a series of conceptual categories that you use to think about the world. Where did they come from?

This is not idle musing. It is helpful to know how they originated and even more important to figure out whether they are still valid. Our tendency is to keep shoving our exposures into the same dated categories, even after the world has changed.

An analogy can be drawn to the folders on a computer or in a file cabinet. Sometimes you just have to wonder what you were thinking when you set up the filing system in the way that you did. But, rather than redoing the structure, you live with it and adapt to it, knowing that it might not be the greatest, but it's good enough for now.

Something very similar happens in the investment world. You even see it at asset management firms, where it's possible to do the equivalent of carbon dating: By looking at the reporting structure being used, you can tell when the code that runs it was written. The degree to which a codification scheme is out of date is especially obvious during periods of rapid change. The fixed income market of the last thirty years is a perfect example. You can see from a glance at a firm's reports when the last conceptual change in categorization occurred.

Investment policies are the same way. If you look at one for a pension plan or foundation, you'll see that the range of investments allowed or prohibited follows some agreed-upon approach to thinking about the markets. That approach tends to lag the evolution of the markets, and given the nature of organizations and the quite infrequent reviews of allocation policy, the policies often lag badly.

If your way of thinking about your investment exposures is out of sync with the reality of today, it's time to rip it up and start over. That also means that you need to examine whether the tools that you use and the information you get from market data vendors need to be adjusted or abandoned. Your ideas and your methods need to go hand in hand, and must reflect the world of today. Like it or not, it's not 1985 any more.]]> preparing for trial http://researchpuzzle.com/blog/2010/07/21/preparing-for-trial/ http://researchpuzzle.com/blog/2010/07/21/preparing-for-trial/#comments Wed, 21 Jul 2010 10:56:44 +0000 tom brakke http://researchpuzzle.com/blog/?p=920
I hadn't thought of it as being somewhat like a court trial, until I had the opportunity yesterday to hear a lawyer discuss a high-profile lawsuit and the related proceedings. There are many differences too, since you are dealing with points of law and defined procedures in one situation and mere convention in the other, but the final judgment in either case may turn on a few critical factors.

One is due diligence. Before arriving at court, the parties do intensive investigations, and the tiniest of details can matter in the end. There's no substitute for this hard (and often tedious) work. Similarly, for the buyer of investment services, the more digging that you do the better understanding of an investment management firm you have. On the other side of the table, the representatives of that firm, who simply want to win the business, don't have the same kind of burden, but thorough preparation can allow them to sidestep many pitfalls, including the offhand remarks in a presentation that can ruin the chances of getting hired.

Lawyers need a theory of the case, and the ability to "sell" that at trial by constructing a narrative that fills in the necessary information and anticipates the sequencing of it that will have the greatest effect. Asset managers looking to win business have to do the same, and must deliver a story that fits their organization, the market, and the goals of the prospect. It's a tough combination, and tougher yet because it's not just a one-time event like a trial. You can't tell one story to one prospect and a completely different one to the next.

The tendency is to fudge and tweak and nudge it. Selling the same story in different ways is one thing, but selling a different story altogether is another matter, as is bending the truth to win the business. "Putting the best face on things" can too easily become a pattern of unethical behavior. It's possible to win business that way, just as it's possible to win a trial that way, but you'll be found out sooner or later.

And if you are not a practiced liar, your body language might give you away and make your defeat a foregone conclusion. Yesterday, a tape of a deposition was played, one given by a well-known and well-respected individual. If all you saw was that tape, you could have predicted the outcome of the trial. He could not tell his story in a believable way.

After the exposition of a case (be it for a judge or jury or investment committee), you need to make an effective close. The lawyer making the presentation yesterday repeated the core of his summation to the jury, and I was struck by how it touched on the facts of the case but was crafted to go beyond that, to capture the emotions of those listening. It was very effective, a reminder that a close is a chance to solidify your message by taking it to another level. Being able to do so is an invaluable skill.

It helps to have something to believe in, so that the emotions are real. In this case, the character and believability of his client sustained the lawyer through adversity and in turn made him more credible in front of the jury. Similarly, if you respect your coworkers and believe in your organization, being convincing is second nature when making an investment presentation. Faking it is not.

One of the mystifying aspects of the case was that the losing party clung to the misguided belief that they would prevail at every step of the way, and got so locked into their perspective that they couldn't see how out of touch they were. That's no different than the trap a bullheaded investor falls into or the one that snares an investment committee that goes into a selection process locked onto a preferred choice and can't see that there are better alternatives, despite all of the evidence presented to them.

Waiting for the jury is always hard, and the verdict may not be what you think it should be. There's no substitute for a compelling case, but meticulous preparation and effective presentation often win in the end, be it in the courtroom or the meeting rooms where millions and billions are awarded for investment in the markets.]]> pick up the pieces http://researchpuzzle.com/blog/2010/07/12/pick-up-the-pieces/ http://researchpuzzle.com/blog/2010/07/12/pick-up-the-pieces/#comments Mon, 12 Jul 2010 15:49:21 +0000 tom brakke http://researchpuzzle.com/blog/?p=904
At its roots, my work is about ideas. Creating new ones, acting as a broker of information, and, to use a term in vogue in the blogosphere, serving as a "curator" who provides new discoveries as well as perspective and (perhaps) guidance for investment travelers.

As a consultant, advisor, and writer, I am in the business of unearthing ideas and applying them for my clients. Some I share with a wider audience. This blog consists of longer pieces (by the standards of the day) with fresh insights or different perspectives -- big chunks of content that hopefully make a splash and some waves when thrown into the great waters of market discourse. I also provide a few Twitter updates here and there, typically links to items of particular note or brief observations (and no "lifestream" updates on my latest doings) -- mere pebbles that might create interesting ripples to watch if you happen to be looking.

In addition, today I started a brand new service called research puzzle pix.[1] You can think of it as a weekday digest of items that might trigger your curiosity or tickle your (investment) fancy. Each edition is anchored with a chart; a small version of the current one appears in the sidebar on this site, along with a brief description of other included items. pix is meant to be a fast read, with enough verbiage provided for you to see if any of the topics are worth pursing before taking the time to click through to the referenced sites. You will not get a long list of links, nor what's hot off the wires. Other sites do that better than I ever could.

I hope that you'll choose to sign up for email notifications or put the new site into your RSS reader, and that you'll find pix a useful and regular part of your information diet.

As with my other activities, the goal is to expose you to ideas in new ways, to pose questions and provide connections that might lead to discovery. I'll keep throwing pieces onto your game table; I hope that you pick them up and see which ones fit into the research puzzle you are trying to solve.

[1] research puzzle pix : This first effort includes the "yield curve accordion.": http://rp-pix.com/a]]> to each his own http://researchpuzzle.com/blog/2010/06/30/to-each-his-own/ http://researchpuzzle.com/blog/2010/06/30/to-each-his-own/#comments Wed, 30 Jun 2010 15:06:31 +0000 tom brakke http://researchpuzzle.com/blog/?p=891
Trying to get in sync with different types of firms (and people) is a critical skill in that regard, which brings us to another chapter concerning "those darn analysts."[1] As noted last week, many analysts struggle with the communications demands of the job. No wonder.

Let's say you are an analyst at a large buy-side firm. Among your clients, if you want to call them that, are portfolio managers with a tremendous array of personal tastes in stocks and stated mandates for the portfolios they run. It's your job to try to help them all do well, and one way or another they will have an important say in how you are compensated and how your career evolves.

One of them might walk into your office and read off a list of new 52-week highs in your universe -- stocks that you don't have rated as buys, but he thinks you should. Another might only want to get you to focus on the big uglies, down-on-their-luck industry stalwarts, no longer loved by the crowd. Others may want some thoughts about a coming IPO without revenues, or a small potential takeover target, or whatever. And let's say that you are, yourself, a classic GARP investor.

Operating in that ecosystem, what constitutes a "buy"? Different things to different people, which makes being all things to all people, as we often ask analysts to be, a recipe for disappointment.

A sell-side analyst deals with analysts and portfolio managers (plus reporters, etc.) of an even-greater variety, limited only by the ways in which stocks in a given universe are used by someone, long or short.

Suffering from a lack of available time, analysts have to decide how to focus their efforts. Invariably, that means migrating to those who share their point of view, who are keen on their particular analytical capabilities, or who hold a certain power (for buy-side analysts, the portfolio manager with the most assets or the ear of the CIO; for sell-side analysts, the dominant firms in the industry or ones known to vote in popularity contests like those of Institutional Investor). Other constituencies get left out or served in passing.

The most successful analysts try to serve a wide range of constituencies and to communicate the landscape of information in tailored ways, understanding the needs of different clients and their variant perspectives on the world of investing. They can be criticized for doing so, as when something is a "buy" for one person who asks about a stock and a "don't buy" for another, even though the demands of their separate approaches make those precisely the correct respective calls.

This business of analysis is all more complex than it's made out to be, perhaps nowhere more the case than in communicating ideas to people that walk different investment paths. "To each his own" (pardon the gender reference, we'll get to that aspect of the issue in due time) is a good mantra for analysts. Pretending that your take on something is all that matters is to make your probability of success lower than it otherwise could be. Learning to add value for clients of all kinds is a rare and valuable skill.

[1] the research puzzle : Last week's posting focused on the broad range of skills that we expect research analysts to have.: http://researchpuzzle.com/blog/2010/06/24/those-darn-analysts/]]> those darn analysts http://researchpuzzle.com/blog/2010/06/24/those-darn-analysts/ http://researchpuzzle.com/blog/2010/06/24/those-darn-analysts/#comments Thu, 24 Jun 2010 11:51:21 +0000 tom brakke http://researchpuzzle.com/blog/?p=869
Some notes: There has been much academic work on the performance of analyst recommendations, which should form the foundation of any detailed discussion of these issues. In addition, you might review my writings about the evaluation services that measure analyst performance, and the conclusions that you should or should not draw from the information.[3] A point to keep in mind is that surveys of institutional money managers consistently show that they don't place much value on sell-side analyst recommendations.[4] The bottom line: Far too much attention is paid to an exercise in futility that doesn't really match up to the needs of investors; stock ratings are fodder for the media (thus the battle over theflyonthewall.com), but beyond that reveal little of what an analyst truly brings to the table.

My concerns lie elsewhere. Think of what we ask analysts to do. (I speak here of fundamental equity analysts, both sell-side ones, who pitch their ideas to institutions and individuals, and buy-side ones, who do the same within their own firms.) While the job can be made to sound simple -- to inform and aid decision makers in their choices -- it involves quite an array of skills and duties.

To be successful, you need to be a business analyst that evaluates anything and everything. The list of most important considerations varies by industry and company, but think of the pieces: operations, sales, marketing, finance, etc. Any of them can cause problems or improvements within a firm; how well do you understand the internal dynamics of each?

Often you are called on to be a technical expert. Especially in areas like computing or biotech, you can be consumed by the details of the products. At the margin, this can suddenly become a large part of your job; I dare say that analysts in the oil industry probably know a lot more today about blowout preventers than they did in March.

In addition, you must be an industry expert. Not just in knowing the players and the news (and keeping up with the trade press, attending industry events, etc.), but in understanding the competitive dynamics of the industry and interrelated industries. Plus, you can't ignore the governmental and regulatory realities and risks.

You must be an astute judge of management talent. In addition to being able to read a management well, you need to toe the line to make sure that you are close enough to make good judgments about the capabilities of the management team, but not too close to be taken in by the story they are trying to sell. Assessing the governance structure for danger signs is part of the job too.

You need to dig into the numbers, serving as a de facto auditor of financial reports. Many industries have specific accounting issues, there are new rules all the time, and age-old shenanigans that can only be found by mastering the details pop up now and again.

With all of this information in hand, you then put on the hat of a forecaster, keeping in mind all of the analytical and behavioral traps that come with it.

At some point, you pull all of this together to try to figure out what a stock is worth, playing your roles of modeler and valuation expert. No matter how laughingly simple or maddeningly complex your approach, you have to have some way to assess value, and it's usually more art than science.

You might spend some time understanding the particular supply and demand dynamics of the stock itself, rather than the company, although Josh Brown's chief complaint referenced above is that almost no fundamental analysts ever do that.

Once you have all of that information processing done, it's time to shift gears. Yes, you need a set of conclusions. If you are a sell-side analyst, you have to slap a simple rating on all of it and a target price too, for what that's worth. A buy-side analyst may get to paint a more rich picture of the possibilities, perhaps even being able to map a range of outcomes as a risk manager might.

Then comes the hard part for many. It's time to be a marketer of your ideas. If you need to put them in readable form, you must be a writer (by the looks of most research reports, not the easiest thing), otherwise a salesperson, going office to office, or speaking to a group, or commenting on a squawk box, or even on television.

I have seen estimates that well over half of a sell-side analyst's time is taken up with marketing duties. Promoting your ideas takes time for analysts at asset management firms too, although nowhere near as much. I have always been surprised, though, that many fine buy-side analysts fail because they aren't good at communicating their ideas effectively.

Now, after all of that, I ask: What are the chances that you are going to be good at this broad spectrum of responsibilities? For one stock? For twenty or forty? Sure, you may have an assistant or even a team to bear some of the burden, but are they organized in a way that recognizes and emphasizes the key pieces of the research puzzle that you face?

It is time for a radical rethinking of the analyst role as now practiced. In most investment organizations, we have made it too easy to say, "those darn analysts," without stopping to realize that we have constructed a job that is unwieldy and unlikely to engender success. Let's go back to the drawing board.

[1] The Reformed Broker : I posted a rather lengthy comment on the site in response.: http://www.thereformedbroker.com/2010/06/18/why-they-all-got-the-bp-call-wrong/
[2] Bloomberg : The article does a good job of presenting different perspectives about why and whether it matters.: http://www.bloomberg.com/news/2010-06-20/best-stocks-were-liked-least-by-analysts-who-failed-to-see-economy-rebound.html
[3] the research puzzle : The recent "yardsticks for pundits" includes links to three of my prior postings.: http://researchpuzzle.com/blog/2010/05/19/yardsticks-for-pundits/
[4] Integrity Research : This piece includes a listing from Institutional Investor that shows "stock selection" as dead last out of twelve things named that portfolio managers look for.: http://www.integrity-research.com/cms/2008/11/19/the-sell-side-just-cant-bear-it/]]> courage and process http://researchpuzzle.com/blog/2010/06/14/courage-and-process/ http://researchpuzzle.com/blog/2010/06/14/courage-and-process/#comments Mon, 14 Jun 2010 13:21:26 +0000 tom brakke http://researchpuzzle.com/blog/?p=803
Although he appears not to carefully cultivate and capitalize upon his guru status like some others, Klarman has pulled back the curtain a little of late, agreeing to be interviewed by Jason Zweig at the 2010 CFA Institute Annual Conference[2] and being the subject of recent pieces in AR: Absolute Return + Alpha[3] and Bloomberg.[4]

It was a line from Klarman's interview with Zweig that spawned this posting and its title: "Courage is a function of process." While the interview and the articles include some information on the "what" (specific investment ideas and considerations), of greater interest are the fundamental elements of "how" and "why" that underpin the strategies of Baupost Group, the fund organization that Klarman leads. The specific ideas will change; the philosophy is foundational. That's what investors should analyze and emulate.

But only if it makes sense for them. In the AR article, Klarman says that your approach must fit your character. If you aren't willing to wait around for opportunities, don't enjoy looking for bargains, and can't bring yourself to lean against the conventional wind, then "you're not a value investor, and you shouldn't be one." Know thyself is the first principle of investing.

And Klarman's way is to stand apart. The staff of Baupost is small in size and structured differently than most investment organizations. The firm is painted as a place where a fierce war of ideas is fostered, but without much of the hubris, finger-pointing, and drama that so easily destabilize the culture at other firms. Anyone dealing with Klarman better be on his toes and ready to analyze without pleasantries; according to Jim Grant, "He comes out and says what's on his mind and expects you to be blunt and direct as well." And, apparently, he isn't too worried about how big his pile of dough is versus others: "I feel great knowing I made a fraction of what I could. The key is doing right by clients, not making more money for myself or partners." How refreshing.

Speaking of those clients, Klarman repeatedly stresses how critical it is to pick the right ones. He realizes that by taking money from those who may be likely to leave at just the wrong time, an organization has a weak base from which to execute its strategy. In a business where everything flows from the level of assets under management, it is difficult but helpful to turn clients away whose behavior is likely to work against you in the long run.

Klarman looks for "idea fluency" among those he works with, so that if he presents a thesis, "I want people to immediately come up with 10 places to look to exploit it." Instead of running to the standard playbook of the day with everyone else, he tries to gain a different perspective, no doubt why he is noted for his ability to deal with "complicated situations." One benefit of that approach is that there are fewer players competing with Baupost on many of their ideas. (It is also the reason that Klarman is not easy for the crowd to clone: The strategies can be hard to execute, especially for individuals.) Positions are approached within a framework of sensitivity analysis and an assessment of the probabilities; knowing as much as you can about the structure of an idea in advance aids in finding the right approach for executing it and in dealing with the vagaries of price movement thereafter.

Once the preparation is in place, you have to know opportunity when you see it, and, according to Klarman, the financial crisis was a "wonderful time to put money to work." As difficult as it is to buy in the face of that kind of tumult, perhaps even more elusive is the ability to stay out of the game when it is being played in a manner that doesn't make sense to you. Sitting in cash is not the way of the investment world, but it is an essential element of the Baupost way. "We make money when we buy," says Klarman. The right price is everything.

Process is something that needs to be evaluated time and again, not a boilerplate explanation that appears in a pitch book year after year without examination and reflection. As indicated by the referenced sources, Klarman spends a great deal of time thinking about the "how" of it all and has put the pieces of the puzzle together in a unique and a successful way. No matter your particular investment strategy, that is where you need to start, and where you need to return, over and over. The real gurus are those that help us to think through the path to investment ideas, not those that pitch us their latest ones. If we listen and learn, maybe someday we'll have the courage it takes to invest wisely and well.

[1] the research puzzle : Here are links and descriptions for some of those postings.: http://researchpuzzle.com/files/view/guru-postings.pdf
[2] AdvisorAnalyst.com : An official transcript has apparently not been produced. This one was created by Cameron Wright.: http://advisoranalyst.com/glablog/2010/05/25/seth-klarman-baupost-value-investing-congress-notes-5182010/
[3] AR: Absolute Return + Alpha : This publication, with one of the clumsiest names in the media world, focuses on the hedge fund industry. A free trial is required to see the interview.: http://www.absolutereturn-alpha.com/Article/2579135/The-value-of-Seth-Klarman.html
[4] Bloomberg : This is the online version of the story.: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=adBgaU4jI6Mo]]> i see levels http://researchpuzzle.com/blog/2010/06/08/i-see-levels/ http://researchpuzzle.com/blog/2010/06/08/i-see-levels/#comments Tue, 08 Jun 2010 20:05:27 +0000 tom brakke http://researchpuzzle.com/blog/?p=735
This posting was originally conceived in response to the current challenges faced by those whose investment process is wholly or partly related to technical analysis, so let's start there.

The universe of market players who use technical analysis to some degree is broader than most people believe. It is not uncommon to be talking to a portfolio manager who stresses how he makes decisions on the fundamentals, when over his shoulder you can see a chart up on his screen. "Just for perspective," he might say if asked about it, but aren't such conceptual frameworks what technical analysis is all about?

Much of it involves seeing "levels" of one kind or another in one way or another, and making decisions in response. Once electronic delivery of charts became ubiquitous, the technicals crept into the consciousness of fundamentalists too, so that a statement by someone that a stock is cheap may be some combination of a valuation assessment and a picture floating around in her head.

For avowed technicians, there are levels everywhere. Sometimes they are clearly and cleanly represented in graphic form, but often these days they are to be found, if you can find them, in the midst of a chart with so many lines that it looks like a picture of multi-colored spaghetti noodles.[1] The goal in this posting is not to describe or compare the formulas and techniques, or to debate their efficacy, but to consider whether they can be applied as they have been in the past.

One thing that interests me (as someone who evaluates processes) is the precision of the levels observed or predicted. I often see notes that say something like, "35.42 is key," with recommended actions to take if that level is violated. How precise or fuzzy[2] should your decision rules be? False precision is unlikely to help in any way, no matter your approach.

But what of the levels in general? Do the old rules still apply? Can you rely on them?

It is a question not limited to technical analysis. I reviewed a quantitative research report last week, the kind that shows various metrics as they are today versus where they have been in the past. The bottom line on the report was "strong buy," based upon a time-tested algorithm, yet when I looked at the individual variables, I found myself saying, "No longer valid, temporarily elevated, distorted by transient factors, etc." as I went through them one by one.

Quant portfolio managers are struggling too, according to Pensions & Investments, and making changes in an attempt "to reverse their performance drought since the start of the financial crisis."[3] You see it everywhere: The old relationships have broken down.

So, perhaps this is the time for fundamental analysts and portfolio managers to shine. After all, if the downside of that approach is that it is easy to be led astray by your emotions, the upside is supposed to be the ability to navigate uncertainty by spotting opportunities not yet apparent in the charts and the formulas. Yet, fundamental analysis is also tied to history and decisions are formed in light of it. Look at twenty years of data on margins or sales growth or whatever, and tell me which levels are normal or valid or reasonable today.

If you work at this blogging thing long enough you repeat yourself a lot, and I knew when writing this that I was revisiting old ground. Seventeen months ago, I wrote about our analytical desire to get "back to normal."[4] Despite a better economy and higher prices for most things, normality seems out of reach.

I see levels, but what do they mean?

[1] The Crosshairs Trader : This posting does a nice job of looking at simplicity versus complexity in charting.: http://www.thecrosshairstrader.com/2009/11/can-you-calculate-your-willingness-to-trade/
[2] Barron's : Michael Kahn referred to "fuzzy lines" in this piece.: http://online.barrons.com/article/SB127059312926473145.html
[3] Pensions & Investments : Entitled, "Quant firms tinkering with factor weightings," the article is restricted to subscribers.: http://www.pionline.com/article/20100531/PRINTSUB/305319978
[4] the research puzzle : The posting included a graphic that remains appropriate today.: http://researchpuzzle.com/blog/2009/01/15/back-to-normal/]]> everything is relative http://researchpuzzle.com/blog/2010/06/01/everything-is-relative/ http://researchpuzzle.com/blog/2010/06/01/everything-is-relative/#comments Tue, 01 Jun 2010 14:13:05 +0000 tom brakke http://researchpuzzle.com/blog/?p=820

The chart is certainly handy, portraying as it does the performance of a manager against an index and a peer group, across a number of time horizons, all in one fell swoop. But it is merely a snapshot of the "what," devoid of the necessary examinations of "why" and "how"; nonetheless it carries inordinate weight in the selection of managers and therefore in the structure of the business.

We are wired to compare ourselves to others,[1] no matter the endeavor. I was asked a couple of weeks ago about my knowledge of the decisions made by the other independent consultants operating under the Global Research Analyst Settlement. Since we had met together during the formative stages of that endeavor, I was exposed to their ways of thinking and benefited from their knowledge, but I explained to my questioner that beyond that I did not review or analyze their work in any detail. My charge was to make independent choices within the parameters of the settlement order, not to do what others were doing.

He responded, "What about benchmarking and best practices?" The specific answer to that question always depends upon the circumstances, but resting your process on comparative measures too often serves as a cover for decision making and an anchor for behavior.

In the case of the settlement, I had extensive experience regarding the issues at hand. In addition, I researched thoroughly the areas where I lacked information, learned from my counterparts during our meetings with regulators, and did extensive due diligence on research providers. Why would I then look over my shoulder to see what others were doing when it came time to implement a solution? Isn't my job to make the best decisions that I can and to be able to articulate why I made them?

As it should be for investment managers. Unfortunately, relative performance evaluation limits their willingness to venture from the pack, because career risk kicks in and if you are too far from your benchmarks or your competitive group at any time your job could be on the line. Message: Don't stray too far. Do what others do.

To complicate things further, it's easy to fall into the trap of equating "best practices" with "best performance" over some period, despite ample evidence that "worst practices" can generate it sometimes too. While the system inhibits would-be pioneers, there are those intrepid souls that venture forth, and the ones that deliver performance for a time are soon followed by others riding hard to catch up, not too concerned about where they are going or what they are doing, just that they are behind. They may arrive alongside just in time for an ambush of sorts.

In an earlier piece I wrote, "When everything is relative, it's easy to lose situational awareness."[2] In large part, that's what has happened to the investment management industry of today, to the sellers of those services as well as to the buyers.

All of whom should read James Montier's latest piece, "I Want to Break Free."[3] As he outlines, it is time to face the choice of whether to maintain and reinforce the pillars of investment faith and practice, or to systematically tear them down.

The simple chart above is a crude representation of one of those pillars. Ask yourself (and don't wait for others to answer): Is the doctrine of relativity that it portrays creating a better industry or a worse one? If it is the latter, where do we go from here?

[1] the research puzzle : As I wrote about in "competitive yoga.": http://researchpuzzle.com/blog/2010/03/20/competitive-yoga/
[2] the research puzzle : The title, "situational awareness," comes from a famous airline incident.: http://researchpuzzle.com/blog/2009/10/26/situational-awareness/
[3] GMO LLC : The article is available following free registration at GMO's site, where you can also find Jeremy Grantham's indispensable commentaries.: https://www.gmo.com/America/MyHome/]]> pricing glamour http://researchpuzzle.com/blog/2010/05/27/pricing-glamour/ http://researchpuzzle.com/blog/2010/05/27/pricing-glamour/#comments Thu, 27 May 2010 14:17:23 +0000 tom brakke http://researchpuzzle.com/blog/?p=807
The "this" was accompanied by a gesture that indicated the modern suburban luxury dealership. Expansive and polished to the nth degree, with a large room full of comfy leather chairs for those waiting during the servicing of their cars, an equally large room with work tables for those not at leisure, and a "library" behind. Huge televisions, lots of goodies, you get the idea. Although it looked out of favor for awhile during the last couple of years, apparently glamour still sells.

As investors, we must constantly monitor how much we are paying for glamour versus intrinsic value. You'll often hear debates about the relative merits of growth investing versus value investing; I prefer the lingo typically found in academic studies, where the terms "glamour" and "value" are used instead. The performance evaluations inevitably favor the latter strategy, because much of the glamour is really faux growth that is misidentified for a time.

The largest audience I ever saw at an IPO road show was for Trilogy Systems. It had a story (wafer-scale integration), but what was really for sale was the glow of success around founder Gene Amdahl. A few months later, I visited a number of companies with a group of analysts. By then Trilogy stock was trading at a dollar, and the buyers of the deal must have struggled to control their anger as they walked into the headquarters of that start-up firm and saw the rosewood-paneled walls and brass railings. As we sat in a large meeting room, a screen descended from the ceiling and the man next to me muttered, "I paid for that screen."

Of course, the anecdotes could go on forever (reviewing just some of the dot-com ones would be exhausting). The general problem with glamour investments is that the odds seem to be working against you. Sure, there are real growth stories out there, and if you are good at finding them you can pay glamour prices and still have attractive returns. It's just that for long periods of time there aren't too many nuggets of gold in the stream.

Since paying up for glamour is one of the most common investment mistakes, your investment process should be structured to force you to wrestle over and over again with the changing dynamics of valuation and fundamentals.

As an example, we can start with those macro situations that have earned the "bubble" moniker, like the aforementioned dot-com bubble, the housing bubble, etc. Most can be analytically parsed as they develop by reducing them to simple economics.[1] A look at the facts indicates that higher prices are needed to sustain the momentum, that the underlying numbers have gone past making sense; it has become a momentum game. As always, knowing which game you are playing is critical. At the top of every bubble, people are caught playing a momentum game while convincing themselves that the fundamentals support prices without really checking to see if they do.

Headline-grabbing events aside, as prices vary for individual stocks and sectors, the rubber band of valuation is stretched here and there as the price of glamour (or of its anti-matter, characterized by disgust and revulsion) fluctuates. True underlying value changes much more slowly. That sets up a key question to answer: "Given my strategy, what do I do about it?"

For those who believe in pure momentum, their money management rules, placement of stops, and strategies for momentum breaks had better reflect the fact that prices get out of whack and that the goal is to capture the upside moves and not the downside ones. On the other side of the spectrum are those unique investors who can anticipate glamour and see what the crowd is going to fashion before it actually does. It's obvious that the errors in that strategy are completely different.

No matter your approach, the evolution of glamour pricing likely matters, perhaps more than you think. You should be able to articulate how your strategy intends to deal with its fickle nature, and you must ensure that you have the execution methodology to back it up.

Otherwise you could find yourself one day sitting in a Hummer that used to be cool and now is just a delivery vehicle for bad economics.

[1] socializing finance : Daniel Beunza wrote on this recently in terms of an "ultimate bottleneck strategy.": http://socfinance.wordpress.com/2010/05/25/how-to-bet-against-a-bubble-the-ultimate-bottleneck-strategy/]]> yardsticks for pundits http://researchpuzzle.com/blog/2010/05/19/yardsticks-for-pundits/ http://researchpuzzle.com/blog/2010/05/19/yardsticks-for-pundits/#comments Wed, 19 May 2010 13:57:11 +0000 tom brakke http://researchpuzzle.com/blog/?p=768
Report cards of previous predictions are harder to find, at least ones that are consistent and fair in their grading. You can be sure that there will be self-reporting of calls that look great, without an accompanying discussion of luck versus skill. The clunkers will never be mentioned again.

Consequently, there is a great need for unbiased reviews of these forecasts, so I share the sentiment of the bloggers mentioned above, but I fear that much of the rhetoric leaves the wrong impression. It is not easy at all to tell who is "good" and who is "bad."

I come to my opinions on this through much study of, consulting on, and writing about research performance analysis, the closest thing there is to a yardstick for pundits. If we could magically get all the predictions in the investment world into a giant database, we would likely use analytics similar to those that measure the performance of recommendations made by research analysts. Long-time readers know that I'm not a fan of those applications as commonly designed. To rehash (and to point you to other postings with more detail should you have a morbid interest in such things):

In "the research performance derby,"[3] I reviewed an article in Bloomberg that ranked research analysts, but I could have written essentially the same piece about listings that appear in a number of other publications. If we had that imagined pundit database, we'd get oodles of those articles purporting to identify the best and the brightest, but very little exposition of the shortcomings and traps inherent in such rankings.

I highlighted one key problem in a subsequent piece called "to the precipice."[4] As I wrote:

There is a conceit in the business that the best among us can pick the highs and the lows, and we evaluate much of our work on that basis. The real truth is that good investors see the shifting odds of risks and returns and are willing to back away from a position as it becomes more likely to one day disappoint, even if the day of reckoning may not be arriving tomorrow. Such an approach at least acknowledges that among the imponderables in the great list of unknowns is exactly when things will change.

The measuring stick causes nearsightedness. Everything is always reduced to an assessment about whether something went up or down, often during a very short time period, and whether you were on the "right" side of the move when it occurred, completely without regard to the wisdom of your actions or whether you will be vindicated later on. Especially at key turning points, the assessment tool coaxes you into playing a game of greater-fool tag rather than helping you make good decisions.

There are other issues too, as I elaborated upon in "the performance parade,"[5] which was part of a series of postings on the Global Research Analyst Settlement. This paragraph can serve as your CliffsNotes (although the supporting arguments are worth your time):

So, a research analyst (or computer in the case of a quant firm) boils down all sorts of valuable information into one variable, which is adjusted further in the mapping process, and evaluated without regard to time horizon or risk. That’s what we use to determine who is best? If so, we get what we deserve.

As we would with attempts to extend the analysis more broadly into other types of predictions. I've been doing this long enough to know that people want easy answers, even if they are misleading, which is a good description of what we'd get from rankings spit out of our hoped-for database.

That said, transparency is important and there should be regular reporting about what people have said in the past and what has transpired since. More of that and maybe the prediction game would feature less inane bloviating about low-probability outcomes and more discussion of how uncertainty is being priced today.

During our formative years, some of us may have felt the forceful impact of a real yardstick applied in ways intended to make us think twice about future transgressions. In dealing with reckless and unashamed forecasters, we should wield a figurative one in the hope that better behavior will ensue. However, we must remember that it is a blunt instrument that should be used sparingly and on the obvious miscreants first. Stopping to look too closely at the numbers on the stick will only confuse us.

[1] The Reformed Broker : Brown provides market perspective in an irreverent style.: http://www.thereformedbroker.com/2010/05/13/5-things-carney-should-do-at-cnbc-com/
[2] The Big Picture : This is one of the most popular sites in the "econoblogosphere.": http://www.ritholtz.com/blog/2010/05/impossible-wall-street-fixes/
[3] the research puzzle : This is from July of 2008, early in my blogging "career.": http://researchpuzzle.com/blog/2008/07/22/the-research-performance-derby/
[4] the research puzzle : The illustration and description in this one might be worth a look.: http://researchpuzzle.com/blog/2009/04/30/to-the-precipice/
[5] the research puzzle : The series on GRAS ran to nine postings; a condensed version was published in CFA Magazine.: http://researchpuzzle.com/blog http://researchpuzzle.com/blog/2009/11/30/the-performance-parade/ ]]> the cave and the flow http://researchpuzzle.com/blog/2010/05/14/the-cave-and-the-flow/ http://researchpuzzle.com/blog/2010/05/14/the-cave-and-the-flow/#comments Fri, 14 May 2010 15:19:38 +0000 tom brakke http://researchpuzzle.com/blog/?p=760
The question is whether or when or how often to seek higher ground and retreat to a cave of our own.

As someone whose mission is to create original ideas, I know that I will do my best work when I spend a lot of time in the cave. But I must also heed the lessons of the river, so I need to gaze down upon it to gauge its features, to approach it close enough to hear the roars of the raging waters, to reach down into it for a handful of water to taste, and sometimes to take a dip in an eddy of information. And yes, occasionally I need to swim out into the main current, hoping that it doesn't sweep me into raging rapids of confusion or over a waterfall of wasted time.

For those that make investment decisions, on their own or within organizations, navigating the information flow in a productive manner is a never-ending challenge. If you are an individual investor, your own interests and inclinations tend to drive your information strategy, especially your need or wish to be a part of the crowd or to stand outside of it. There is no right answer on how to cast your information net, but the gathering process had better fit well with the investment strategy that you have adopted. For example, the information sources and daily routines of technical traders and deep value buyers should have almost nothing in common -- they are trying to do different things.

So too an investment organization. Its strategy should dictate how resources are aligned and how information is sourced and processed. Everyone from the receptionist to the chief investment officer has gadgets streaming a 24/7 mix of the personal and the professional, the important and the mundane, the signals and the noise. Trying to monitor and control it in a comprehensive and disciplined way would be unproductive, counterproductive, and just plain futile, although whoever is in charge can set the tone and remind everyone that very few of the big leaps forward come from the torrent of bits and bites that we have difficulty swimming away from.

And the question must always be asked: "Who is spending time in the cave?"

It is not banishment to be assigned to the cave, but freedom. The freedom to be apart, to take the time to examine ideas in detail and follow them wherever they lead, to explore the nooks and crannies of the possibilities. There, it is easier to sort the facts from the opinions, the reality from the sheen, and the essence from the superfluous.

All of this can be taken to extremes, of course, and a trip to the cave could turn you into a hermit, out of touch with the world in which your insights should be applied. A brilliant idea scribbled on a piece of paper once a decade and handed to an outsider could be valuable in a sense (some pundits have gained fame and fortune with the equivalent of it), but it's the rare organization that would have the patience required to fund that kind of talent.

Instead, the goal for someone leading an investment organization should be to look at the mix of roles and to see where it would pay to add a cave dweller, or at least someone who goes there occasionally. Despite the vast changes in the nature of information flows and the structure of investment markets, many jobs are defined in more or less the same terms as they were decades ago. Those titles and job descriptions previously applied to a world in which the interactions and temptations were much different than they are today. A forward-thinking organization should recognize that and begin to reconstruct who does what and how.

We have enough people frolicking in the river.]]> more leapfrogging http://researchpuzzle.com/blog/2010/05/05/more-leapfrogging/ http://researchpuzzle.com/blog/2010/05/05/more-leapfrogging/#comments Wed, 05 May 2010 14:00:21 +0000 tom brakke http://researchpuzzle.com/blog/?p=748
Before dealing with that comment specifically, I'd like to draw your attention to a paper by Ambrus Kecskés, Roni Michaely, and Kent Womack, entitiled "What Drives the Value of Analysts' Recommendations: Earnings Estimates or Discount Rate Estimates?"[2] As background you ought to know that the academic literature over the years has consistently shown that there is little if any exploitable information in the level of the average recommendation on a given stock, but that the changes in the level of the average recommendation have some predictive power in explaining subsequent returns.

The authors explore the differences in upgrades or downgrades depending on whether they are accompanied by changes in earnings estimates, or whether they instead involve "discount rate changes," which as defined in the paper include both what might classically be considered discount rate changes (with no change in underlying information, a change in recommendation would have to result from a change in discount rate) and changes in long-term growth rates, which, like discount rate changes, are "soft" and long-term. In contrast, estimate changes are specific and more near-term, making them, in the hypothesis of the authors, less subject to cognitive biases.

(As for those growth rates, the authors echoed one of the assertions in "unpegged," my attack on PEG ratios,[3] when they wrote that "analysts rarely change their discount rate estimates and growth rate estimates let alone justify them with detailed explanations or models.")

The paper indicates that earnings-based recommendation changes are much more powerful when accompanied by estimate changes, reinforcing the fact that changes in earnings estimates (or cash flows) are what matter most. (This is also supported by surveys of portfolio managers, who say that they pay much less attention to recommendation changes than they do to estimate changes.)

That brings us to the comment on my previous posting, which was from a person with experience as a sell side analyst. He also shared his thoughts as "dsquared" on Felix Salmon's review of "behavioral leapfrog."[4] His main point was that rather than being behavioral in nature, the leapfrogging of estimates results from an application of game theory by the analysts, that they are responding rationally to the incentive structure under which they operate and that there is no incentive to be bold in making estimates because it doesn't pay for them.

As someone who labored over an eight-part series on misaligned incentives in the investment business,[5] I should have thought to include that in my piece. Watching and interviewing analysts over the years (those on the buy side as well as the sell side) leads me to think the behavioral aspects are broadly dominant, but dsquared makes an outstanding point and it is one of great importance to those involved in research management. I believed that most firms incorporated sufficient incentives for analysts to be aggressive about getting earnings as close to the mark as they can -- and to do so well before other analysts if possible. dsquared indicated in his private comment to me that it wasn't the case at his firm. The bottom line in this regard is clear: With all the empirical evidence pointing to earnings estimates as being critically important, research directors need to make sure that the incentives are in place to highly reward analysts that are good at estimating earnings.

The other point made by dsquared was that Salmon drew a questionable conclusion from my posting. I agree. While Salmon is free to state his views, to clarify my original conclusions it helps to summarize them from two different points of view. If you are an observer of estimate changes, you need to understand that, be it for behavioral reasons or because of incentive structures, estimate changes tend to persist and the sooner that you can understand when a migration starts and why it might be occurring, the better chance you have to take advantage of it. If you are a creator of estimates, it is important to break free from the behavioral fetters to make bold predictions. To those I would add another, courtesy of dsquared: If you are compensating people who create estimates, make the incentive structure do what you should want it to do.

There will be other posts down the road regarding estimates and recommendations. Keep those electronic cards and letters coming in.

[1] the research puzzle : If you have not read that piece, it will make sense to do so before continuing.: http://researchpuzzle.com/blog/2010/04/05/behavioral-leapfrog/
[2] SSRN : Over the years (and with a variety of co-authors), Womack has produced a number of interesting papers regarding analyst recommendations.: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1478451
[3] the research puzzle : This has been my most widely-read posting to date.: http://researchpuzzle.com/blog/2010/02/10/unpegged/
[4] Reuters : Salmon is one of the leading financial bloggers of the day.: http://blogs.reuters.com/felix-salmon/2010/04/05/the-behavioral-economics-of-earnings-estimates/
[5] the research puzzle : Here is an index of those postings.: http://researchpuzzle.com/files/view/incentives-series.pdf]]> the sideshow http://researchpuzzle.com/blog/2010/04/27/the-sideshow/ http://researchpuzzle.com/blog/2010/04/27/the-sideshow/#comments Tue, 27 Apr 2010 20:21:20 +0000 tom brakke http://researchpuzzle.com/blog/?p=736
I will spare you the long-form essay of my own thoughts, which tend toward the pragmatic rather than the political, and are an amalgamation of views from "both sides." Those who read my piece about "playing in the street"[1] know that I'm disgusted by much of what passes as "the business," and that the buyers of financial services have been derelict in not expecting and demanding better.

In the legislative branch, the procedural maneuvers and sausage making regarding the reform bill are in full swing. Hearings of one sort or another have been going on for awhile, but today was a special day, when various panels of Goldman Sachs men (including "Fabulous Fab") were brought before a Senate committee to explain the nuances of mortgage finance and what it takes to put the client first. It was, however, the sideshow of the title above.

You'd never know it by the media glare and the comments from market players. I didn't watch the hearings, but on and off I monitored the reaction of folks on Twitter and in the blogosphere; it was clear that many of them were paying rapt attention. Most of what I read were variations on the themes of, "Senators are idiots who don't understand any of this (although they are happy to take campaign contributions and, by the way, had a lot to do with screwing things up in the first place)."

Well, yes. Did you expect your reactions to be different than that? It was predictable that each thing said that showed a legislator to know less than you about finance would prompt your outrage, which, thanks to our electronic age, you could share with us all. Meanwhile . . .

From the break of dawn it was evident that the real issues of the day had nothing whatsoever to do with that sideshow on Capitol Hill. The main event was playing out around the world, as evidenced by widening credit default swaps for sovereign and financial issuers, sizable currency moves, and dropping equity markets. There is the smell of contagion in the air. More pungent now, it has been there for awhile, and the U.S. equity market has refused to acknowledge the odor -- reminiscent of its 2007 ignorance when the fissures in the mortgage market started emitting foul smells from the underground.

No matter, since the hearings drew the interest, with some commentators even thinking that the weak stock market had something to do with the exemplars of capitalism being berated by know-nothing glad-handers.

Today was a great example of how easy it is to be distracted by the showy and the sensational. It happens to all of us as individuals -- and to groups of fiduciaries and to investment organizations and to Masters of the Universe running in packs.

It happened to the tranche-buyers of Abacus and Timberwolf and other structured products now in the news, as they fell in love with the alchemy of financial engineering as a way to play the keep-up-at-any-cost game of relative performance. When they finally faced the cold, hard fact that house prices actually could go down, there weren't any bids for the paper.

With all that's in the air right now -- the sights, the sounds, the smells -- it's easier than ever to be distracted or confused. Don't be led astray by that carnival barker over there. For now, there's nothing behind the curtain that matters. Go watch the high-wire act.

[1] the research puzzle : I have some of my own anecdotes in here; I should at some time publish some of the others I've heard.: http://researchpuzzle.com/blog/2010/04/17/playing-in-the-street/]]> vogue traders http://researchpuzzle.com/blog/2010/04/22/vogue-traders/ http://researchpuzzle.com/blog/2010/04/22/vogue-traders/#comments Thu, 22 Apr 2010 20:04:44 +0000 tom brakke http://researchpuzzle.com/blog/?p=726
If you followed the link above to Kedrosky's choice for the best responses to his question, you saw that his top pick was simply "trader." That is, while we can try to assign a new moniker to the activities, the trading mentality itself can lead to an inclination to "push the envelope," with capital and encouragement being readily available from management until the trades stop working. That's true in spades at the major investment banks, as the securitization dance revealed. Proprietary trading, hard to define because it is interwoven with other business lines and sometimes camouflaged by client activities, is subject to the resulting performance and incentive pressures (and potential errors).

The firms are reluctant to share information about the size of their prop trading operations, for competitive and political reasons, but there's no dispute that they have grown dramatically. The question is what impact that has had on the behavior of the markets. Even if we don't venture into the "putting the world at risk" issues, I believe the increased emphasis on prop trading is part of a general "vogue trading" shift to momentum strategies.

It's always interesting to speculate on market structure and who's doing what and why. There are many different games being played at once; some we can readily surmise, others are hidden to us until well after the fact, and a large number we never really learn about unless something goes really right or really wrong. That said, it's evident that trading is king these days.

Now, there's much to like in how a good trader operates. Devoid of fundamental inputs, a pure technical trader has the potential to steer clear of the love affairs with positions that can snare a fundamental investor. There is real power in assessing a trend and adhering to prudent trading rules and money management techniques that help to limit losses and not gains. And an agnostic willingness to go long or short helps a good trader to eliminate the hope factor and focus on what is working and how to capitalize upon it. Discipline is the key, of course, and the loss of it, by a trader or a firm, can be devastating.

Throughout the market ecosystem, "trading" now dominates "investing." Spurred by the availability of electronic information and trading platforms, that certainly seems the case with active individual investors. At asset management firms, the career risk is such that most decision makers feel that they can't afford to be out of sync too long, and have adopted more of a trading mentality than they advertise. While there's no way to know for sure in the aggregate, it's probable that quantitative portfolio strategies have become more adaptive overall as momentum has ruled. Totally beyond my ken are the effects of high-frequency trading, but it seems likely given the time period of its ascendancy that the algorithms driving it are leaning with the wind.

We may not all be traders now -- the market is never any one thing -- but the pendulum has swung a long way in that direction. Will it fall back? How quickly? When? Why?

Since being in vogue has never been so in vogue, it's time to look in the mirror and decide if you like what you see.

[1] Infectious Greed : Here's Kedrosky's follow-up blog posting on the same topic.: http://paul.kedrosky.com/archives/2010/04/t_what_is_a_man.html]]> playing in the street http://researchpuzzle.com/blog/2010/04/17/playing-in-the-street/ http://researchpuzzle.com/blog/2010/04/17/playing-in-the-street/#comments Sun, 18 Apr 2010 00:09:35 +0000 tom brakke http://researchpuzzle.com/blog/?p=714
They piled up over the years. Another involved Lyondell Petrochemical: A nice income stream was baked into the structure, and I got sold harder on it (I was then managing an income fund) than anything I can ever remember. Brought public by a little outfit named Goldman Sachs, the stock went down fifty percent the first year, earning it a nickname, "Lyin' Down."

As fixed income securities became more complex and derivatives became prevalent, still more learning opportunities presented themselves. To be clear, no one ever tied me down and made me buy anything, but I developed a general wariness of the Street and its practices. Even though my firm generated tons of trading business and those on the sell side were adept at acting like intermediaries, their actions were often those of adversaries.

The firms (the majors especially) often knew facts I didn't know or figured the odds better than I did. That's not surprising, since they were full of talented, well-paid hard chargers who were placed perfectly at the center of the flow of ideas and money. I expected that to be the case. What I was slower to understand was that even as a big client they weren't going to tell me the whole truth if it meant extra profit for them.

That ethos was taken to a whole new level over the last couple of decades. At the same time as the firms moved from partnership structures to public corporations, there was a bull market in stocks and bonds -- and an explosion in over-the-counter products. Proprietary trading and structured finance began to dominate, and the inherent conflicts in the old business model went into hyperdrive.

The more opaque the structure, the higher the fees. Unsuspecting clients became fodder for a firm's own money machine, or could be sacrificed in favor of clients deemed to be higher up the ladder of importance. Municipalities, sovereigns, companies, asset managers, endowments, individuals; clients of every stripe and size were put into positions that sported confusing acronyms and fanciful names. No matter that they didn't understand them, really, or that the piper would have to be paid down the road. The important thing was that the deal was done.

And so the logical conclusion is that without internal or external restraint, the firms were bound to go too far. On Friday, the SEC charged Goldman with fraud in one such instance. I'm not a lawyer and I haven't read the complaint. I don't know what the legal issues are or how it will all come out,[1] but the allegation rings true in every respect. It is the way business is done; it is in the DNA of the animal that brought us to the brink of disaster not that long ago and which continues to run amok.

As has been pointed out to me, even the "losers" in the financial crisis who had been playing the game for awhile came out of it with more money than I'll ever have, and those who finessed that little hiccup (with some help from Uncle Sam) are coining it again. So they're not so dumb, I guess, if all you care about is money.

At one time there was a quaint notion that if your clients did well over time, you'd do well over time, especially if they thought you helped quite a bit along the way. Goldman even had a saying in that regard. Last fall, in a posting concerning another example of its shortsightedness, I wrote, "It's not long-term greedy, it's long-term stupid."[2] I stick by that characterization of Goldman -- and of the other firms. Instead of maximizing the long-term value of their businesses, their goal has become the production of short-term profits (and the accompanying compensation) at any cost. The firms act as if there is an inexhaustible supply of gullible clients, and for too long investors (and citizens, given that "too big to fail" is still the way of the world) have proven them right.

Playing in the Street is dangerous, especially since a drag race between daredevils might happen at any time and they won't think twice about running us over. We could call the cops, but maybe we should just take the law into our own hands.

[1] The Reformed Broker : Although it's fair to say that I found Josh Brown's summary entirely plausible.: http://www.thereformedbroker.com/2010/04/16/spare-me-the-sudden-outrage/
[2] the research puzzle : Entitled "back at it," it concerned the flap over the Goldman "huddles.": http://researchpuzzle.com/blog/2009/09/02/back-at-it/]]> the tao jones http://researchpuzzle.com/blog/2010/04/14/the-tao-jones/ http://researchpuzzle.com/blog/2010/04/14/the-tao-jones/#comments Wed, 14 Apr 2010 14:05:35 +0000 tom brakke http://researchpuzzle.com/blog/?p=697 The Tao Jones Averages by Bennett Goodspeed. Subtitled A Guide to Whole-Brained Investing, it was published in 1983, the year I entered the investment business.

Twenty years prior, DLJ had issued the first in-depth research report on a company, which kicked off an era of "analexia" that Goodspeed bemoaned and which still is in force. He argued instead for an approach reflective of the Tao (conveniently pronounced "Dow") that offered a wider net for gathering information and a broader perspective for making investment decisions.[1]

It's always interesting to go back many years later and see whether a book is still relevant. Since this one deals with the timeless characteristics of human nature rather than specific investment ideas, it's probably not surprising that it holds up quite well. Many of the tenets of what we now call behavioral finance are presented in a whimsical but effective fashion.

The passages about herding are all the more interesting with the benefit of hindsight, given that the subsequent quarter of a century provided such stunning proof that market players spend much more time trying to "keep up with the Joneses" than they do studying the fluidity of economic structures and the temporariness of things -- if they did more of the latter, they might see the need for a little risk management.

As the book makes evident, seeing clearly is highly valuable in investing, but it is much is much easier "to adapt the world to our belief systems, rather than try to understand it as it is." While the old saying is that "I'll believe it when I see it," in actuality "I'll see it when I believe it" is how we operate most of the time. (It was eerie to once again read that observation in the book after listening to all of the Wall Street titans say that no one saw the financial crisis coming.) In general, we don't embrace or evaluate new information well at all.

While it's tempting to view the book as gauzy Eastern philosophy with no practical application, its central message is that a good investment process is one of balance, and that the lopsided approach practiced by most organizations and individuals is doomed to fail. Based upon his experience and interviews with notable investors, Goodspeed included concrete suggestions on how to make better decisions. (One of the founders of Inferential Focus, which gathers and interprets intelligence for its investment and corporate clients, Goodspeed died the year the book was published.[2]) As I argued in my own recent piece on "structured myopia,"[3] it is critically important to know where your blind spots are and to try to eliminate them before they do you damage.

A number of "real world" investment situations were included in the book and are instructive today despite being of the now-forgotten past. Especially of interest are the stories of investors who looked at information differently than the crowd to garner huge gains. I also found a couple of things prophetic: Jim Rogers was quoted as saying that oil prices were unsustainable and destined to go to "ten dollars or so." Heresy at the time, it came true two years later. The Inferential Focus analysis of the U.S. auto industry's structural weaknesses (including the looming health-care burden) was an inconvenient truth that was ignored repeatedly in the ensuing years by those in hot pursuit of rallies in the stocks, but it was right on the mark.

For those that are suckers for apt quotations, Goodspeed included a raft of them. A couple of my favorites:

"Nothing is more suicidal than a rational investment policy in an irrational world." - John Maynard Keynes

"Stupidity well packaged can sound like wisdom." - Burton Malkiel

Our challenge as investors is to recognize the messages that we are being given by others, the belief systems that we rest our actions upon, and not just the type of environment that we are in now but how it is changing. This book (unfortunately long out of print) is a fun read whose lessons are aimed at correcting our urge to "understand running water by catching it in a bucket."

Our methods and our minds are resistant to change. If nothing else, reading a book like this forces you to consider the possibility that you aren't seeing the complete picture. Sound familiar?

[1] Amazingly enough, shortly thereafter a novel by David Payne was published with the title Confessions of a Taoist on Wall Street.
[2] Inferential Focus : The firm's site has some interesting examples of its work. Disclosure: At different times in the past, I have been a client of and a consultant to IF.: http://inferentialfocus.com/
[3] the research puzzle : The "seeing" theme keeps appearing.: http://researchpuzzle.com/blog/2010/02/25/structured-myopia/]]> behavioral leapfrog http://researchpuzzle.com/blog/2010/04/05/behavioral-leapfrog/ http://researchpuzzle.com/blog/2010/04/05/behavioral-leapfrog/#comments Mon, 05 Apr 2010 12:25:01 +0000 tom brakke http://researchpuzzle.com/blog/?p=608
How those expectations get formed is the subject of today's observations, although we'll only scratch the surface. Management guidance is the biggest anchor for estimates; its role in earnings (and stock) management is a subject for another day. Neither are we going to focus on quarterly estimates and results, nor the "earnings surprise" metric and how it's used analytically.

Instead, we'll start with this simple histogram: behavioral-leapfrog

It is a map of what analysts think the earnings per share of a company will be over the next year. It serves to define the market's expectations, and how it morphs over time will say a lot about how the company's stock will perform relative to the market. Let's look at one important factor in how the distribution might change. (I am indebted to Mitch Zacks, whose book Ahead of the Market contains the best written example of this phenomenon that I have seen.)

Let's say you are research analyst "A"; you currently have an earnings estimate of $1.25, a little below the consensus figure of $1.27. (The range is $1.22 to $1.35.) It's time to update your model, and you find that things are improving more rapidly than you had anticipated. The company's sales look like they'll be higher than expected and the operating leverage is kicking in, leading you to think that they will earn $1.65. Now what do you do?

Do you publish it as such? In one sense, you would be off the conceptual map, far above the consensus. Are you willing to bet that dramatically on your analysis? What will your research director say? How about the institutional sales people? You would be blazing new trails with that estimate -- how confident are you?

Often what is easy to do in a situation like this is to think, "You know, if I use $1.45, I would be well above the high range. I'd still get credit for being right. There's no sense being too aggressive on this." And so begins a game of behavioral leapfrog. The other analysts covering the company will immediately notice the new number and think that they too should take another look. They will be asked questions about the estimate you published. Their reviews may discover some of the same improvements that you spotted, and their estimates will move higher, sometimes by a little and sometimes by a lot. Someone who can see that same $1.65 potential as you did will decide to top you with $1.50 or $1.55.

This can go on for quite awhile. Let's say that the company does end up actually earning $1.65. As visibility improves, the corps of analysts will keep raising numbers; you will do so too, as you get closer bit by bit to the number you thought the company could do all along. The activity produces a relatively gradual movement of the consensus number until it reaches that higher plateau. (Since the consensus figure forms the denominator of the forward P/E ratio, this is a matter of some import.[1])

Many, if not most, quantitative approaches incorporate a factor based upon changes in earnings estimates because of the persistence of these moves. While the predictive effectiveness of the factor waxes and wanes in different kinds of markets -- and works better for some stocks than others -- it is worth studying because it illuminates the lag between the prospective improvement in a company's performance and the pricing of its stock in the market.

All of this stems from our behavioral inclination to get comfortable with things as they are and to prefer small incremental changes rather than big ones. (A more famous frog analogy, that with the pot of warming water, also comes into play.) The process of investing is full of similar traps. Take, for example, the movement in and out of a holding at an asset management firm, where the same principle applies. Just as the hardest thing for an analyst to do is to make a full conceptual reversal (as from being below consensus to being high on the Street, or moving from a "strong sell" rating to a "strong buy"), so too for a portfolio manager to go immediately from shorting a stock to buying it in size.

Because that is the case, we have a choice to make. We can adopt strategies that take advantage of the game of leapfrog that we observe, or we can do our homework and, if the time is right, get out ahead of the army of frogs by taking the biggest leap we can.

[1] the research puzzle : For more on valuation issues, check out this piece on the "unpegged" PEG ratio.: http://researchpuzzle.com/blog/2010/02/10/unpegged/]]> days of dreck http://researchpuzzle.com/blog/2010/03/30/days-of-dreck/ http://researchpuzzle.com/blog/2010/03/30/days-of-dreck/#comments Tue, 30 Mar 2010 18:25:47 +0000 tom brakke http://researchpuzzle.com/blog/?p=643
For whatever reason, it seems as if hype is in full bloom right now. Although much of the evidence supports the view that post-crisis (and post-Madoff), the average investor has become more cautious, the claims of easily-available riches seem to get wilder by the day.

In years past, the pump-and-dump and other boiler room specialties were executed primarily via phone. I'm sure that they are still out there, but thankfully they don't call me. I do get mail from shysters, however, and it has picked up quite a bit of late. I feel lucky that newsletter writers who have generated "stunning" results are willing to share their future ideas with me for a small fee. ("My #1 Natural Gas Stock Pick Could Hand You 500% Profits Before the Year is Out," the one I received yesterday helpfully proclaimed.)

Also in with the bills (wouldn't some "found money" come in handy?), there might be a glossy brochure touting a stock. The fine print, if you bother to read it, says that the substantial cost of the mailer was paid by an entity that holds a huge position in the shares being discussed, and which also has compensated an "analyst" to write the putative research piece you have in hand. The fantasies of spiking prices and untold wealth are found in larger type.

In addition to those old-fashioned methods, much of the racket has gone high tech and social, and the unsuspecting are being played masterfully. As always, there are many variations on the con. What is common among them is that all the electronic village needs is some movement in price that grabs its attention and the game is on. "Some movement in price" can be remarkably easy to come by.

On Monday, Servidyne (SERV) hit the screens of the thrill seekers. The initial pop was triggered by the company; it went vertical from there. I did a quick look at the firm to see what all the fuss was about. There was news of a contract with an unnamed retail outfit. The incremental market cap on the day soon far exceeded any likely economic benefit from the deal, unbeknownst to those trying to catch the move. They also weren't aware of the company's woeful financial history or question marks about its governance, or that a director bought before the news release and others were awarded "stock appreciation rights" in the nick of time. Right on schedule, research reports from a couple of questionable sources touted Servidyne's prospects. Wasn't that convenient?

The predator in me says I should just get in the business of shorting this garbage. (I have been keeping a list of stocks that fit the profile, and so far they all have gone down -- in a rising market.) The educator in me thinks that I have to figure out a way to get the message out to the unsuspecting before they become victims. The wanna-be regulator in me believes that we need to crack down in some way on these abusive practices.

The really sad part is that these promotional tactics are common and have been adopted to a degree throughout the business of investments. Most paid-for stock research is simply PR. Some of the biggest names in investment management send out messages with exaggerated claims and carefully misleading performance information, so what's the difference between that and this? Online forums are full of grifters and their marks, yet even reputable sites with worthwhile editorial content are making money from advertising networks that serve up banners and links that hype dross and dreck to their readers.

Understandably, many people felt stung by big investment firms over the last decade and are trying to go it alone. Often they don't realize that the promise of empowerment makes them susceptible to a whole new set of risks, especially if they trade based upon technical breakouts, which sometimes are manufactured by others.

[1] the research puzzle : Short version of that posting: Look for a diversity of inputs and be skeptical.: http://researchpuzzle.com/blog/2010/03/25/narrative-power/]]> narrative power http://researchpuzzle.com/blog/2010/03/25/narrative-power/ http://researchpuzzle.com/blog/2010/03/25/narrative-power/#comments Thu, 25 Mar 2010 20:03:45 +0000 tom brakke http://researchpuzzle.com/blog/?p=624
The investment world illustrates the power of narrative. Up and down the informational food chain, stories are used to enlighten and, sad to say, to deceive. The "tellers" are the sellers of ideas, themes, and securities that find their way into our portfolios.

For stock investors, many of the stories originate with companies and their officers, who learn that crafting a narrative that puts everything in the best light is part of their leadership role. Sometimes, those messages are reinforced and amplified by sellside analysts whose telling of the story becomes part of their own brand. (As a reminder, I keep a now-tarnished silver plate Tiffany business card holder on my desk, on which is inscribed: "CUC International Inc. | Bear Stearns | $40 in '97." Someday I'll retell the whole tale.)

Some equities even become known as "story stocks" because belief in them requires the ability to see beyond conventional wisdom. They may work out or they may not, but it pays to know where in the story you are before playing. An investment manager recently told me that he limits such stocks to a predefined part of his clients' portfolios and needs to analyze those stocks differently than others. That's good advice.

Once an idea works well, it often becomes a theme in market storytelling. Take the case of General Growth Properties, recently back from the dead. I have watched the unfolding of that story with interest (although not of the financial variety). There were lots of twists and turns, but here's the bottom line that I saw: Some savvy market players did intensive analysis and due diligence to find mispriced assets, and their timing was good because the stock and credit markets healed to the point that some part of the value could be realized. We'll know in the fullness of time whether that story is the one that is passed down through the generations, but I see another take on it all too frequently: "We can buy these five-letter symbols and make a killing, dude." That's the wrong story and the wrong lesson.

We keep stories in our heads for a long time and try to apply them over and over. Market pundits have a particular fondness for comparing the current environment to specific market years of the past. I did that on Wednesday; the big jump in yields reminded me of when bonds started getting slammed in late March of 1987, a fateful year in itself. Those memories probably explain why I am so sensitive to asset class dislocations.

One story that continues to captivate is the financial crisis. Michael Lewis tells the tale that most will hear, given that "no one writes with more narrative panache about money and finance than Mr. Lewis," according to the New York Times. Others howl in protest at that, including Janet Tavakoli, who penned a piece on Lewis that featured a title that called him a "junior salesgirlieman,"[1] and Yves Smith, who ripped apart Lewis' "hagiography" of individuals that she thinks don't deserve it.[2] All three want to tell the story as they see it, and all three have philosophies to proclaim and books to sell. I can find things I agree with and things I disagree with in each.

As a buyer of ideas, I need to sort out the stories that make sense and that are applicable to what I am trying to accomplish. How I do so was summed up by others during a couple of interactions last week. The first occurred during a business lunch, at which I was described by someone in just four words: "Tom loves to learn." The second was included in a comment from a first-time reader who was attempting to assess my approach. After reading several posts, he figured that I had a "skeptical nature." There you have it.

My advice: Read widely and well, and realize that understanding comes from taking nothing for granted and questioning everything. And never fall in love with the story or the storyteller.

Cracking the narrative apart puts the power in your hands, not theirs.

[1] Huffington Post : She takes some good shots here, although storytelling is not Tavakoli's strong suit. She could often use a better editor.: http://www.huffingtonpost.com/janet-tavakoli/michael-lewis-junior-sale_b_498781.html
[2] naked capitalism : This is a long "debunking" post with lots of comments, and interesting throughout.: http://www.nakedcapitalism.com/2010/03/debunking-michael-lewis-subprime-short-hagiography.html]]> competitive yoga http://researchpuzzle.com/blog/2010/03/20/competitive-yoga/ http://researchpuzzle.com/blog/2010/03/20/competitive-yoga/#comments Sat, 20 Mar 2010 17:16:51 +0000 tom brakke http://researchpuzzle.com/blog/?p=610
The females at the table started talking about yoga. Specifically, the conversation touched on a woman known to be exceptional at everything she tries, no matter the field of endeavor (don't you just hate that), who had started coming to yoga classes. She was just a beginner, but was already very good at it, just like everything else. There was a tone of envy.

I remarked: "I didn't know that yoga was a competitive sport." By explanation, I was told, "It's just human nature."

We can't get away from comparing ourselves to others, no matter how destructive the act of comparison might be. The process of investing is one of the greatest examples of that. While each of us should have individual goals that reflect our own liabilities, circumstances, skills, resources, and behavioral make-up -- and should adopt strategies that reflect them -- we are repeatedly conned into playing someone else's game. We are lulled into the belief that there's a big measuring stick in the sky to which we need to compare ourselves.

Nonsense.

There is nothing sillier than a retiree with five million dollars comparing his equity returns to the S&P 500. In all likelihood, the only big mistake that he can make is to incur too much risk, yet he judges his performance in comparison to a particular benchmark because everyone else uses it, and will evaluate his advisors or mutual funds or whatever on that basis, even though the act of comparison invites errors.

The investment world is full of such behavior. The entire counterproductive relative performance structure of institutional money management is the greatest example, causing investors large and small to make bad decisions in the guise of making good ones. And then there are our tendencies to follow gurus that advocate strategies that make no sense for us, to copy trades posted online by others because they were "right" last time, and to feel left out if our neighbor said he made a killing in something that neither of us understands.

Our decision on St. Patrick's Day to celebrate in a different way than the mob (insert old folks joke here) was a good one. We had a wonderful time, because we weren't afraid to have our own kind of party. The willingness to be detached from the crowd is also the first step to finding an investment approach that makes sense.

Like yoga, investing should be an intensely personal activity. You should observe and learn from others without measuring yourself by them. But we have difficulty doing so. It is human nature to invent performance games and, as if to prove the point, someone did create "competitive yoga," a sport they would like to get into the Olympic games. (Announcer: “Did you see that? From 'happy baby' backwards over the head to 'downward dog' has never been done before. Incredible!”)

It is important to evaluate your investment approach with great rigor. But it is critical to remember that looking across the market room at what someone else is doing is unlikely to lead you to your own personal investment nirvana.]]> going active http://researchpuzzle.com/blog/2010/03/11/going-active/ http://researchpuzzle.com/blog/2010/03/11/going-active/#comments Thu, 11 Mar 2010 14:58:41 +0000 tom brakke http://researchpuzzle.com/blog/?p=590
In choosing investment managers, many seem to hold dissonant beliefs: Yes, we want active management, but we don't want the managers to be too active, lest they stumble. (Unless, of course, they fit in our "alternatives" bucket.)

If you spend any time in places where financial advisors or plan sponsors gather (online, at a conference, wherever), you know that at a moment's notice the discussion can devolve into a theological battle about the relative virtues of active versus passive management. We are going to explore that territory now, so pick sides if you must, although this discussion is about understanding the degree of "activeness" of managers and looking for useful ways to apply what we find.

To do so, we will examine the concept of "active share," which comes from the work of K. J. Martijn Cremers and Antii Petajisto, as published in The Review of Financial Studies.[1] The goal of the authors was to move from the industry practice of primarily depending on tracking error to determine how active a manager is, their hypothesis being that tracking error is good at determining the extent of a manager's bets on systematic risk factors and not very good at measuring its bets on individual positions versus a benchmark. Active share focuses on the latter.

How different is a manager from the benchmark? Is the manager really a "closet indexer," playing it close to the vest while earning higher fees than a truly passive manager? Or does he stray further afield in search of returns and in what way?

The authors make a persuasive case for including active share as an analytical tool to explore those questions. More importantly for those seeking grist for the active management debate or for those just looking to find the best managers, the main conclusion of the research is revealing: The most active managers (as measured by active share) deliver the best performance.

In one sense, that comes as no surprise. The rise of hedge funds is in large part due to their willingness to be different, to hold positions regardless of their representation in an index, and to hold them in great concentration (in both senses of the word). And, a less scientific view of mutual funds indicates that good performance over time usually comes from a manager who is willing to stand apart from what everyone else (read "the market") is doing. However, as typified by the anecdote at the top, the gears of manager selection (for and by individual and institutional investors) often grind in ways that lead to supposedly safer choices.

The slicing and dicing of data in the article includes other information of interest, including the impact of size on the amount of differentiation in a typical fund's portfolio (not good news for big funds) and historical information that shows a decline in active share among supposedly non-passive managers over time.

As you might expect if you have read any of my other postings on academic research,[2] I have a few quibbles with the article. The most notable was the choice of benchmarks for the calculation of active share. The authors considered a wide variety of benchmarks to find the one for each mutual fund that had the "greatest amount of overlap." So, to measure how different the funds were from their benchmark, an index to which they are most similar is used? That seems a bit illogical. It would be preferable to look at active share versus the stated prospectus benchmark; I believe you should try at all times to measure managers versus what they say they are trying to do.

Nevertheless, the work by Cremers and Petajisto is an important foundation for analysis. I have been surprised that the concept of active share has not gotten more play in the years since it first appeared in a working paper by the authors. There have been a few articles about it and there are some initial signs that the concept is gaining a minor foothold in the business, but it deserves greater attention and more study (by academics and investment professionals) to see if the concept truly has legs. Those reviews should include longer time periods, management structures other than mutual funds, and asset classes other than equities.

To date, the evidence supports the view that portfolio differentiation as measured by active share is a key metric to assess manager skill. Interestingly, the article also argues that tracking error is not very good at doing so, although given a choice I'd opt to have more of it rather than less of it. If I hire active managers, I want them to be active, across whatever dimension they can use to their advantage, and I want measurement tools like active share that help me judge them outside of the conventions of the day.

[1] The Review of Financial Studies : This is the paper as published. Earlier versions of the working paper are available at SSRN.: http://rfs.oxfordjournals.org/cgi/reprint/hhp057?ijkey=M0noS3O1M6QvzdG&keytype=ref
[2] the research puzzle : Here are some postings in that regard.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/academic-research-series.pdf]]> pictures with warren http://researchpuzzle.com/blog/2010/03/03/pictures-with-warren/ http://researchpuzzle.com/blog/2010/03/03/pictures-with-warren/#comments Wed, 03 Mar 2010 15:08:16 +0000 tom brakke http://researchpuzzle.com/blog/?p=551 Pictures at an Exhibition as a tribute; it was structured as a series of piano pieces imagining a stroll though an exhibition of his late friend's paintings.[1] It's time for us to take a similar journey.

The title of this posting refers, of course, to Warren Buffett. I have written extensively about investment gurus in previous postings;[2] Buffett is in a class by himself.

In our gallery, we have many pictures of Warren. Graham and Dodd disciple extraordinaire. Investor without peer. Cheapskate, as much as a multibillionaire can be. Folksy, happy -- the word "avuncular" seems to have been made just for him. A lovable capitalist.

In fact, that list shows that our little exhibition doesn't really have enough angst to it -- and amounts to variations on a smiley-faced theme -- that is, until you walk around the back of a two-sided canvas and see a profile of a predator. You quickly search the catalog; how could this work be here?

Every now and again, a renegade does offer a more penetrating view of Buffett than the standard fare, going beyond the flat abstractions toward a portrait that features depth and nuance.[3] Such renderings are important for us to see, because the complexity of Buffett and his creation, Berkshire Hathaway, are often overlooked amid the simplistic sketches.

Most ventures into gurudom include trying to copy an Old Master by using a paint-by-the-numbers technique. Mimicry can be dangerous, as many holders of Coca-Cola can attest. Thinking that Buffett's stamp of ownership meant a stock could be bought and held, "Coke was it" for many in the Nineties. But it became wildly overvalued, and value destruction was never quite so classic in its unfolding. In 1997, Buffett called the company one of "the Inevitables," destined to dominate its business for decades. He was right on that front: The Coke machine marches forward, but these many years later it still isn't close to the price it sold for back then. Perhaps Buffett used derivative strategies against the firm's position to cushion the blows and, in any case, the damage was sheltered by his winners; those that adopted the idea as their own likely suffered a worse fate.

One of the difficulties in assessing Buffett's work is that many of the pictures of Warren are pictures by Warren. He has always been a master of the catchy phrase and the well-choreographed show. As a legend, he gets to paint his own portrait most of the time, and the media can be as fawning as art critics are with the star of the day, distorting our perceptions of the man. Is he the one who warns of the "financial weapons of mass destruction" or the derivatives savant? Is he the "snatch 'em up when they are cheap" guy or the one who has bent value into many different shapes? Is he the "buy America" cheerleader or someone who can talk his book in a way that belies how much his firm has on the line?

A significant element of Buffett's greatness has been his malleability and willingness to address a complex world in new ways, which is quite apart from the iconic persona normally presented. Do we see who he really is?

It is time to go to the last area of our exhibit. Don't walk down the hallway to the left. That leads to the natural history wing and a diorama depicting the return of the sandhill cranes to the Platte River basin every spring. Turn instead to the right, for photographic evidence of the other great migration to Nebraska -- to see and touch the Oracle. The throngs show up in May, but throughout the year there are smaller pilgrimages as well, usually of business students that Buffett has made time to see.

As you enter the cavernous final room, you witness from floor to ceiling thousands and thousands of those travelers, in individual pictures with Warren. The snapshots are remarkable in their similarity, and a significant number depict the stranger in the photograph holding Buffett's wallet. The effect is dizzying, a montage of sameness that is an echo chamber for the eyes.

It is very hard to look past allegiance and admiration when doing investment analysis. I don't know whether Berkshire Hathaway is a buy today or a sell, but I know that if I keep staring at the pictures at the exhibition -- or imagining myself in one -- I'll never figure it out.

[1] Never published in Mussorgsky's lifetime, the composition didn't hit the charts until it was orchestrated by Maurice Ravel. Listeners looking for a somewhat edgier treatment can try the Emerson, Lake, and Palmer version.
[2] the research puzzle : Here are some examples for would-be members of a guru's gang.: http://researchpuzzle.com/files/view/guru-postings.pdf
[3] The Pragmatic Capitalist : See, for example, this posting titled "The Many Myths of Warren Buffett.": http://pragcap.com/the-many-myths-of-warren-buffett]]> structured myopia http://researchpuzzle.com/blog/2010/02/25/structured-myopia/ http://researchpuzzle.com/blog/2010/02/25/structured-myopia/#comments Thu, 25 Feb 2010 16:17:53 +0000 tom brakke http://researchpuzzle.com/blog/?p=545
An innate sense of where the crowd is going is critical to success, so that's "the sociology of investing" that gets most of the attention. Relatively little scrutiny is given to how investment firms work and how investment decisions are made within them. A great posting yesterday on the blog socializing finance[1] speaks to one of the themes I have been preaching for years: Firms are often structured in ways that make no sense given how markets work. The posting highlights some nascent efforts to integrate trading desks across asset classes at large brokerage firms, but the principles that underlie the need to do so should be applied even more broadly.

Specialization dominates the investment decision making process. There are remarkably few generalists in the business and, within firms, little sharing of information across asset classes -- or even within them if there's no incentive to do so. I once asked a famous strategist how much his equity people talk to those in fixed income. He said, "I can't even get the growth guys to talk to the value people."

Awhile back, I wrote about "where we draw the lines."[2] The "lines" of our organizations, like our analytical boundaries, are convenient, but they inhibit our ability to sense market opportunities and to seize them. The most rigid appear between asset classes -- and they are reinforced by consultants, advisors, media, etc., looking for simple descriptive boxes -- but there are many others that lurk as well. And they are cemented in place by the misguided belief that incentives should flow to individuals or teams or groups or divisions based overwhelmingly or exclusively upon their unique contributions.

Where those lines are depends on the past and the personality of the firm in question. One of the most common hierarchical equations amounts to "equity > fixed income," although it depends on a firm's history, assets, and who is in charge as to whether that's specifically in play. No matter, it serves as a wonderful example of the principles that I am trying to illustrate.

It is normally the case that fixed income and equity operations are quite separate at most firms. Those in research, trading, and portfolio management jobs are charged with doing their business and are compensated accordingly. That might make sense if the market was kind enough to act like one didn't matter to the other, but that's never been the case and the financial innovations of the last couple of decades have only intensified the interdependence. The flow of information between the two groups of specialists should be continual and substantive, but that rarely happens.

The ironic thing in the equation that I gave above is that, when push comes to shove, you are often better off paying attention to the developments in the bond market. I remember clearly an interview ten years ago, during which a star equity analyst explained to CNBC that her positive view on Amazon.com made sense, despite her firm's debt analyst having issued warnings on the company. She said that equity analysts look forward and fixed income analysts look backward. You may recall that Amazon got crushed.

Recently I saw an online commentary that boiled down to, "Who cares about Greece?" I tweeted a response that said that "the credit market is always the canary."[3] A litany of all of the examples over the last few decades where the first signs of trouble showed up in areas of the market that would be classified as "fixed income" would be very long indeed. As if more proof was needed, the financial crisis was Exhibit A. Equity investors ignored the rumblings for months and paid for it dearly.

Myopia is the enemy of the investor. Structured myopia makes no sense whatsoever, for the individual investor or for the biggest firms in the world, but you find it everywhere.

[1] socializing finance : The blog has several authors; this posting was written by Daniel Beunza.: http://socfinance.wordpress.com/2010/02/24/proving-sociologists-right-pencil-pushers-and-neardenthals-stave-off-the-next-crisis-by-uniting-on-the-trading-floor/
[2] the research puzzle : This posting used the Morningstar style grid as a jumping-off point to examine the analytical structures we create.: http://researchpuzzle.com/blog/2008/10/13/where-we-draw-the-lines/
[3] Twitter : I have a few updates a day, mostly links to interesting articles I find.: http://twitter.com/researchpuzzler]]> best in show http://researchpuzzle.com/blog/2010/02/19/best-in-show/ http://researchpuzzle.com/blog/2010/02/19/best-in-show/#comments Fri, 19 Feb 2010 13:55:32 +0000 tom brakke http://researchpuzzle.com/blog/?p=539
I love dogs as much as the next guy, including the wonderful mix of breeds that we have in our neighborhood. (They all have one thing in common: Labradors and rottweilers and terriers have all turned tail and run when they have heard the manic attack cries that Kitty emits if they approach our door.) Watching the televised coverage of the archetypes of the canine world parade around Madison Square Garden, you get caught up in the emotional aspects of the competition. Your biases show up in a hurry, from "I want one of those" to "I wouldn't be caught dead with one of those."

In a way, it is much like our instinctive reaction to various investments. We take a natural shining to some things and don't understand at all what others might see in that which disinterests us. At the dog show, in dulcet tones the announcer describes the breed being judged, including some hints about the personalities of the dogs that might not be noticeable at first glance. We would all be better off if someone was there to give us such advice before making our investment decisions; a little voice that said, "This one is guaranteed to break your heart," would be nice to have.

For someone who observes how decisions are made, watching Westminster leads to many questions about process. Certainly the winnowing behind the scenes (much like the screening that portfolio managers go through to get a chance to win an institutional account) would be fascinating to see, but the television coverage picks up with the semifinals, the judging of the various groups. A set routine is followed, with the judge for the group first probing the dog's physical characteristics, then observing its gait and presentation as it shows its stuff for the crowd. (Again the echoes of manager selection are inescapable for someone who has been through that drill.)

To the uninitiated, the next part seems like hocus-pocus, but I'm sure to devotees it's not. The judge, after having spent a short time with each of the dogs, and maybe seeing them take one last comparative walk, selects the best of the group. Like the figure skating judges on the other channel, they are highly-qualified arbiters of what's best, with technical checklists to run down in their minds, but it's done on the fly and in the moment. The investment business is full of decisions like that. It is fair to describe them as "hit and miss," with all sorts of behavioral risks about.

Which is all just a prelude to the final stage. The winners of the seven groups are to meet in the ring to determine which is the champion dog of the year. The judge is shown arriving in style, having been "sequestered for two days." He spends a short time with the dogs and pronounces the winner. It all seems a bit perfunctory to the uneducated.

Having seen the swings of emotional momentum in the markets and how they build over time, I could only wonder about whether the same things happen in the show world too. I had a hint when one of the announcers responding to the choice said something like, "Many people were enamored already before the announcement." Yes, this dog was the it girl and Westminster was the culmination of her coming out.

Certainly the judge was fully aware of the dog before his sequestration. Did he react to her introduction at the Garden with a thought of "there she is"? We'll never know, although he was quoted later as saying that a dog like Sadie comes around once every ten years. That's quite a statement to make after a few minutes together in the show ring.

Which is not to say that there was collusion or that the selection was preordained, only that our decisions come wrapped in packaging that we may not see if we don't look for it. The selection of an outside manager by an investment committee may come down to a little thing noticed at the last minute, or it may have been in the cards for months and the process was just a show. The stock-by-stock decisions of an individual investor are different from that drawn-out selection process in time and scope, but remarkably similar in the need to carefully and objectively sort out the "whys" of the choices that we make.

Sadie got to ring the bell of the New York Stock Exchange and, unless she spends her last days in dissolute living, she'll go down as one of the greats. For us, those markets open day after day, and our decisions today reverberate for some time to come. So, before you pronounce something best in show, take an extra minute. It may keep you from ending up with just another mutt.

[1] OK, I don't really know what the dogs thought of it, but the dog people were pretty excited.]]> unpegged http://researchpuzzle.com/blog/2010/02/10/unpegged/ http://researchpuzzle.com/blog/2010/02/10/unpegged/#comments Wed, 10 Feb 2010 13:14:19 +0000 tom brakke http://researchpuzzle.com/blog/?p=515

Yes, it's the famous PEG ratio, which is widely given as a reason to embrace or avoid a stock depending on which side of that line its numbers line up on. Many individual investors cling to it as a guide, and it's amazing how often professional investors cite this relationship in marketing materials, articles, and television appearances. Go to Investopedia and one of its featured articles explains why: "Stock theory suggests that the stock market should assign a PEG ratio of one to every stock."[1] Well, no.

The history of this myth is of interest. When Peter Lynch shepherded Fidelity Magellan to extraordinary gains, he became the first investment star to "go platinum." He was copied widely by other managers and, with the increased democratization of the market, by individuals too. The main tenets of his philosophy could be described as "buy what you know" and "look for cheap growth." Each has come to be applied beyond reason, the latter resulting in senseless application of the PEG ratio.

In looking at that calculation, only one of the three variables has any precision: We can observe the market price (P) at virtually any time and be assured that we have an accurate number. The E is a different matter entirely. Which earnings? Forward, trailing, smoothed, operating, adjusted, owner? Why? How deep into accounting and the theory of finance do you want to go?

For most investors, not very far. We like our heuristics clean and easy, not hairy. So, in combining the first two variables we get the P/E ratio, the "multiple" upon which most valuation work rests, despite the questionable assumptions that may be baked in at any time. The addition of the third element, growth (G), gives us not the epiphany we seek, but even more confusion.

While we can debate which earnings number is best to use, each approach is the result of a fair bit of scrutiny -- reported earnings hew to accounting standards and estimated earnings and the various "adjusted" constructs are the product of intense analyst effort. Conversely, the long-term growth rates commonly used in PEG ratios get little attention and are, in general, lousy. Analysts spend almost none of their time thinking in depth about those numbers, and the buy side doesn't press them on the validity of their projections. Consequently, many of the growth rates tend to be extrapolations of the past and/or the echo of management fantasies, and are a lagging indicator at best. Studies of realized growth rates have shown that the projections don't pass muster; they are way too high for most firms, especially the ones that are expected to grow the fastest, while actually being too low for those firms that analysts are most downbeat about. Figuratively speaking, one might say that the denominator of the equation is, in fact, the lowest common denominator.

To add to all of those shortcomings, a finance whiz can quickly dispel any notion that there should be a linear relationship between the P/E ratio of a stock and its growth rate, or that the PEG ratio can be effectively used to compare the valuation of one firm to another, given differences that would exist in their financial structures. As for specific calculations, valuation expert Aswath Damodaran says that the use of the forward P/E ratio as the numerator is erroneous, since that year of earnings growth is also in the estimated growth rate, resulting in double counting. Yet, that may be the most widely-used version of the PEG. It is the one found on the basic Bloomberg stock description page.

Lynch's concept makes sense: Incremental growth is worth something. Figuring out what that might be, though, is tricky and difficult business. In common practice, the PEG ratio takes that good idea and simplifies it into meaninglessness. Unfortunately, most of those that use it don't realize how unpegged from reality it really is.

[1] Investopedia : The title of the piece is "PEG Ratio Nails Down Value Stocks.": http://www.investopedia.com/articles/analyst/043002.asp]]> thinking about doing http://researchpuzzle.com/blog/2010/02/04/thinking-about-doing/ http://researchpuzzle.com/blog/2010/02/04/thinking-about-doing/#comments Thu, 04 Feb 2010 13:35:29 +0000 tom brakke http://researchpuzzle.com/blog/?p=501 New York Times the other day was a large graphic that depicted the stages of a jump that is a specialty of Ryan St. Onge, who will be competing in freestyle aerials at the Winter Olympics. Specifically, it showed each element of "a triple-flip jump with a full twist in each of the second and third flips." I got dizzy just looking at it.[1]

The article -- as you might expect in something called the "Science Times" -- quickly started breaking down the physics of it all, and then examined how jumpers who do those types of maneuvers make the tiny adjustments while en route that will allow them to master those natural forces (and maybe even take home a gold).

What caught my eye was this paragraph:

But while not in the air, Mr. St. Onge devotes a lot of time to analyzing what he does. "I probably spend 80 percent of my time thinking about it, and 20 percent doing it," he said.

Over the years, I've met investors of all stripes, from individuals to fiduciaries to big-name players, and they use strategies that range across every approach you could imagine. As far as I could see, almost none of them came anywhere close to St. Onge's allocation of time. Part of it is the allure of the information flow: Flip on the screen and it starts washing over you and you start making decisions. Part of it is that the business has gotten to be one where transaction costs are nothing and positions are fleeting (and "ownership" does not extend to governance). Much of it is that following is an art form in the markets, and whether it's the legendary gurus or the latest smart-sounding Tweetster that we use as a role model, we tend to copy first and think later. Plus, human nature is such that just doing it feels instinctively correct, and, in the hurly-burly of the modern world, we expect activity above all else.

For every investor and for every strategy, there is a sensible mix of doing versus thinking about doing, and the almost universal tendency is to shortchange the latter. Investment firms that battle each other for excess returns (and the client dollars that go with them) often are remarkably similar to each other in how they approach the investment equation. With little innovation in methods (exacerbated by the tendency to hug benchmarks), the quest for sustainable advantage becomes hiring the smartest people, since everyone is doing the same thing. It can sometimes work, but in the investment business, smart people are a dime a dozen.

Those that are unusual are the ones that can see a new way or a new angle, and those that, like St. Onge, spend tremendous amounts of time questioning, practicing, anticipating, adjusting, and exploring how they do what they do, before they do it. We are all forced to react when it's time to perform. The nature and amount of our preparation will determine how well we do.

[1] The New York Times : The online link does not have the graphic, but it does have a video. Even better.: http://www.nytimes.com/2010/02/02/science/02ski.html]]> stuck in one dimension http://researchpuzzle.com/blog/2010/01/27/stuck-in-one-dimension/ http://researchpuzzle.com/blog/2010/01/27/stuck-in-one-dimension/#comments Wed, 27 Jan 2010 21:07:32 +0000 tom brakke http://researchpuzzle.com/blog/?p=487
There are certainly errors that are made by being spread too thin. In my own case, I think that my roles as a consultant, advisor, and writer work off of each other in a way that yields benefits for my clients, but there are days when I wonder if I'm getting the equation wrong. As for firms, we need look no further than the "financial supermarkets" of yore (for a time, I was a cog in one of the many wheels of a prime example) to see that trying to be all things to all people can damage the firm as well as the people that work for it and invest with it.

The topic today is the opposite case, and as an example we'll look at the world of golf. In August, I wrote a piece about the Accenture advertisements that featured Tiger Woods and my take on the "competitive keys" that they illustrated.[2] As was clear years ago to anyone familiar with the structure of the PGA Tour, there was only one golfer that really mattered. Everything revolved around Woods and everything was based upon Woods. An entire economic edifice, inside and outside of the tour, was built upon his ever-broadening shoulders.

It worked until it didn't. While few could have written the script as to how it would unwind, since the specific risk that caused the blowup wasn't widely known (they rarely are), the conditions were ripe for a reversal of fortune. In this case, the golf world had a taste of life without its Tiger the year before, when he was injured. (Bottom line: Golf was injured too.) While it would be foolish to count such a great player out going forward, there's no doubt that everything has changed, and that the one person who was holding at bay all of the weaknesses in the structure of the sport can't do it anymore.

Such is the nature of a star system. The similarity to the world of investment management is easy to see. Firms have a hard time resisting the concentration that comes from riding a successful strategy or a successful manager. One thinks of Janus during the go-go years, ever more invested in a philosophy, with the huge cash flows plowed into that way of thinking (and the archetypal stocks of the time). More recently, the soap opera involving TCW and Jeffrey Gundlach is but the latest example of the lurking hazards if an investment firm is dominated by one personality. The list of similar situations is very long indeed, if lacking in some of the juicier bits of the back-and-forth lawsuits that have been filed in that particular case.

Day to day, it's easy to get similarly trapped when facing investment decisions. If you have your rally cap on, it's hard to see the negatives cropping up, just as positive possibilities are obscured if there is a bearish haze that clouds your view. You could have a paired trade on and think of yourself as market neutral, but if both the long and the short represent your world view, all you are is leveraged to your belief system.

It's a fine line to walk, since having the strength of your convictions is important, as is making the most of the things you do best. But when you fall in love with a narrow approach, especially if it's what's working now, you can lose sight of many of the clues that matter. Consciously looking for the other side of things should be an integral part of your decision processes.

Even the unthinkable happens now and again. Inching away from a perceived winner rather than being increasingly attracted to the light of success is prudent risk management. But it's very hard to do.

[1] The Reformed Broker : Which was the "In 2009, I learned that . . ." lesson that I shared in this compilation by Joshua Brown.: http://stocktwits.net/thereformedbroker/2009/12/30/in-2009-i-learned-that/
[2] the research puzzle : The posting, linked here, was written in advance of the PGA at Hazeltine, which turned out to be the first time Woods lost a major championship when holding the lead entering the final round. The link from my posting to the Accenture ads no longer works, for obvious reasons.: http://www.researchpuzzle.com/blog/2009/08/10/competitive-keys]]>