|The Key to Successful Investing|
|Saturday, 21 May 2016 09:10|
Why do we listen to experts and their forecasts?
The answer has to do with human nature or because our society demands specialization, or a division of knowledge: solicitors see dentists when their teeth hurt, and dentists see solicitors for legal advice. We have a natural tendency to listen to experts. Unfortunately, when it comes to financial advice, the quality of the advice given is much less clear-cut. Infact, there is no convincing evidence that “experts” have an ability to predict, and, if they have some ability, their predictions are at best just slightly better than random ones. Of the few research papers that have been written examining the work and attitude of security analysts, studies shows that they are worse at predicting, while having a greater faith in their own skills. One survey of almost 2,000 predictions by brokerage-house analysts showed that they predicted nothing - a naive forecast made by a lay-person using figures from the last period as predictors of the next would not do markedly worse. Yet analysts should do considerably better because they have advanced knowledge of companies' orders, contracts and capital expenditure. There is also the “nerd” effect by which analysts place too much faith in their spreadsheet models, focusing on those ‘internal’ variables that can be ‘stress-tested’ by sensitivity analysis, which necessarily exclude uncertainty or the "unknown unknowns." The problem is there is always something non-routine or too abstract to be taken into account, such as (say, for a building development): power-cuts; bad weather; accidents; or strikes, yet too many analysts give too little (if any) attention to even the thinnest layer of uncertainty or forecasting errors. The sad conclusion is that analysts rarely rate better than a cab-driver using the simplest methods within their reach. The problem is that we focus on the rare occasions when these methods work and almost never on their far more numerous failures. Another study of almost 300 specialists showed that their error rates were many times more than estimated, and that there was a negative correlation between the reputation of the analyst and the worse the prediction! Perversely, there seems to be logic to such incompetence: the “experts” desire to protect their self-esteem. When they were right they attributed it to their own talent and depth of understanding; when wrong they blamed unusual circumstances, or worse, they did not recognise that they were wrong at all by spinning stories around it. But it is human nature to think we are better than others at whatever we do for a living and protect our self-esteem: we all attribute our successes to our skills, and our failures to external events outside our control, namely randomness. Put bluntly, we are happy to take responsibility for the good stuff but not for the bad.
The secret to successful investing
Instead of putting all your savings into “medium risk” stocks or bonds allocate percentage (anything from 70-90% depending upon you risk profile and age), to extremely safe instruments, and the remainder into extremely speculative investments, but by as many small bets as possible, so that you have high risk on one side and minimal risk on the other. The average will be a medium riskportfolio that’s built to weather market stormsby having a small downside but large upside. For many that means focusing on companies with strong balance sheets with little if any debt, don’t pay-out dividends by selling the “family silver” (which is not sustainable), that are not in highly cyclical businesses (such as those involving commodities), and with sustainable earnings due to having irreplaceable products or from hard to overcome barriers to entry ie not short-term flashes in the pan. Perhaps the best exponent of this is the proven “star” fund manager Neil Woodford, who recognizes that there is a choice between short-term profit and the longer-term gains so has sometimes ploughed a lonely course with the majority of professional opinion against him, “I invest for the long-term but most fund managers have a time horizon that doesn’t extend beyond the length of their nose.” For years he has invested heavily in 2 sectors: tobacco and pharmaceuticals that most investors like to hate, and avoided 2 others: ‘Big Oil’ and banks, which offer limited upside but (as we have seen), almost limitless downside. Conversely, and as outlined above, he has also put a chunk of his fund into much riskier smaller, early-stage businesses (some of which are not even listed), to get exposure to out-sized returns. Finally, remember, he also says that reinvested dividends account for the great majority of equity market returns over time, so equity income remains his tried and tested approach.
|Last Updated on Sunday, 22 May 2016 21:06|