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One of the best value investors on the planet is of course, James O’Shaughnessy.
James O’Shaughnessy, also known as Jim, is a Principal, and Chief Executive Officer at O’Shaughnessy Asset Management, LLC. He’s widely regarded as a pioneer in quantitative equity analysis. Jim and his team have identified characteristics that have led to successful investing over the last fifty years, and it is these characteristics that form the foundation of their strategies.
As of June 30, 2016 O’Shaughnessy Asset Management managed approximately $5.4 billion. O’Shaughnessy is also the author of What Works on Wall Street, an awesome resource full of back-tested quantitative investment strategies.
So in short, he’s another really smart guy that value investors need to follow. Let’s see what he wrote about Models vs Humans in his classic investing book.
The following is an excerpt from What Works on Wall Street:
In a famous cartoon, Pogo says: “We’ve met the enemy, and he is us.” This illustrates our dilemma. Models beat human forecasters because they reliably and consistently apply the same criteria time after time. In almost every instance, it is the total reliability of application of the model that accounts for its superior performance. Models never vary. They are always consistent.
They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They don’t favor vivid, interesting stories over reams of statistical data. They never take anything personally. They don’t have egos. They’re not out to prove anything. If they were people, they’d be the death of any party.
People, on the other hand, are far more interesting. It’s more natural to react emotionally or personalize a problem than it is to dispassionately review broad statistical occurrences—and so much more fun! It’s much more natural for us to look at the limited set of our personal experiences and then generalize from this small sample to create a rule-of-thumb heuristic.
We are a bundle of inconsistencies, and although making us interesting, it plays havoc with our ability to successfully invest our money. In most instances, money managers, like the college administrators, doctors, and accountants mentioned above, favor the intuitive method of forecasting.
They all follow the same path: analyze the company, interview the management, talk to customers and competitors, etc. All money managers think they have the superior insights and intelligence to help them to pick winning stocks, yet 80 percent of them are routinely outperformed by the S&P 500.
They are victims of their own overconfidence in their ability to outsmart and outguess everyone else on Wall Street. Even though virtually every study conducted since the early 1950s finds that simple, actuarially based models created with a large data sample will outperform traditional active managers, they refuse to admit this simple fact, clinging to the belief that, while that may be true for other investors, it is not the case with them. Each of us, it seems, believes that we are above average.
Sadly, this cannot be true statistically. Yet, in tests of people’s belief in their own ability, typically people are asked to rank their ability as a driver—virtually everyone puts their own ability in the upper 10 to 20 percent! In his 1997 paper The Psychology of the Non-Professional Investor, Nobel laureate Daniel Kahneman says:
“The biases of judgment and decision making have sometimes been called cognitive illusions. Like visual illusions, the mistakes of intuitive reasoning are not easily eliminated…Merely learning about illusions does not eliminate them.”
Kahneman goes on to say that, like our investors above, the majority of investors are dramatically overconfident and optimistic, prone to an illusion of control where none exists.
Kahneman also points out that the reason it is so difficult for investors to correct these false beliefs is because they also suffer from hindsight bias, a condition that he describes thus:
“psychological evidence indicates people can rarely reconstruct, after the fact, what they thought about the probability of an event before it occurred.”
Most are honestly deceived when they exaggerate their earlier estimate of the probability that the event would occur …Because of another hindsight bias, events that the best-informed experts did not anticipate often appear almost inevitable after they occur.”
If Kahneman’s insight is hard to believe, go back and see how many of the “experts” were calling for a NASDAQ crash in the early part of the year 2000 and contrast that with the number of people who now say it was inevitable. What’s more, even investors who are guided by a quantitative stock selection system can let their human inconsistencies hog-tie them.
A September 16, 2004 issue of the Wall Street Journal includes an article entitled A Winning Stock Picker’s Losing Fund, showing how this is possible.
The story centers on the Value Line Investment Survey, which is one of the top independent stock-research services and has a remarkable long-term record of identifying winners. According to the Wall Street Journal, “But the company also runs a mutual fund, and in one of Wall Street’s odder paradoxes, it has performed terribly.”
Investors following the Value Line approach to buying and selling stocks would have racked up cumulative gains of nearly 76 percent over the five years ended in December, according to the investment-research firm. That period includes the worst bear market in a generation.
By contrast, the mutual fund—one of the nations oldest, having started in 1950—lost a cumulative 19 percent over the same period. The discrepancy has a lot to do with the fact that the Value Line fund, despite its name, hasn’t rigorously followed the weekly investment advice printed by its parent Value Line Publishing.”
In other words, the managers of the fund ignore their own data, thinking they can improve on the quantitative selection process!
The article goes on to point out that another closed-end fund, called the First Trust Value Line Fund, does adhere to the Value Line Survey advice, and has performed much better and more consistently with the underlying research.
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