In 2004 Louis Lowenstein wrote a paper titled – Searching for Rational Investors in a Perfect Storm in which Lowenstein attempted to measure the performance of 10 value managers through the turbulent market period of 1999-2003. Here’s an excerpt from the abstract:
I decided to see how a group of ten value funds, selected by a knowledgeable manager, performed in the disorderly boom-crash-rebound years of 1999-2003. Did they suffer the permanent loss of capital of so many who invested in the telecom, media and tech stocks? How did their overall performance for the five years compare with the returns on the S&P 500?
For most managers, mimicking the index, it was difficult not to own Enron, Oracle and the like, but the ten value funds had stayed far away. Instead, they owned highly selective portfolios, mostly 34 stocks or less, vs. the 160 in the average equity fund. They turned their portfolios at one-sixth the rate of the average fund. Bottom line: every one of the ten outperformed the index over the five year period, and as a group they did so by an average of 11% per year, the financial equivalent of back-to-back no-hitters.
In 2005, Seth Klarman wrote a fantastic response to Lowenstein’s paper titled – A Response to Lowenstein’s Searching for Rational Investors In a Perfect Storm. Here’s a excerpt from that response:
Let me offer a simple thought experiment. Imagine that every adult in America became a securities analyst, full time for many, part-time for the rest. (With close to half the adults in this country already investing in stocks or mutual funds, this may not be quite as ludicrous as it sounds.) Every citizen would scour the news for fast-breaking corporate developments. The numerate ones would run spreadsheets and crunch numbers.
The less numerate would analyze competitive factors for various businesses, assess managerial competence, and strive to identify the next new thing. Now, for sure, the financial markets would have become efficient. Right? Actually, no. To my way of thinking, the reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The Internet will not make the market efficient, even though it makes far more information available at everyone’s fingertips, faster than ever before. Markets are inefficient because of human nature—innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions—they simply cannot help it.
So if the entire country became security analysts, memorized Ben Graham’s Intelligent Investor, and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. Even if they somehow managed to be long-term value investors with a portion of their capital, people would still find it tempting to day-trade and perform technical analysis of stock charts.
People would, in short, still be attracted to short-term, get-rich-quick schemes. People would notice which of their friends and neighbors were becoming rich—and they would quickly find out how. When others did well (if only temporarily), people would find it irksome not to be participating and begin to copy whatever was working today. There is no salve for the hungry investor like the immediate positive reinforcement that comes from making money instantaneously.
A country of security analysts would still overreact. They would shun stigmatized companies, those experiencing financial distress, or those experiencing accounting problems. They would still liquidate money-losing positions as they were making new lows. They would avoid less liquid securities, since those are the last to participate in a rally and hard to get out of when things go wrong. In short, a country full of well-trained investors would make the same kind of mistakes that investors have been making forever, and for the same immutable reason—that they cannot help it.
Hedge funds may have more tools at their disposal. They can go long and short. They can leverage. They have the resources to hire the cream of every crop. But going long and short involves risks and even the cream of the crop, the best and the brightest, can make mistakes or become impatient. Hedge funds are big business, and every investment business, be it the stodgiest of old line investment firms or the savviest hedge fund, faces pressure, short-term pressure, to perform. That pressure, from within and from without, dictates that investment firms will always be putting capital to work—even when there is little worth doing.
In addition to solid investment performance, many hedge funds strive for low volatility. While low volatility is pleasing to clients, fulfills marketing promises, and satisfies certain kinds of clients who measure risk this way, this emphasis can become an over-emphasis. At its worst, this results in excessive diversification, technically-based and irrational risk reduction techniques such as stop-loss orders, and, because of the perceived volatility, avoidance of certain fundamentally attractive investments.
Hedge funds tend to avoid investments that are hard to explain to clients. Finally, instead of rationally assessing new developments, they are prone to seizing up in the face of adversity—slavishly gyrating to the dictates of Mr. Market instead of soberly profiting from them. In short, market efficiency is a fine academic theory unlikely ever to bear meaningful resemblance to the real world of investing.
In 1984, Warren Buffett penned an essay entitled The Superinvestors of Graham-and-Doddsville, making the case that numerous disciples of Benjamin Graham’s school of value investing were profiting fabulously, yet independently from each other, by following the precepts of a particular investment philosophy. Even then, it was apparent that there was little, if any, academic interest in understanding and analyzing the astonishing market outperformance of the nine value investors that Buffett examined. How fortunate for the latest two decades of value investors that this was so!
The challenge for academics is simple. Select in advance a group of investors to be studied. Verify with a panel of value investing experts that the individuals to be studied are, in fact, value investors (and not simply those who call themselves value investors). Determine in advance a sufficiently long period over which they will be studied (but not so long that most of them will be retired by the end of the period). Perhaps choose a group of “growth stock” investors to also be examined over the same period. Finally, establish criteria in advance for an analysis of risk, illiquidity, and other considerations which academics are prone to using after the fact to explain away any market outperformance. Then, let the investing begin.
Here is a link to the Lowenstein paper: Searching for Rational Investors in a Perfect Storm.
Here’s a link to Klarman’s response: A Response to Lowenstein’s Searching for Rational Investors In a Perfect Storm.
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