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Ignore experts, prophets and economists

15 December 2010 David Knee, Prudential Portfolio Managers South African Head of Fixed Inco

For the vast majority of professional money managers an investment edge – the ability to add value consistently over time – is hard to demonstrate. Many of the claims made by managers in respect of their ‘edge’ fail to stand up against robust scrutiny. So says David Knee, Prudential Portfolio Managers South African Head of Fixed Income. He claims the key to delivering an enduring investment edge is using the tools at your disposal to promote discipline, rigour and consistency as counterweights to often inappropriate emotional reactions to price movements; as well as patience and an extended time-horizon to exploit volatility.

“Investors do have a chance to add real value if they look at longer-term valuations and take medium-term decisions,” he says. “How can we outperform in a market where there are millions of investors who are bringing their weight of human capital to bear on the market?” Knee asks.

A common response to this challenge would be to suggest some increased ability to forecast economics, asset prices and returns. And claim skills, techniques or research in-house or contracted from external ‘experts’ that others do not have.

But does this work? In Knee’s opinion, such an approach is a hard sell.

Knee says that one of the reasons that it is so difficult to gain an investment edge by using only traditional techniques is the question of what makes us human.

“Human decision making involves personal judgements and emotions,” he explains. “We just can’t help being drawn in – we hate losing money, we rush into things, we look back with hindsight bias and regret, we think we have skills and insight which we don’t, we are over-confident, we remember the calls that worked and forget our mistakes. It’s all part of being a human investor.”

And when it comes to investor confidence versus accuracy, beware! In an academic study researchers in the USA assembled a group of students and a group of investment professionals, gave them two blue-chip companies and asked each group to forecast which company would outperform over a specific period, as well as how confident they were in their forecasting.

“The students got about half their calls right. The investment professionals did a whole lot worse - the more confident they were, the worse they did! In my view, the more confident investment managers are, the more confident you should be of ignoring their views,” Knee says.

(Click on image to enlarge)

He explains that more detail can make an event seem more plausible when in fact it makes it less so, or at least doesn’t change the odds at all. Investors misunderstand the odds because sometimes they have too much information and more information isn’t necessarily better information.

“All too often we make judgements about markets where we are misunderstanding the odds. The chance that tomorrow will be an ‘up’ day in the market is pretty much the same even if the last 20 days have all been up. So beware of jumping on market trends when in fact you have no reason to suspect that the next observation will follow the trend, except that the previous observations have done so,” Knee adds.

Follow the experts?

Using the world’s most respected central banker, Alan Greenspan, as one example amongst many, Knee illustrated how the experts do not necessarily have better insight. In June 1999, Greenspan was asked if he could detect a stock market bubble: “Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgement that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.”

Six months after Greenspan made his observation the NASDAQ, which had tripled in the previous three years, peaked and began to fall, a process that only ended when it was 80% down from the peak.

“It’s easy for us to attribute soothsayer type abilities to so-called experts when we are looking to hang our investment hat on something. There is no reason to expect so-called experts to have any more insight into the future than you or I do,” says Knee.

But surely we can trust economists to forecast accurately, you may ask? Not necessarily, as The Average Forecast error for US GDP/CPI for 1991 to 2000 illustrates from a study by the Swedish Central Bank of some 40 mainstream forecasters.

 (Clik on image to enlarge)

“Can we rely on economists to be independent in their forecasting, or will they rely on what else is going on in the world of forecasting – do they follow the herd? Unfortunately the evidence is that they are very influenced by what other people are saying,” says Knee.

So what can we do about this?

Knee says that for Prudential Portfolio Managers the starting point is to step back and think about the medium-term valuation.

“We try to frame our thinking by considering what we should be paid to own an asset class over a medium-term period. Then we use a variety of tools to promote discipline, rigour and consistency to ensure we can just ignore valuation signals. We use patience and an extended time-horizon to exploit volatility. We do have a chance to claim an edge if we look at longer-term valuations and take medium-term decisions,” he adds.

“The key is to buy assets when they are deeply out of favour, priced cheaply and are offering a risk premium. Then take a medium-term view that looks through the volatility.”

Knee says that an investment edge is hard to claim, even for the vast majority of professional money managers.

“Any investment process based on views of the future is flawed. Ignore experts, prophets and economists. Consistently buy assets where the odds are on your side – high risk premia – and be prepared to wait. Hope is NOT an investment strategy,” he concludes.

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