What works on Wall Street: Jim O'Shaughnessy

Gyan on Treadmill dated 26-Mar-2018

Jim O'Shaughnessy

James ('Jim') O'Shaughnessy is the author of the book 'What works on wall street'. The book is in my review list. In this delightful google talk laced with wit and wisdom, Jim makes some awesome points which are valuable for any investor.

(You can watch the presentation here)

He starts off by talking about the mistakes made by both passive investors (who invest in Index Funds) and active investors (who research and pick stocks). The only mistakes that passive investors make is to sell off in panic at market bottoms. On the other hand, active investors make two kinds of mistakes. One, sell off in panic in market bottom and two, is to compare their returns against the benchmark (?). Active investors compare the portfolio performance over a period of three years. Market returns are cyclical over three years and mean reversion happens in that time frame. So if you have a comparison period of three years, you might be comparing apples and oranges.

Let us pause here for a moment and look at what we do here in India. Assume that we have an investible surplus, first thing you do is to go to Moneycontrol's mutual fund section and look for fund with the five stars. Then we invest and see that the fund performance has fallen immediately after we invest and next year it becomes a four star and then a three star. I have had countless experiences with this failed strategy. For instance I invested in TIGER fund when it was five star and exited at a loss two years later when it became three star. I invested in HDFC top 200 fund when it was 5 star, stuck with it when it was three star and in the last two years, it has outperformed.

Let us go back and listen to Jim...

Investors are subject to Recency Bias. We pay greatest attention to what has happened recently and we extrapolate the recent event into the future. (two mistakes, the same point made by Tobias Carlisle in his speech of 'Reigno' motif). As per some swedish study on the investment habits of identical twins, 45% of investment decisions we make are genetic. Availability bias is how easily we remember something. 

If you can have a long-term investment outlook and manage to live by it, that is as close to investment super power as possible. 

From discussing the biases, he moves on to discussing process. A good investor values process over outcome. He quotes Deming, 'if you cannot explain what you are doing as a process, you do not know what you are doing'. The same point (about the importance of process) was made by Tobias Carlisle in his presentation also where he mentioned that 'simple models outperform expert's discretion'. In this case 'Simple Model' equates 'Process'. As a part of process, try to analyse as much data as possible.

Jim stresses the need for investors to understand market history. In the market, the trends tend to repeat themselves. What looks attractive from a 4-5 year data (recency bias) may be a disastrous investment strategy for the long-term. There are many people who recommend buying high PE stocks because they are 'growth stocks'. But in reality, all the potential growth is already factored in and if you buy such a stock, you will end up with hardly any returns (in fact -6% compared to SP500 as per the study by Jim and his team)

Due to the three year cycle that was discussed earlier, in every 10 years, there is a chance of your portfolio under-performing at least in three of the ten years.

Successful investors ignores forecasts and predictions. But as retail investors we crave forecasts because we crave stories and narratives. 

Another bias is the 'Halo Effect'. You attribute a lot of qualities because you are impressed with an individual. You like a stock because, everyone is talking about it, and some experts are recommending it etc. Jim gives example of the '10 stocks of the next decade', prediction by Fortune magazine. Of these 10 stocks, 2 went bankrupt and the remaining 8 gave a return of -27% when S&P 500 gave a return of about 125%. That is Halo Effect in action.

Since this talk was focused on active investors, Jim says that two qualities required are patience and persistence. Pay zero attention to the view of others. Stick to your process, stick to your model and think long-term.

Successful investors think in terms of 'Probabilities' rather than 'Possibilities'. There are lot of things that are possible. However, only few things are probable. People who think in terms of possibilities freak out. 

He analyses as to what companies outperform in the long run. As per him, the companies with the highest shareholder yield (dividend + buyback) tend to outperform. Dilution, debt, acquisitions, expansion - all tend to reduce the shareholder return. 

Finally discipline is very important. You must be able to stick to your process and approach when things are going difficult. Resist the temptation to invest based on tips, expert opinion or any of the biases (recency, availability, halo effect) discussed earlier. You may face situations where you are not in control, people are rejecting your ideas or you may lose self-esteem. But the smart active investor will win in the end if he or she is disciplined. 

Lot of amazing lessons here...Thank you Jim...