The Virtuous Investor: Rule 5
Do not get distracted – avoid the temptations of a materialistic world
This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.
“Whether it be through negligence or for lack of knowledge of it, the most part of christian men instead of true honourers of God are but plain superstitious.”
Erasmus of Rotterdam
A fundamental step to investment success is to expand your investment knowledge, as I have explained in the first part of this series. With increased knowledge about investments, the virtuous investor forms a set of investment beliefs that guide her approach to investing for years to come.
Unfortunately, though, most investors either never formalise their investment beliefs or they adopt investment beliefs of other investors uncritically and without testing the validity of these beliefs in practice. The end results can be devastating if these beliefs are rooted not in fact but superstition.
In my experience there are three ways how the virtuous investor can get distracted by the temptations of a materialistic world:
Following star investors’ stock picks, especially star hedge fund managers.
Letting political ideology and beliefs guide your investment beliefs.
Following academic research that is hard or impossible to replicate.
As for the first distraction, following star investors, it amazes me how many websites and news articles are devoted to monitoring the public utterances of star investors and their portfolio investments. To me, it feels as if the price of a specific stock jumps whenever there is a news report that a prominent investor has bought into this stock. Activist hedge fund managers typically use this effect to their advantage to put public pressure on a company that they think is over- or undervalued as has recently been the case with General Electric and Harry Markopoulos. And while I do not know of any proper research of the announcement effect of star investors (please email me if you do), there is at least some indication that it exists in the case of Sovereign Wealth Funds.
I am happy for these star investors and the return boost they can get from publicly announcing a specific investment, but have you ever wondered why these investors would tout one stock or another in public (other than in their regulatory filings)? It is called talking your book and always reminds me of that famous Saturday Night Life skit from the early 2000s: When you want to sell a stock, you need to convince someone else to buy it…
There is increasing evidence that at least when it comes to hedge fund managers, this is exactly what happens in practice. Patrick Lou from Harvard analysed the public speeches of hedge fund managers at investment conferences. He summarizes his results thus:
Hedge funds sell pitched stocks after the conferences to take profit and create room for better investment opportunities. However, the pitched stocks still perform better than non-pitched stocks in the funds’ portfolios afterwards. Hedge funds do not pitch obviously bad stocks because maintaining a good reputation helps them raise money.
There is good and bad news here. On the one hand, hedge fund managers publicly tout a stock to drive up market demand in order to reduce their positions. But on the other hand, they seem to be so successful in raising demand (especially from mutual funds as the author notes), that the pitched stocks still perform better than the non-pitched stocks after the conference. However, the paper also shows that this announcement effect lasts only for a few days, after which trading volumes and relative performance settle down towards pre-announcement levels. And since the virtuous investor should be focused more on the long-term success of her investments, it seems a really bad idea to follow star investors’ public announcements.
The second approach to investment beliefs is to adopt political beliefs as part of your investment beliefs. The most prominent example is the eternal fight between regulation and free markets. Politicians and investors to the right of the centre typically operate under the assumption that free markets are the best means to use scarce resources and create the best outcome for everyone. Politicians and investors to the left of the centre typically operate under the assumption that regulation is necessary to prevent the less fortunate to be exploited by the capitalists and reduce inequality. In my view, both sides are wrong.
Here in the UK, the Conservative Party is adamant that privatisation is the best way to manage public services. Our current foreign secretary and the Chancellor of the Exchequer both sympathise with the idea of privatising the National Health Service in the UK or letting US health insurance companies access the British market. The idea is that a privatisation of the NHS would make our health care system cheaper and more efficient. This was pretty much the same idea that led to the privatisation of the British railway system in 1979. The subsequent mess was so bad that in 2002 the Labour government had to re-nationalise the company responsible for the rail tracks, the London Underground, which had been partially privatised, was re-nationalised in 2007 and in several railway lines are at risk of nationalisation time and again because their service has become so bad that they are no longer viable as a public service. And a cursory look at the mess that is the health care sector in the US should tell even an ideologue that introducing the same system in the UK would be a move backward in terms of affordability and accessibility of health care.
But the parties and investors on the left of the political spectrum are no better. In the UK, the Labour Party is toying with the idea of nationalising water utility companies to force them to make fewer profits – and presumably provide access to clean water for less money. This is literally what previous Labour governments have done in the Water Act of 1973. The effect was that utility companies refused to pass on the high inflation of the 1970s for political reasons and did not invest enough in the maintenance and development of the existing sewage system. In the end, the water quality declined so dramatically that it eventually caused health risks and sewage spills created a lot of environmental distruction. In 1989 the water utilities were privatised again.
The fact is that free markets are the most efficient way to manage resources and create the best possible outcome for the public. But free markets break down in the face of externalities (i.e. costs that are not priced in the market but can be pushed onto outsiders) or when facing common goods where individual businesses can free ride on the use of public goods and thus exploit public resources for private gain. The list of these market failures is long and reaches from pollution to banking failures (remember too big to fail?).
Yet, many investors continue to let their political beliefs and personal ideologies guide their investment beliefs. But politicians have different incentives than investors and thus, politicians might propose policies that are bad for investors and markets but good for their own career and their party.
Finally, the third distraction for the virtuous investor is to follow academic research that does not hold up in practice. I recently wrote a post why I don’t write about factor investing and smart beta. What I did not mention in that post is that according to research of Campbell Harvey, Yan Liu and Caroline Zhu out of the several hundred systematic risks factors that have been identified in the academic literature, only about three (value, momentum and a third, very exotic, factor) seem above suspicion when corrected for the possibility of data snooping and data mining.
The fact is that if you want your research to be published by a reputable academic journal in order to have a decent chance at making a career in academia, you better have positive results for your research. Research that shows no effect rarely gets published. This leads to a bias in academic papers in favour of positive results, some of which may be due to chance alone. When these findings are then replicated by other researchers or practitioners the size of the effect is much smaller or vanishes altogether. In short, what seems to make money in academic research often doesn’t make money in real life. Studies have shown that this bias is so pervasive that by now we face a replication crisis in almost all fields of scientific enquiry.
So, what is the virtuous investor supposed to do?
Finance and investing suffers from a massive challenge. Unlike in engineering or natural sciences, models and techniques cannot be tested in a laboratory. They have to be tested in live markets, which means that untested products and investment approaches will come to market and lead to massive losses for investors following these approaches.
However, over time, we get a better understanding of what works in markets and what doesn’t. This is at the heart of the evidence-based investing movement. The idea is to only invest based on insights that have been thoroughly tested by independent research and have a decent track record. This does not mean that evidence-based investing will never be wrong, but it is the best available technique we have to avoid unnecessary mistakes like the ones, I have discussed here.
There are other techniques that I recommend, such as writing an investment policy statement and testing its veracity with the help of investment diaries. I will discuss these techniques in future instalments of this series.