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Pricing’s influence on investment decisions (podcast)

This episode of Tradestreaming Radio includes a conversation with William Poundstone, author of Priceless: The Myth of Fair Value (and How to Take Advantage of It).

We discuss:

  • market psychology of pricing
  • crowd following and momentum stocks
  • how investors are susceptible to pricing cues
  • what behavioral economics says about risk assessment

Poundstone’s book is a sweeping overview of some of the most influential ideas and people in behavioral economics the past 60 years.  While much ink is devoted to Tversky and Kahneman and their work, the second half of the book takes on a more practical approach in how we can all use the findings of behavioral finance to our benefit.

My interview with Poundstone focuses more on the quirks in the investment process rather than merely looking at consumer behavior.  Tradestreaming is more concerned with how Poundstone’s insights affect our investment behavior, our aversion to trade losses, and our perception of rapidly rising stocks.

We all chase momentum stocks and have a hard time buying real value.  Pricing theory and its place in behavioral economics literature is a small but growing field specifically in the investing vertical.

More resources


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Should the government get into the insurance biz?

Well, Professor Terrance Odean, Professor of Finance at UC Berkley, thinks so.

From an Op-Ed in the NYT:

Anyone planning for retirement must answer an impossible question: How long will I live? If you overestimate your longevity, you might scrimp unnecessarily. If you underestimate, you might outlive your savings.

This is hardly a new problem — and yet not a single financial product offers a satisfactory solution to this risk.

We believe that a new product — a federally issued, inflation-adjusted annuity — would make it possible for people to deal with this problem, with the bonus of contributing to the public coffers. By doing good for individuals, the federal government could actually do well for itself.

Prof. Odean thinks the government could actually play the role of Ultimate Backstop.  Annuity buyers pay a premium to an insurance company in return for a “guaranteed” payment stream.  Of course, nothing is guaranteed and investors are subject to default by underwriting insurers.

The U.S. government doesn’t face the same default risk (though theoretically does face some risk).  Here’s how it would work:

  1. investors would enroll in a qualified retirement plan (like a 401k) and choose an annuity option
  2. investors would receive payouts based on a variety of factors like mortality tables and interest rates

Proponents of this product (hey, roll-em up and issue an ETF that tracks them) believe that the Treasury would even benefit from such a plan as it decreases reliance on foreign lenders and expands the domestic investor base.  While I don’t particularly like government meddling, it’s an interesting idea.

Prof Odean is a Tradestreaming favorite and his works have been incorporated into much of my book.  He’s done great, insightful work on investor overconfidence-caused underperformance, overtrading (which is also caused in part by overconfidence), expenses and mutual fund flows.

Source

Paying for Old Age (New York Times) Feb 25, 2011

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Humans and Machines Both Reign Supreme: Takeaways from the Battle of the Quants

As markets gyrate, investors continuously hear two diverging voices in their heads.

Matt Dillon (voice of Confidence): Yo, Johnny.  My strategy rocks and I’m in it for the long hall.  I’ve looked over my allocations and they make sense.  I mean, I know what I’m doing here and everything is under control.

Woody Allen (voice of Self-Doubt):  When I began implementing my strategy, I was sure.  Oh, was I sure.  But now?  I dunno.  Am I headed in the right direction? Is volatility too much for me?

Well, the investing kings of the universe also suffer from these opposing forces.  Put differently, quants need to balance the confidence needed to put millions of dollars behind an algorithm they’ve designed and think works versus the fear that if things hit the fan, they’re just a congressional meeting away from notoriety.

Luis Lovas had a great article recounting a meeting that occurred last week, The Battle of the Quants.

The afternoon’s main battle was a panel that pitted a quant team dedicated to automated algorithms against a team that (presumably) considers human discretionary decision making as a better tool for alpha. In other words, like the Jeopardy challenge of IBM’s Watson, it was human vs. machine. That particular event I was completely fascinated by.  An interesting pre-game commentary relates the Jeopardy match to the Singularity by author Ray Kurzwell, a convergence of human and machines.  In the battle pitting algo’s against humans the outcome was decided by an audience vote.  The voting was not simply two choices: “for the machines” or “for humans”, but a third choice was offered more aligned with Ray Kurzwell’s Singularity – “a combination of human and machine decision making”.  As you might have guessed, that third choice was the overwhelming favorite. I believe the majority have the confidence to let machines decide many things but are wanting of human intuition or that proverbial finger on the button as a measure of risk control so fear does not overwhelm.

Kinda like me flying in an airplane.  I know the technology has been good enough for decades to replace a human pilot.  But I’m happy that someone is sitting there.  Just in case.

And hopefully it’s Sully.

And hopefully the pilot is sober.

Source

Confidence and Fear: Why Quantitative Models Win (High Frequency Traders)

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Screen your way to profits with new screener

Empirical Finance has launched a simple stock screener for general usage (read, free).  And it’s pretty nice.

In its announcement of the launch of Empirical Finance Data, the company said the site is intended to accomplish a few goals

  • Demystify quantitative long/short.
  • In our mind, the only reason many fund managers can pitch overpriced products to investors, is due to a serious information asymmetry problem. We are here to shakes things up a bit.
  • Currently, the only way to access quantitative long/short equity is via expensive private placement vehicles (e.g., hedge funds), expensive mutual funds, and expensive managed accounts. The key theme across all these vehicles is the following theme, “EXPENSIVE.”
  • Allow “hands-on” investors an opportunity to build straight forward quantitative portfolios using high-quality data via our basic screening tools.

That’s cool for me — that’s what Tradestreaming is all about. Finding the tools, data and research to make more accurate — profitable — investment decisions.  This dovetails nicely into the category we call Stock Screening 2.0 — using technology and proven investment techniques to quantify the investment process.

The screener is super simple and currently sizes stocks up in 4 ways

  1. Joel Greeblatt’s Magic Formula
  2. Piotroski’s F-score
  3. Novy-Marx’s Profit and Value Score
  4. Cooper, Gulen and Schill’s Asset Growth strategy

Users can search for all rankings of an individual stock or screen for the highest ranking stocks in a particular screen according to market cap.  Check it out.

Additional Resources

Empirical Finance Data Services (Empirical Finance Blog)

What is Tradestreaming: Screening 2.0 (Tradestreaming)

Advanced Resources

John Reese’s The Guru Investor: How to beat the market using history’s best investment strategies (Tradestreaming Bookshelf) provides great research for investors interested in creating guru strategies that recreate the types of investments history’s best investors made (guys like Lynch, Buffett, Graham, etc.)

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When following the fast money can be a good long term strategy

Stone Street and The_Analyst had an interesting piece yesterday that appeared on Zero Hedge.  Entitled Financial Voyeurism, Why You Can’t Beat Fast Money, the piece took to task all the excitement surrounding hedge fund’s public 13F filings (.pdf) every quarter.

According to Stone Street:

funds and asset managers with greater than $100 million in assets under management are required to report their holdings. The list includes exchange-traded or NASDAQ-quoted stocks, equity options and warrants, shares of closed in funds shares of closed-end investment companies, and certain convertible debt securities. Short positions are NOT included in the 13F. In addition, managers can request confidential treatment of their filing if they feel that their strategy would be compromised by the disclosure. This includes circumstances where the manager has an ongoing acquisition or disposition program. Confidential treatment can last for three months to one year. Lastly, it is important to note that the 13F must be filed no later than 45 days after the end of the quarter. Most funds wait until the deadline to report, as such they are lagging indicators.

The issue is that clearly, investors blindly following 13F followings in an effort to replicate hedge fund portfolios are missing crucial information.  Beyond the lag between buying and filing, not all the fund’s holdings appear in these filings.

So, the incessant race in the blogosphere to analyze these reports for any changes in holdings appears to be somewhat futile.  Fast money momentum players look to piggyback portfolio changes of guru investors in the hope that the market has not fully incorporated this information into current prices.

But, it works

The thing is, with certain investors like Mr Buffett, this strategy actually works.  According to a study I quote in my book, Tradestream, a piggybacking strategy that incorporated only positions included on public filings would achieve alpha close to that of Buffett’s actual portfolio.

The researchers found that Buffett, although touted as the king of value investing, was actually running a growth portfolio.  From Martin and Puthenpurackal’s Imitation is the Sincerest Form of Flattery:

An investor who mimicked the investments from 1976 to 2006 after they were publicly disclosed in regulatory filings would experience statistically and economically significant positive abnormal returns using various empirical tests and benchmarks.  This indicates the market under-reacts to the initial information that Berkshire Hathaway has bought a stock and is slow in incorporating the information produced by a skilled investor.

I understand that Buffett takes larger positions and his holding period is longer than your typical hedge fund.  And that matters.  It would be harder to replicate portfolio performance in a fund like Renaissance that has huge turnover in its portfolio and very short holding periods.

But there are a lot of funds that take bigger, more concentrated positions, like some of the Tiger Cubs, Paulson, Ackman, etc.  Sometimes, even just mimicking a fund’s best idea works.  What these blogs and services are doing in scrambling to reveal and analyzing quarterly filings comes from a good place but needs to be put in context.

Do it, but with class and rigor

I think the point here is not to throw the baby out with the bathwater and poo-poo portfolio replication in general.  On the other hand, mimicking anything that moves — cloning any hedge fund manager — doesn’t make sense either.  That’s dumb money.

What I’ve done after publishing my book is move more and more into rules-based portfolio replication.  But I did it with rigor. I  identified firms that take concentrated positions and hold onto them.  I them backtested them using AlphaClone (see why I called AlphaClone “the cure to investor insanity“) to determine which strategies come closest to mimicking their own performance.  For some funds, it’s their largest holding.  Others performance comes from the largest new holding.  Other positions include the most widely held tech stock, for example.

These portfolios do work but they require vigilance and methodology.   See the performance of one of our portfolios, the Tradestreaming Guru Strategy.

Source

Financial Voyeurism, 13-F Chasers: Why You Can’t Beat the Fast Money (Stone Street Advisors)

Martin and Puthenpurackal: Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway (SSRN)

Cohen, Polk and Silli: Best Ideas (SSRN)

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Random Walk’s Malkiel sells out

I first read Princeton U.’s Burton Malkiel when I was in college.  Certainly a best-seller, his 1973 A Random Walk Down Wall Street was as common on a Harvard Econ professor’s shelf as beer pong was in a Dartmouth frat.

For Malkiel, Wall St.’s high priced investment advice was an anathema — investors just couldn’t beat the market, so why try?  Better to invest in low-cost, passive indexes and go out and have fun.

Well, Malkiel is back with the 613th or something printing of Random Walk and in anticipation of the book’s launch, he’s hitting the interview circuit.

Can it be that the Grinch of Wall St has had a change of heart?  In an interview with RegisteredRep, he dropped a whammy:

RR: You write, “You can do as well as the experts — perhaps even better.” That philosophy must drive financial advisors crazy.
BM: In a way, you really need to interpret that. I’ve become frankly more appreciative of what a financial advisor can do. For me, it’s keeping people from beating themselves. Keeping people on an even keel. It’s easier said than done. It’s very hard work.

I’m sort of an informal financial advisor for all of the Princeton widows. I remember so many of them would come in with tears in their eyes in the third quarter of 2008 when it looked like the world was falling apart — “and I have to sell all of my equities!” That’s what I mean by keeping people on an even keel.

Either he’s hankering for a new job or he just really knows his audience.

Source

Malkiel: Wall St. Has Caught Up to Random Walk (RegisteredRep)

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Differentiating your view on a stock

Last week, I interviewed Jim Valentine, author of Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts. For professional researchers, Jim emphasized the need to have a differentiated view on a stock.

From our chat:

I think another thing that may be getting more into the investment arena, in terms of best practice, is to identify the two to four critical factors that impact every one of your stocks. This kind of goes back into the time management thing. What I find is that there are a lot of really smart analysts who know a lot about other companies, but they don’t have a differentiated view from consensus on any particular issues that are going to drive the stock. Ultimately they become a company analyst, rather than a stock analyst.

So the best practice, in effect, is to do some research, figure out what are those two to four critical factors, and then focus all your time on those for your companies, as opposed to all the other factors out there that are, in effect, noise.

Pro analysts vs. the rest of us

This need to differentiate makes sense for equity analysts: ultimately, the good ones get paid to pick spots when their information and view on an investment diverges from consensus.

But I’m torn if this makes total sense for the rest of us.   How important is it for the majority of investors to do something completely off the beaten path?  We know that stocks with greater investor recognition typically do better than those with less.  Do we really need to stick our investing necks out to try and find the next $GOOG or $AAPL?

In my own investing, I tried for years to come up with original stock picks — either ones that no one was looking at or ones that everyone hated on.  Now, I’ve automated much of my investment process leveraging the Tradestream and spend much of my time finding strategies that take me out of the investment selection process.

Where is the line between being an investing contrarian and not getting swept along with every fast-and-quick investment fad and just doing things according to “the book”?

More resources

Learn more about the book and Jim Valentine

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Meat of the Tweet: Using big data solutions to pick stocks (video)

Last week, Opera Solutions hosted a seminar entitled The Meat of the Tweet: Applying Big Data Analytics to Social Media Data.

For investors, the presentation of Dr. Riza Berkan about his firm Hakia and its investing application, SENSEnews (around 4:30) shouldn’t be missed.

the social media brain appears to be something greater than all the individuals participating in it and we’re just beginning to understand how we can ask questions of it

Watch live streaming video from smw_newyork_google at livestream.com

I’m going to be interviewing SENSEnews for an upcoming show of Tradestreaming Radio.  Keep tuned to listen — should be interesting.

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Winning trade of the week: front running the hedgies

From the great-idea-but-really-hard-to-implement:

comes a strategy to find profits by uncovering lesser known stocks before the big institutional investors come and plunk their money down on ’em — essentially front-running hedge funds.

By looking at stocks varying investor recognition, Sloan and Lehavy found 4 ways that recognition and stock prices are related

  1. security value is increasing in investor recognition
  2. expected return is decreasing in investor recognition
  3. the above two relations are increasing in a security’s idiosyncratic risk
  4. financing and investing activities are increasing in investor recognition

Performance

The researchers find that those stocks in the decile of  stocks with the highest change in institutional ownership generate size-adjusted returns of 14.4% whereas the lowest decile generates returns of –11.0%.

Takeaways

Well, this is all nice and dandy but actually applying this strategy is quite difficult. In fact, according to Empirical Finance (h/t for bubbling this paper up)

As amazing as these results are, they are of little use to the investor because the returns and the change in institutional ownership are occur during the same quarter.  That is, the investor won’t know which stocks have the highest change until after the 14.4% return has already been generated.

Nevertheless, it appears as if the gains in the owned stocks point to an underpricing in the market.  In addition to the issue of returns and ownership occurring in the same quarter, we still don’t know a whole lot about what constitutes investor recognition — how investors encounter stocks and continue to drink from a particular issue’s tradestream.

How investors discover new opportunities

  1. David Jackson, founder of Seeking Alpha, always believed that investors would encounter smaller companies by way of researching their bigger competitors. In fact, we launched an advert product that enabled smaller companies and their IR firms to target investors researching larger ones.
  2. Companies like StockTwits provide an opportunity for investors to discover lesser-known stocks residing in the long tail.
  3. Peter Lynch, the scion of buy-what-you-know investing, encouraged investors to buy the stocks of companies they’re familiar with.  As tragically hip companies like Skullcandy and Pandora ready to IPO, investors are given opportunities to invest in firms that make products they use daily.
  4. creating backtested strategies that piggyback guru investors a la AlphaClone is something I’ve spoken about a lot on this site (and in my book) — though this helps less if you’re trying to find firms not widely owned on the Street

Regardless, with social media, the dissemination of good ideas in lesser know companies will be something studied, analyzed, and made profitable.  Good times.

More resources