(Image: Zen Buddha Silence by Marilyn Barbone.)
July 2, 2017
In Investing: The Last Liberal Art (Columbia University Press, 2nd edition, 2013), Robert Hagstrom has an excellent chapter on decision making. Hagstrom examines Philip Tetlock’s discussion of foxes versus hedgehogs.
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Philip Tetlock, professor of psychology at the University of Pennsylvania, spent fifteen years (1988-2003) studying the political forecasts made by 284 experts. As Hagstrom writes:
All of them were asked about the state of the world; all gave their prediction of what would happen next. Collectively, they made over 27,450 forecasts. Tetlock kept track of each one and calculated the results. How accurate were the forecasts? Sadly, but perhaps not surprisingly, the predictions of experts are no better than ‘dart-throwing chimpanzees.’ (page 149)
In other words, one could have rolled a 6-sided dice 27,450 times over the course of fifteen years, and one would have achieved the same level of predictive accuracy as this group of top experts. (The predictions were in the form of: more of X, no change in X, or less of X. Rolling a 6-sided dice would be one way to generate random outcomes among three equally likely scenarios.)
In a nutshell, political experts generally achieve high levels of knowledge (about history, politics, etc.), but most of this knowledge does not help in making predictions. When it comes to predicting the future, political experts suffer from overconfidence, hindsight bias, belief system defenses, and lack of Bayesian process, says Hagstrom.
Although the overall record of political forecasting is dismal, Tetlock was still able to identify a few key differences:
The aggregate success of the forecasters who behaved most like foxes was significantly greater than those who behaved like hedgehogs. (page 150)
The distinction between foxes and hedgehogs goes back to an essay by Sir Isaiah Berlin entitled, ‘The Hedgehog and the Fox: An Essay on Tolstoy’s View of History.’ Berlin defined hedgehogs as thinkers who viewed the world through the lens of a single defining idea, and foxes as thinkers who were skeptical of grand theories and instead drew on a wide variety of ideas and experiences before making a decision.
FOXES VERSUS HEDGEHOGS
Hagstrom clearly explains key differences between Foxes and Hedgehogs:
Why are hedgehogs penalized? First, because they have a tendency to fall in love with pet theories, which gives them too much confidence in forecasting events. More troubling, hedgehogs were too slow to change their viewpoint in response to disconfirming evidence. In his study, Tetlock said Foxes moved 59 percent of the prescribed amount toward alternate hypotheses, while Hedgehogs moved only 19 percent. In other words, Foxes were much better at updating their Bayesian inferences than Hedgehogs.
Unlike Hedgehogs, Foxes appreciate the limits of their own knowledge. They have better calibration and discrimination scores than Hedgehogs. (Calibration, which can be thought of as intellectual humility, measures how much your subjective probabilities correspond to objective probabilities. Discrimination, sometimes called justified decisiveness, measures whether you assign higher probabilities to things that occur than to things that do not.) Hedgehogs have a stubborn belief in how the world works, and they are more likely to assign probabilities to things that have not occurred than to things that actually occur.
Tetlock tells us Foxes have three distinct cognitive advantages.
- They begin with ‘reasonable starter’ probability estimates. They have better ‘inertial-guidance’ systems that keep their initial guesses closer to short-term base rates.
- They are willing to acknowledge their mistakes and update their views in response to new information. They have a healthy Bayesian process.
- They can see the pull of contradictory forces, and, most importantly, they can appreciate relevant analogies.
Hedgehogs start with one big idea and follow through – no matter the logical implications of doing so. Foxes stitch together a collection of big ideas. They see and understand the analogies and then create an aggregate hypothesis. I think we can say the fox is the perfect mascot for the College of Liberal Arts Investing. (pages 150-151)
KNOWING WHAT YOU DON’T KNOW
We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know. – John Kenneth Galbraith
Last year, I wrote about The Most Important Thing, a terrific book by the great value investor Howard Marks. See: http://boolefund.com/howard-marks-the-most-important-thing/
One of the sections from that blog post, ‘Knowing What You Don’t Know,’ is directly relevant to the discussion of foxes versus hedgehogs. We can often ‘take the temperature’ of the stock market. Thus, we can have some idea that the market is high and may fall after an extended period of increases.
But we can never know for sure that the market will fall, and if so, when precisely. In fact, the market does not even have to fall much at all. It could move sideways for a decade or two, and still end up at more normal levels. Thus, we should always focus our energy and time on finding individual securities that are undervalued.
There could always be a normal bear market, meaning a drop of 15-25%. But that doesn’t conflict with a decade or two of a sideways market. If we own stocks that are cheap enough, we could still be fully invested. Even when the market is quite high, there are usually cheap micro-cap stocks, for instance. Buffett made a comment indicating that he would have been fully invested in 1999 if he were managing a small enough sum to be able to focus on micro caps:
If I was running $1 million, or $10 million for that matter, I’d be fully invested.
There are a few cheap micro-cap stocks today. Moreover, some oil-related stocks are cheap from a 5-year point of view.
Warren Buffett, when he was running the Buffett Partnership, knew for a period of almost ten years (roughly 1960 to 1969) that the stock market was high (and getting higher) and would either fall or move sideways for many years. Yet he was smart enough never to predict precisely when the correction would occur. Because Buffett stayed focused on finding individual companies that were undervalued, Buffett produced an outstanding track record for the Buffett Partnership. Had he ever not invested in cheap stocks because he knew the stock market was high, Buffett would not have produced such an excellent track record. (For more about the Buffett Partnership, see: http://boolefund.com/warren-buffetts-ground-rules/)
Buffett on forecasting:
We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.
Here is what Ben Graham, the father of value investing, said about forecasting the stock market:
…if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.
Howard Marks has tracked (in a limited way) many macro predictions, including U.S. interest rates, the U.S. stock market, and the yen/dollar exchange rate. He found quite clearly that most forecasts were not correct.
I can elaborate on two examples that I spent much time on (when I should have stayed focused on finding individual companies available at cheap prices):
- the U.S. stock market
- the yen/dollar exchange
The U.S. stock market
A secular bear market for U.S. stocks began (arguably) in the year 2000 when the 10-year Graham-Shiller P/E – also called the CAPE (cyclically adjusted P/E) – was over 30, its highest level in U.S. history. The long-term average CAPE is around 16. Based on over one hundred years of history, the pattern for U.S. stocks in a secular bear market would be relatively flat or lower until the CAPE approached 10.
However, ever since Greenspan started running the Fed in the 1980’s, the Fed has usually had a policy of stimulating the economy and stocks by lowering rates or keeping rates as low as possible. This has caused U.S. stocks to be much higher than otherwise. For instance, with rates today staying near zero, U.S. stocks could easily be at least twice as high as ‘normal’ indefinitely, assuming the Fed decides to keep rates low for many more years. Furthermore, as Buffett has noted, very low rates for many decades would eventually mean price/earnings ratios on stocks of 100.
In addition to the current Fed regime, there are several additional reasons why rates may stay low. As Jeremy Grantham recently wrote:
- We could be between waves of innovation, which suppresses growth and the demand for capital.
- Population in the developed world and in China is rapidly aging. With more middle-aged savers and less high-consuming young workers, the result could be excess savings that depresses all returns on capital.
- Nearly 100% of all the recovery in total income since 2009 has gone to the top 0.1%.
Grantham discusses all of these possible reasons for low rates in the Q3 2016 GMO Letter: https://www.gmo.com/docs/default-source/research-and-commentary/strategies/gmo-quarterly-letters/hellish-choices-what’s-an-asset-owner-to-do-and-not-with-a-bang-but-a-whimper.pdf?sfvrsn=8
Grantham gives more detail on income inequality in the Q4 2016 GMO Letter: https://www.gmo.com/docs/default-source/research-and-commentary/strategies/gmo-quarterly-letters/is-trump-a-get-out-of-hell-free-card-and-the-road-to-trumpsville-the-long-long-mistreatment-of-the-american-working-class.pdf?sfvrsn=6
(In order to see GMO commentaries, you may have to register but it’s free.)
Around the year 2012 (or even earlier), some of the smartest market historians – including Russell Napier, author of Anatomy of the Bear – started predicting that the S&P 500 Index would fall towards a CAPE of 10 or lower, which is how every previous U.S. secular bear market concluded. It didn’t happen in 2012, or in 2013, or in 2014, or in 2015, or in 2016. Moreover, it may not happen in 2017 or even 2018.
Again, there could always be a normal bear market involving a drop of 15-25%. But that doesn’t conflict with a sideways market for a decade or two. Grantham suggests total returns of about 2.8% per year for the next 20 years.
Grantham, an expert on bubbles, also pointed out that the usual ingredients for a bubble do not exist today. Normally in a bubble, there are excellent economic fundamentals combined with a euphoric extrapolation of those fundamentals into the future. Grantham in Q3 2016 GMO Letter:
- Current fundamentals are way below optimal – trend line growth and productivity are at such low levels that the usually confident economic establishment is at an obvious loss to explain why. Capacity utilization is well below peak and has been falling. There is plenty of available labor hiding in the current low participation rate (at a price). House building is also far below normal.
- Classic bubbles have always required that the geopolitical world is at least acceptable, more usually well above average. Today’s, in contrast, you can easily agree is unusually nerve-wracking.
- Far from euphoric extrapolations, the current market has been for a long while and remains extremely nervous. Investor trepidation is so great that many are willing to tie up money in ultra-safe long-term government bonds that guarantee zero real return rather than buy the marginal share of stock! Cash reserves are high and traditional measures of speculative confidence are low. Most leading commentators are extremely bearish. The net effect of this nervousness is shown in the last two and a half years of the struggling U.S. market…so utterly unlike the end of the classic bubbles.
- …They – the bubbles in stocks and houses – all coincided with bubbles in credit…Credit is, needless to say, complex…What is important here is the enormous contrast between the credit conditions that previously have been coincident with investment bubbles and the lack of a similarly consistent and broad-based credit boom today.
The yen/dollar exchange
As for the yen/dollar exchange, some of the smartest macro folks around predicted (in 2010 and later) that shorting the yen vs. the U.S. dollar would be the ‘trade of the decade,’ and that the yen/dollar exchange would exceed 200. In 2007, the yen/dollar was over 120. By 2011-2012, the yen/dollar had gone to around 76. In late 2014 and for most of 2015, the yen/dollar again exceeded 120. However, in late 2015, the BOJ decided not to try to weaken their currency further by printing even larger amounts of money. The yen/dollar declined from over 120 to about 106. Since then, it has remained below 120.
The ‘trade of the decade argument’ was the following: the debt-to-GDP in Japan has reached stratospheric levels (over 400-500%, including over 250% for government debt-to-GDP), government deficits have continued to widen, and the Japanese population is actually shrinking. Since long-term GDP growth is essentially population growth plus productivity growth, it should become mathematically impossible for the Japanese government to pay back its debt without a significant devaluation of their currency. If the BOJ could devalue the yen by 67% – which would imply a yen/dollar exchange rate of well over 200 – then Japan could repay the government debt in seriously devalued currency. In this scenario – a yen devaluation of 67% – Japan effectively would only have to repay 33% of the government debt. Currency devaluation – inflating away the debts – is what most major economies throughout history have done.
Although the U.S. dollar may be stronger than the yen or the euro, all three governments want to devalue their currency over time. Therefore, even if the yen loses value, it’s not at all clear how long this will take when you consider the yen versus the dollar. The yen ‘collapse’ could be delayed by many years. So if you compare a yen/dollar short position versus a micro-cap value investment strategy, it’s likely that the micro-cap value investment strategy will produce higher returns with less risk.
- Similar logic applies to market timing. You may get lucky once in a row trying to time the market. But simply buying cheap stocks – and holding them for at least 3 to 5 years before buying cheaper stocks – is likely to do much better over the course of decades. Countless extremely intelligent investors throughout history have gone mostly to cash based on a market prediction, only to see the market continue to move higher for many years or even decades. Again: Even if the market is high, it can go sideways for a decade or two. If you buy baskets of cheap micro-cap for a decade or two, there is virtually no chance of losing money, and there’s an excellent chance of doing well.
Also, the total human economy is likely to be much larger in the future, and there may be some way to help the Japanese government with its debts. The situation wouldn’t seem so insurmountable if Japan could grow its population. But this might happen in some indirect way if the total economy becomes more open in the future, perhaps involving the creation of a new universal currency.
TWO SCHOOLS: ‘I KNOW’ vs. ‘I DON’T KNOW’
Financial forecasting cannot be done with any sort of consistency. Every year, there are many people making financial forecasts, and so purely as a matter of chance, a few will be correct in a given year. But the ones correct this year are almost never the ones correct the next time around, because what they’re trying to predict can’t be predicted with any consistency. Howard Marks writes:
I am not going to try to prove my contention that the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise…
One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…
It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.
Marks gives one more example: How many predicted the crisis of 2007-2008? Of those who did predict it – there was bound to be some from pure chance alone – how many of those then predicted the recovery starting in 2009 and continuing until today (early 2017)? The answer is ‘very few.’ The reason, observes Marks, is that those who got 2007-2008 right “did so at least in part because of a tendency toward negative views.” They probably were negative well before 2007-2008, and more importantly, they probably stayed negative afterward. And yet, from a close of 676.53 on March 9, 2009, the S&P 500 Index has increased more than 240% to a close of 2316.10 on February 10, 2017.
Marks has a description for investors who believe in the value of forecasts. They belong to the ‘I know’ school, and it’s easy to identify them:
- They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
- They’re confident it can be achieved.
- They know they can do it.
- They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
- They’re comfortable investing based on their opinions regarding the future.
- They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
- They rarely look back to rigorously assess their record as forecasters. (page 121)
Marks contrasts the confident ‘I know’ folks with the guarded ‘I don’t know’ folks. The latter believe you can’t predict the macro-future, and thus the proper goal for investing is to do the best possible job analyzing individual securities. If you belong to the ‘I don’t know’ school, eventually everyone will stop asking you where you think the market’s going.
You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture. On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.
No one likes investing on the assumption that the future is unknowable, observes Marks. But if the future IS largely unknowable, then it’s far better as an investor to acknowledge that fact than to pretend otherwise.
Furthermore, says Marks, the biggest problems for investors tend to happen when investors forget the difference between probability and outcome (i.e., the limits of foreknowledge):
- when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
- when they assume the most likely outcome is the one that will happen,
- when they assume the expected result accurately represents the actual result, or
- perhaps most important, when they ignore the possibility of improbable outcomes.
Marks sums it up:
Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage. (page 123)
Or as Warren Buffett wrote in the 2014 Berkshire Hathaway Letter to Shareholders:
Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: firstname.lastname@example.org
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.