June 10th, 2009 by AdvisorAnalyst

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Is being right overrated when it comes to investment strategy and selection? That is a question provoked by Holman Jenkins of the Hoover Institute in his essay, The Financial Markets and Fear Itself. Abnormal Returns’ Tadas Viskanta, says it is:

Much too much is made in the media about who is right, and who is wrong.  (Not that these thing are well tracked.)  On television, in print and on the Internet we are inundated with pundits who crow about their prescience, while omitting their missed forecasts.  The funny thing is that for investors, being right is greatly overrated.

Investors and traders need only worry about one thing:  profitability.  Are you generating requisite profits from your portfolio for the risks assumed?  Everything else is just noise.

The need to be right is a common error for beginning investors.  Any one who has ridden a stock down for a large loss can attest to this.  Behavioral finance experts have a term for this:  the disposition effect.  Investors tend to sell winners too soon, and losers too late.  You could even think of this as ‘get-even-it is.’  Investors do not want to admit that they made a mistake.

David Merkel, an asset manager, and one of our favourite bloggers, on the other hand asks “Do you want to be proud, or do you want to make some money?”:

I’m going to take the other side of this one. This is a bear/choppy market argument. During a sustained bull market, being right makes lots of money.

When I choose stocks, I do all that I can to have the odds tipped in my favor — industry analysis, earnings quality analysis, valuation analysis, balance sheet analysis, free cash flow use, and even a review of the anomalies like momentum, volatility, balance sheet growth, etc.

It’s not perfect, but I typically have 70% winners, and my winners are larger than my losers. Being right helps make money… does anyone doubt that? But hubris destroys.

Does that mean I give up my risk control disciplines? No. I get things wrong, and when I am wrong, I cut my losses. Every 20% move down requires a review — if the thesis is intact, I buy enough to rebalance. If not, I sell.

Also, my methods continually improve my portfolio, selling things with less potential to buy things with greater potential.

Humility is an asset in all of life — it is even more so when it comes to asset management.  Reckless, macho asset management tends to lose, while those that focus on “what could go wrong?” tend to win.  Ben Graham’s main idea was not cheapness, it was margin of safety — we need to focus on safety more, and cheapness less.

In his long and thought provoking article Holman Jenkins makes the point, that contrary to popular belief, hedge fund managers such as the hugely successful John Paulson and Kyle Bass did not foresee the full extent of the financial crisis:

But, you say, didn’t a handful of shrewd hedge fund managers detect a bubble and clean up from betting against it? Yes, fund managers like John Paulson and Kyle Bass made huge fortunes betting against subprime. This doesn’t prove that all the signs were there to be read and so others must have behaved irresponsibly. Think about this: Somebody is always short something, just as others are long the same thing. For every buyer, there is a seller. But those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes.

Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less. The reason they didn’t, it’s reasonable to suppose, is because no more than anyone else did they foresee the catastrophic consequences we now suppose were destined to flow from excessive issuance of subprime mortgages.

Jenkins goes on to explode several more myths and other urban legends:

Here are some of those myths and counterarguments:

Myth: The Wall Street Mill was out to make suckers out of average Americans:

It isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. aig, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.

So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.

Myth: Wall Street’s supposedly greedy compensation machine (These guys were personally eating their own cooking, not just their firms):

Nor is it true that Wall Street executives and CEOs had insufficient “skin in the game,” so that “perverse” compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizeable bonuses in the years in which the securities were created and sold. But most also had considerable wealth in the form of stock and stock options in their firms, which bet their own capital on these securities. Many also appear to have invested directly in funds to hold the subprime securities.

They had skin in the game. Personal losses to top executives in banks that failed or whose share prices collapsed were in the millions, hundreds of millions, and in some cases billions of dollars.

Myth: It was based on the idea that the housing market was going up forever:

The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred.

The designers of these securities, moreover, knew exactly where a disproportionate share of the underlying mortgages were coming from: a handful of counties in southern California, Arizona, and the environs of Las Vegas as well as Florida, where home prices had been rising vertiginously. Far from swallowing the supposed inviolability of the housing-only-goes-up rule, middle-aged mortgage securitization bankers knew that house prices can correct sharply, having lived through regional housing busts in the southwest in the late 1980s, and in New England and California in the early 1990s. Anyone who works in the business knows that the experience of the past half century has been increasing volatility in home prices and a steady rise in the foreclosure rate — a nine-fold increase that began in the 1960s and accelerated in the prosperous 1980s and 1990s.

Finally, there is no national housing market:

Ah, you say, but their risk models and assumptions never allowed for a national drop in home prices. Yes, for good reason — there’s no such thing as a national market for houses. Even well into the subprime implosion, as recently as the middle of 2008, the Federal Housing Finance Agency’s House Price Index was continuing to report stable or rising prices in about half of the 292 metropolitan areas it tracks. Half a million new houses are still going up a year — because people want houses where they want houses.
And he goes on.

Read entire the Holman Jenkins article here.

Read more from the author/contributor here.

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