MICHAEL MAUBOUSSIN: Consuelo, I think the answer is buy cheap and hold versus just buy and hold. So there’s a key element of the initial valuation. So for example, let’s go back to 2000. It’s a great point. S&P 500 was trading at something in the high 20s, low 30s on a price earnings multiple or some metric evaluation. By the way, it was very depressed in 1982, and it had basically a 20 year great run. Small caps. At the same time, small capitalization stocks were really quite cheap. In fact, if you look at the value line index, they have a median PE multiple. And the median of that group at the same time the S&P was peaking, was just 13 times.
CONSUELO MACK: Wow.
MICHAEL MAUBOUSSIN: Which means that half of the stocks they followed traded below 13 times. So if you had bought the S&P 500 on that day and held it, you would have done quite poorly. But had you bought the small cap index, for example, you would have actually had a pretty satisfactory decade. So it’s not just buy and hold. It’s buy cheap and hold. And that’s the key thing to insert in there to deliver good returns over time.
CONSUELO MACK: Michael, you’ve written about the role that skill and luck play in investing. To my great chagrin, you have discovered that in fact, luck plays a great role in investing and investing results. So why is it that investing relies more on luck in many respects than it does on skill?
MICHAEL MAUBOUSSIN: Let me start by articulating kind of a continuum in life between pure skill, no luck, and pure luck, no skill. Right? So pure skill, no luck would be like a running race. Right? Where you line people up, and the fastest person is going to win pretty much every time. Pure luck? It’s the roulette wheel or the lottery or something like that. And almost everything in life is somewhere in between. So the question is, where is the combination, relative contributions to both? Now, there’s a very interesting idea called the paradox of skill. And what it says is, when everybody is really skillful at something, the skill basically cancels out and what becomes important is luck. So I think investing is very much in that realm.
And the reason it’s so hard to beat the market is because everybody is really good at it. Everybody works really hard at it. Everyone is working with basically the same information. So it makes things pretty efficient for the most part. And so I don't think it’s all luck, but I think it’s closer to that luck side of the spectrum. As a consequence, by the way, it means you really do have to think about longer time periods to be able to assess a strategy or assess a particular manager, because it’s only over time that the skill will shine through. In the very short term, it tends to be very noisy and very lucky.
CONSUELO MACK: So Michael, what skills do make a difference in investing?
MICHAEL MAUBOUSSIN: I think there are really three things to look for. One is what I’ll call an analytical edge. And that really has two components. One is investors who are consistently looking for differences between price and fundamentals, and that specifically, the asset misspecifies the potential outcome for the fundamentals. The second thing is, once you have an edge, an advantage, the other key thing is how you position your portfolio. Specifically, when you have a really good idea, it should be a bigger part of your portfolio. And when the idea is not as good, it should be a little bit smaller part of your portfolio. It might be like a race track bet. If you’ve got a really great race track bet idea at the horse track, you should put a lot of money into it. If it’s not such a good idea, less money.
The second one is behavioral. And there’s been really wonderful literature on behavioral financial over the last 20 or 30 years, and there’s specific traps or biases that we all tend to fall for. We tend to be over confident. We tend to anchor. The key for an investor is to learn about those things, and more importantly, is to look for investors who develop ways to manage or mitigate those potential mistakes. The other thing on behavioral is what I call a Mr. Market Mindset. Mr. Market is a beautiful metaphor that was developed by Ben Graham, the father of security analysis and long time professor at Columbia Business School. And he had this wonderful metaphor for how the market works. It was this accommodating fellow named Mr. Market who would name a price every day at which he would sell his stake to you or he would buy something from you. And unfortunately, this guy had uneven mood swings. And so some days, he would be very optimistic and want only high prices. Other days, he’d be very pessimistic and would try to shovel everything over to you at a low price. The key is to recognize that he’s not there to inform you, but rather to work with you. And you can ignore him if you want, but when he’s offering high prices, you should be selling. And when he’s offering low prices, you should be buying.
The third and final one is institutional barriers. In other words, there’s a lot of pressure for investors to be with the pack, because they're worried about straying too far from everyone else, or having a portfolio return for some period of time that’s too far from everyone else. So there are institutional pressures. And they want to be sort of with the group. And overcoming one of these barriers, analytical, behavioral or institutional, one or two of them is kind of hard. But overcoming all three is very, very difficult. It’s the rare money manager who can do that. But that is what I would call the skill set that you're looking for.
CONSUELO MACK: You’ve just said that to have all three skills is very difficult to find them. So that tells me, number one, what should I do as an investor? And number two, then should we just invest in index funds? Is it really nigh impossible to find an investor that has these skills sets?
