MICHAEL MAUBOUSSIN: I think that’s very likely. And in fact, you can even make that argument going back in time. Because for example, we’ve had very steady buying from Asian central banks, in particular, China. And there have been estimates that that has depressed the yield somewhere between 50 and 150 basis points, or half a percent to one and a half percentage points. So I think that argument has been true.
So the key is to look at the absolute expected returns for equities. And you pointed out in your math a moment ago, it looks like it’s a little bit over 8%. And going back to the same fundamentals, as we know, balance sheets in corporate America, there may be lots of worries at the federal government level, and there may be some balance sheet concerns for individuals, but corporations are still in really good shape. It fits and starts, but we're probably the earlier phase of the recovery. The recovery continues. And a lot of these large companies and these S&P, they're multi-nationals with great exposure, and they're trading at relatively bargain basement valuations. So when you look out three to five years and you say, how do I look at bonds versus stocks, they really do look quite attractive.
CONSUELO MACK: Let me ask you about behavioral finance. And the fact is that you have said earlier that behavior is key to understanding the markets and understanding your role in it. So give us a little bit about kind of what’s the leading edge thought now in behavioral finance and investor psychology? What do we need to know as individual investors?
MICHAEL MAUBOUSSIN: Well, I mean, by the way, this is not only a fascinating literature, it’s a really important literature. And it’s not just investing, but it’s really all facets of your life. The way I like to think about this is when we're faced with certain types of situations, this is all of us, our minds are naturally going to want to jog down one path when there’s a better way to think about the problem. So you have to learn about those kinds of situations, almost build them up in a little mental rolodex in your mind. Being able to identify them in context, to pick them out when you see them professionally or personally, and then finally, develop tools and techniques to manage and mitigate them. So the first step is really learning about these things, and then the next is managing them. So we have lots of different examples.
CONSUELO MACK: So give me an example.
MICHAEL MAUBOUSSIN: One of my favorite ones is something called the inside versus the outside view. And I guess I’ll introduce this by telling a story of a race horse, Big Brown. Three years ago, along came a beautiful colt named Big Brown. He won the Kentucky Derby very convincingly, four and three quarters lengths. He went on to win the Preakness.
CONSUELO MACK: Preakness.
MICHAEL MAUBOUSSIN: By five and a quarter lengths, even stronger. So he’s one step away from horse racing immortality, right, which is the Triple Crown. And by the way, he had a trainer who was gushing with confidence. He said, “It’s a foregone conclusion that my horse is going to win the race.” And in fact, handicappers weren’t too far behind him. He went off at three to ten odds, which if you work out the math is about a 77% probability.
So what happened in the Belmont? It was a hot and steamy day. Attendance doubled, because people wanted to come see history made. And he made history, which he was the first Triple Crown contender ever to finish last in the last leg of a Triple Crown. So what do you take away from that? This is the inside versus the outside view. And the inside view says when we solve problems, all of us, the way we typically do this is we gather lots of information, we combine it with our inputs and then we look into the future. And that could be when will I hand in my term paper, when will we launch our new product as a company? The outside view by contrast says when I'm looking at my problem, I'm going to think of it as an instance of a larger reference class. And I'm basically going to say when other people have been a situation before, what happened?
So now we can go back and look at Big Brown using the inside versus the outside view. Now the inside view is, great looking colt. He’s undefeated. Right? And the trainer is gushing with confidence. The outside view would ask the question, what happened when other horses were in this situation before? And as it turns out, there were 29 horses in a position to win the Triple Crown. Eleven of those succeeded. But here is the interesting thing: eight of the nine horses that tried before 1950 succeeded, like 90% success rate, but only three of 20 since 1950 succeeded, which is about a 15% success rate. It sort of dampens your enthusiasm for Big Brown’s prospects. And by the way, none had done it since 1978. Now your response to that might be, well, maybe he’s just really fast. Maybe he deserves those odds because he’s so good. And it turns out there’s a way to measure that, something called the speed figure, which measures a horse’s performance adjusted for just certain conditions. Well, it turns out of the last six Triple Crown aspirants, Big Brown was by far the slowest. He was downright lead hoof compared to these other horses.
So now we have two important pieces of information. One is a very low base rate of success, and by the way, not a particularly good horse try. So he was clearly the favorite to win that race. I want to be clear about that. But at 77% probability, he’s a massive underlay. It’s not a big transportation to go over to financial markets to think about the same thing. Right? The odds are basically the price, what is anticipated will happen. And the fundamentals are how fast the horse can run. And what as an investor you're always looking for is a disparity between price and fundamentals. Same idea. It’s a little harder to do in investing than it is at the race track, but it’s the same fundamental concept.
CONSUELO MACK: So I'm thinking of the Big Brown equivalents. There are portfolio managers, for instance, who have beaten the market- Bill Miller, Legg Mason, 15 years in a row, and then he didn’t beat the market. So there’s something that you’ve talked about a lot called reversion to the mean, as well. So talk to me about, if I'm looking at my portfolio manager and they’ve had a streak, they’ve had a great run, no one else did it besides Bill for 15 years, how do I apply that outlier, that outside the box analysis, to my portfolio manager that I’ve invested in that’s done really well?
