More Than You Know

by Michael J Mauboussin

  What kinds of things do we do in response to stress? Sapolsky notes that our reactions are “generally short-sighted, inefficient, and penny-wise and dollar-foolish.” The body mobilizes to deal with the immediate threat. This stress response is effective in a crisis but can be very costly if you experience every day as an emergency.2

  Why Money Managers Do Get Ulcers

  The research shows that stress stems from a loss of predictability and a loss of control, where the common element is novelty. I believe that secular trends in the economy and in the money management industry are contributing mightily to the sensation of less predictability and control.

  The loss of predictability, for instance, reflects the accelerating rate of innovation in the global economy. For example, the average life of a company in the S&P 500 Index has gone from roughly twenty-five to thirty-five years in the 1950s to about ten to fifteen years today (see exhibit 10.1).3

  EXHIBIT 10.1 Average Lifetime of S&P 500 Companies

  Source: Foster and Kaplan, Creative Destruction, 13. Reproduced with permission.

  The spectacular rise and fall of companies in recent years certainly adds to the feeling that business is less predictable than ever before.

  We also see the lack of predictability in the volatility data. While market-level volatility has been stable, firm-specific risk has been steadily rising since the 1970s. Although the volatility of a market portfolio has not changed much in the last few generations, money managers today have a higher risk than ever of being in the wrong stocks.4

  The loss of control not only reflects actions within the portfolio but also evaluation of the portfolio by the owners. Shareholders and mutual fund rating companies judge money managers at least every ninety days, and in order to keep their assets, many money managers try to minimize tracking error versus their benchmark. Managing tracking error often requires mirroring the market and generally entails short-term trading.5 In a sense, reducing tracking error is rational for money managers because there’s no use worrying about how the portfolio will perform over the next three years if you’re out of a job along the way. But closet indexing is not ideal for shareholders.

  The concern about a flightier investor base is well founded. In the 1950s, the average holding period for a mutual fund was over fifteen years. By 2006 the holding period had shrunk to about four years.6 Pension fund administrators, too, are becoming more active in hiring and firing fund managers. For example, in 2001 the state of Florida sacked Alliance Capital in part because of losses in Enron and despite Alliance’s good long-term performance.7

  I believe the perceived loss of predictability and control is causing many money managers chronic stress. And the predictable reaction to stress can lead to suboptimal portfolio-management decisions.

  Shortening Horizons

  What are the physical responses to stress? In effect, we get primed to take care of business in the here and now. Our blood pressure rises, our body mobilizes energy to the tissues that need it most, our short-term memory improves, and we set aside long-term projects like immune systems and reproduction. With a physical stressor, focusing on the short term versus the long term can be the difference between life and death. When the stress passes, we can return to a more balanced state. But chronic stress keeps us on high alert, suppressing our natural balance.

  Of particular importance for money managers, stress encourages a short-term focus.8 Recent research shows that people (like other animals) often prefer small, immediate rewards to larger rewards in the future. For example, people prefer one apple today over two apples tomorrow. But if the trade-off is far enough in the future—for example, one apple in a year versus two apples in a year and a day—people are prepared to wait for the higher reward. Seeking short-term gains at the expense of more attractive long-term rewards is suboptimal for long-term investors.9

  How do we know that money managers are increasingly short-term oriented? We see it in the portfolio turnover data. Average portfolio turnover has surged in recent decades, going from roughly 20 percent in the 1950s to well nearly 100 percent today (see exhibit 10.2). In 2006 alone, one out of fourteen equity funds turned its portfolio over at an annual rate of 200 percent or more; three in ten funds in excess of a 100 percent rate; and only one in four turned less than 30 percent.10

  EXHIBIT 10.2 Mutual Fund Turnover, 1946-2006

  Source: Bogle Financial Markets Research Center. Reproduced with permission. Morningstar, Inc., author analysis.

  The turnover rise in the “passive” S&P 500 Index and lower commission costs suggest that a reasonable turnover level today is certainly higher than it was thirty or forty years ago. But most money managers are turning their portfolios too rapidly, resulting in substantial transaction and market impact costs, as well as an unnecessary tax burden. Short-termism is eating portfolio performance.

  In the highly competitive money-management business, costs often play a prime role in separating the best- from the worst-performing funds. So we would expect to see a correlation between high turnover and low relative return. The data bear this out. In 1997, Morningstar did a comprehensive study of turnover and performance for U.S. equity funds. It showed that low-turnover funds outperformed high-turnover funds over various time horizons (see exhibit 10.3).11 The study also suggested that turnover did enhance performance for riskier funds, a finding that the academic research also supports.12

  When updated through year-end 2006, these data show a similar result. Analysis confirms that the second-lowest turnover group (20 to 50 percent) delivered the best returns over the past one-, three-, and five-year periods. Based on this analysis, we believe that the appropriate turnover for an active fund is somewhere in the 20 to 100 percent range. The low end, with an eighteen-month to five-year implied average holding period, appears appropriate for value funds and the upper end’s twelve to eighteen months look reasonable for growth funds. These guidelines are subject to numerous caveats.13

  EXHIBIT 10.3 Portfolio Turnover and Long-Term Performance

  Source: Morningstar, Inc.

  Imitating Ulysses

  Go to your doctor with the symptoms of stress, and you’ll get a standard list of recommendations: seek support from social networks, exercise sufficiently, and make sure you have a healthy diet. How do you deal with the repercussions of stress in money management? The prescription is to work hard on maintaining an appropriate long-term focus.

  Ulysses had the crew bind him to the mast of his ship to protect him from the call of the Sirens. Money managers, especially when feeling a loss of predictability and control, are drawn to short-term activity. Like Ulysses, money managers should take the steps necessary to focus on the long term if they are to optimize long-term fund performance. If the source of stress is largely psychological, so too is the means to cope with it.

  11

  All I Really Need to Know I Learned at a Tupperware Party

  What Tupperware Parties Teach You About Investing and Life

  Anybody familiar with the workings of a Tupperware party will recognize the use of various weapons of influence.

  —Robert Cialdini, Influence: The Psychology of Persuasion

  Tupperware . . . developed what I believe to be a corrupt system of psychological manipulation. But the practice . . . worked and had legs. Tupperware parties sold billions of dollars of merchandise for decades.

  —Charlie Munger, in Whitney Tilson, “Charlie Munger Speaks—Part 2”

  A Tip from Shining Shoes

  Nearby my old office building, the window of a shoe store advertised the generous offer of a free shoe shine. I walked by this store dozens of times and thought nothing of it. One day, though, with my shoes looking a little scuffed and some time on my hands, I decided to avail myself of this small bounty.

  After my shine, I offered the shoeshine man a tip. He refused. Free was free, he said. I climbed down from the chair feeling distinctly indebted. “How could this guy shine my shoes,” I thought, “and expect not
hing?”

  So I did what I suspect most people who take the offer do—I looked around for something to buy. I had to even the score, somehow. Since I didn’t need shoes, I found myself mindlessly perusing shoe trees, laces, and polish. Finally, I slinked out of the store empty-handed and uneasy. Even though I had managed to escape without pulling out my wallet, I was sure many others weren’t so fortunate.

  A topic that is fascinating in investing—and in life—is why humans act the way they do. A few months after my sweat-on-the-brow-inducing shine, I read Robert Cialdini’s Influence: The Psychology of Persuasion, a book that provides many of the answers to this question.

  Cialdini’s work over the past three decades has concentrated on what induces a specific form of behavior change: compliance with a request. Cialdini argues that six tendencies of human behavior spur a positive response to a request.1 All these tendencies are important to understand for life, and a few of them are particularly important for investors.

  As I read Cialdini I realized that the shoe store was preying on an essential rule of human conduct—the code of reciprocity. If someone gives you something, you feel that you must give something in return. If you want to use this innate tendency to your advantage, you give something small and ask for something large in return. A two-dollar shoeshine for two-hundred-dollar wing tips is a good trade.

  I take a brief look at each of the tendencies, discuss how party sellers use them, and highlight the three tendencies most important for investors.

  You Can Fool Mother Nature

  Here are the six tendencies—reciprocation, consistency, social validation, liking, authority, and scarcity—along with brief descriptions. While Cialdini does not strongly stress the point, I believe these tendencies are deeply rooted in evolutionary psychology. Each behavior likely contributed to the reproductive success of our forebears.

  • Reciprocation. Research shows that there is no human society that does not feel the obligation to reciprocate.2 Companies make ample use of this tendency, from charitable organizations sending free address labels to real estate firms offering free house appraisals.

  • Commitment and consistency. Once we have made a decision, and especially if we’ve validated that decision through public affirmation, we’re loath to change our view. Cialdini offers two deep-seated reasons for this. First, consistency allows us to stop thinking about the issue—it gives us a mental break. And second, consistency allows us to avoid the consequence of reason—namely, that we have to change. The first allows us to avoid thinking; the second allows us to avoid acting.

  • Social validation. One of the main ways we make decisions is by observing the decisions of others.3 In a famous illustration of this point, psychologist Solomon Asch put a group of eight subjects in a room and showed them a series of slides with vertical lines of various lengths. He asked the group to identify which line on the right matched the length of the one on the left (see exhibit 11.1). The answer was obvious, but Asch instructed every member of the group, save one, to give the same, wrong answer.

  The subjects, bright college students, were clearly confused, and one-third of them went with the majority view even though it was obviously incorrect. While extreme, Asch’s experiment shows how we all rely to some degree on what others do.4

  EXHIBIT 11.1 The Asch Experiment

  Source: Illustration by author, based on Asch, “Effects of Group Pressure Upon the Modification and Distortion of Judgment.”

  • Liking. We all prefer to say yes to people we like. We tend to like people who are similar to us, who compliment us, cooperate with us, and who are attractive.

  • Authority. In one of the most enlightening and unsettling human experiments ever, social psychologist Stanley Milgram (of “six degrees of separation” fame) had subjects come in and play the role of “teacher” for a “learner.” The subjects asked the learner questions, and were told by a stern, lab-coated supervisor to administer progressively stronger electric shocks in return for incorrect answers. The learners would scream in pain and beg for mercy to avoid the increasingly painful shocks. Even though they were never forced to do anything, nor were they subject to reprisal, many of the subjects ended up doling out lethal shocks.The learners in this experiment were actors and the shocks fake, but Milgram’s findings were real and chilling: People obey authority figures against their better judgment. Here again, the behavior generally makes sense—authorities often know more than others about their field—but such obedience can lead to inappropriate responses.5

  • Scarcity. Evidence shows humans find items and information more attractive if they are either scarce or perceived to be scarce. Companies routinely leverage this tendency by offering products or services for a limited time only.

  These tendencies are singularly powerful. But when they are invoked in combinations, they are even more potent and create what Charlie Munger calls lollapalooza effects (yes, lollapalooza is in the dictionary).

  All I Really Need to Know . . .

  The seemingly innocuous Tupperware party, which according to The New York Times is “back with a vengeance” in the affluent suburbs of New York City, captures such lollapalooza effects.6

  The Tupperware party takes advantage of four of the six tendencies. This is big business: Tupperware generates annual sales of about $1 billion from its in-home “consultants.”

  First is reciprocity. Early in the party, there is a quiz game that allows participants to win play money that they can “spend” on giveaway items. Each participant is also encouraged to share with the group the uses of products she has already purchased—evidence of commitment. Once the buying starts, each transaction demonstrates that others want the product, providing social validation.

  But perhaps the single most important facet of the Tupperware formula is the tendency to say yes to people you like. The purchase request comes not from a stranger, but rather a friend. Indeed, the Tupperware handbook counsels the salespeople to use the “feel, felt, found” method, effectively encouraging similarity through empathy while still highlighting product features.

  Combine these effects, and it’s not hard to see why many people try to avoid going to Tupperware parties in the first place: they know that once they are there, they will buy something. For example, the Times reported that one attendee spent “far more than she had planned,” no doubt swept up by the lollapalooza effect.

  The Psychology of Investing

  Investors need to pay a great deal of attention to what influences their behavior. Three of Cialdini’s six tendencies are particularly relevant for investors: consistency and commitment, social validation, and scarcity.

  Psychologists discovered that after bettors at a racetrack put down their money, they are more confident in the prospects of their horses winning than immediately before they placed their bets.7 After making a decision, we feel both internal and external pressure to remain consistent to that view, even if subsequent evidence questions the validity of the initial decision.

  So an investor who has taken a position in a particular stock, recommended it publicly, or encouraged colleagues to participate, will feel the need to stick with the call. Related to this tendency is the confirmation trap: postdecision openness to confirming data coupled with disavowal or denial of disconfirming data. One useful technique to mitigate consistency is to think about the world in ranges of values with associated probabilities instead of as a series of single points. Acknowledging multiple scenarios provides psychological shelter to change views when appropriate.

  There is a large body of work about the role of social validation in investing. Investing is an inherently social activity, and investors periodically act in concert. Awareness of breakdowns in the diversity of opinion and respect for extreme valuations can help offset the deleterious impact of social validation.

  Finally, scarcity has an important role in investing (and certainly plays a large role in the minds of corporate executives). Investors in particular seek informational
scarcity. The challenge is to distinguish between what is truly scarce information and what is not. One means to do this is to reverse-engineer market expectations—in other words, figure out what the market already thinks.

  12

  All Systems Go

  Emotion and Intuition in Decision Making

  People base their judgments of an activity or a technology not only on what they think about it but also on what they feel about it. If they like an activity, they are moved toward judging the risks as low and the benefits as high; if they dislike it, they tend to judge the opposite—high risk and low benefit. Under this model, affect comes prior to, and directs, judgments of risk and benefit.

  —Slovic, Finucane, Peters, and MacGregor,

  “Risk as Analysis and Risk as Feelings”

  We sometimes delude ourselves that we proceed in a rational manner and weight all of the pros and cons of various alternatives. But this is seldom the actual case. Quite often “I decided in favor of X” is no more than “I liked X.” . . . We buy the cars we “like,” choose the jobs and houses we find “attractive,” and then justify these choices by various reasons.

  —Robert B. Zajonc, “Feeling and Thinking:

  Preferences Need No Inferences”

  The strategies of human reason probably did not develop, in either evolution or any single individual, without the guiding force of the mechanisms of biological regulation, of which emotion and feeling are notable expressions. Moreover, even after reasoning strategies become established in the formative years, their effective deployment probably depends, to a considerable extent, on the continued ability to experience feelings.