Buying the dip, speculating

[Tsumitate Wrestler]

Why would pre-cost returns be a useful metric to an individual investor?

He's saying you can do it yourself by trading the securities yourself so no need to give Blackrock a cut.

Right, luckily I have a Bloomberg terminal and a NYSE integrated feed at home. Now where can I subscribe to the years of institutional insight?

[adamu]

It's a good book though. You guys should read it before debating it

[RetireJapan]

Just bought it -thanks for the tip

[Jackson]

Finally figured out the mechanics to do the trades, and looks like the dip is finished, lol!

[ChapInTokyo]

Just bought it -thanks for the tip

It's a good book. Kay's explanation of how momentum rules in the short run, whereas mean reversion rules in the long run, using the investment styles of George Soros and Warren Buffet as an example, is another good part of the book.

Investment strategies for imperfectly efficient markets

The efficient market hypothesis, although illuminating, is not true. Momentum rules in the short run mean reversion in the long run. A day is short run; five years is long run. If there were a means of telling just when the short run becomes the long run, there would be a sure-fire route to making money: ride the wave, jump off before it breaks.

This isn’t possible. The two phenomena of momentum (short-run positive serial correlation) and mean reversion (long-run negative serial correlation) map into two basic investment techniques. One is understanding the vagaries of market sentiment; the other is analysing the sources of fundamental value.

The first strategy seeks to understand the mind of the market and the psychology of its participants – exploit momentum, buy into market rises, sell ahead of market falls. The alternative approach ignores these fluctuations, focuses attention on fundamental value and anticipates that, in the long run, truth will out through mean reversion. The first of these strategies can be associated with George Soros, the second with Warren Buffett. These two men are the best-known and most successful investors of recent decades. Both are now over eighty years old, having begun their public investment careers in the 1960s.

Soros left Eastern Europe as a child refugee. A devotee of Karl Popper, he would prefer to be remembered for his philosophy rather than his fortune. But Soros will go down in history as the man who broke the Bank of England in 1992. His massive bet against sterling on ‘Black Wednesday’ – another contender for the title of ‘the greatest trade ever’ – proved decisive in forcing Britain out of the European Monetary System. Soros’s Open Society network has made large philanthropic contributions to the promotion of education and democracy in post-Communist Eastern Europe. His Quantum Fund – an early example of what is now known as a hedge fund – returned an average of 30 per cent per annum to its investors over the period from 1970 to 2000. The Quantum Fund traded actively, buying and selling currencies or commodities and any other assets that appealed, or failed to appeal, to Soros and his colleagues.

Berkshire Hathaway is Buffett’s investment vehicle, and was a textile company when Buffett took control. Insurance is now Berkshire’s largest business. Insurance premiums are received well before claims are paid, so insurance generates a large float of investable cash. This facilitates investment, and Berkshire owns many companies – from the private jet charter business Netjets to See’s Candies, famous for making the world’s largest lollipop – and large stakes in businesses such as Procter & Gamble and Heinz. Buffett’s investment success has taken him from modest beginnings to vying with Bill Gates (to whose foundation he is donating most of his fortune) as the world’s richest man. Despite that, Buffett still lives in the bungalow in Omaha that he bought fifty years ago, and regularly enjoys a meal at a local steak house washed down with a glass of Cherry Coke (he switched brands after buying a 10 per cent stake in the Coca-Cola Corporation).

There will always be individuals who have outperformed the market – just as there will always be winners of the lottery. I’ll observe in Chapter 8 how exceptional investment performance rarely persists. Most people who do well are lucky rather than clever. But Buffett and Soros not only established outstanding records; they also continued to demonstrate remarkable performance long after they had been widely recognised as the most talented managers of their generation. To win the lottery once may be evidence of either luck or skill; to win it repeatedly is evidence of skill.

You might think that the strategies of the folksy Buffett and the philosophical Soros would be the subject of intense study by students of finance and investment professionals. You would be wrong. These individuals receive a lot of journalistic attention but no academic attention. Since Buffett and Soros cannot exist, according to the strong efficient market hypothesis, they are treated as if they don’t. A lot of ink has been spilt on the proposition that what plainly exists in practice can’t exist in theory.

In turn, Buffett and Soros are open in their contempt for most academic work in finance. They can afford that contempt. But their contempt is not simply the practical man’s disdain for the intellectual – they are both smart and well-read people. They simply believe that much of this academic work is misdirected, engaged in obsessive pursuit of narrow ideas of limited application. The distinction between the market as a mechanism for voting on events and the market as a mechanism for voting on market reactions to events was understood and expressed generations ago by Keynes and Samuelson – and by Benjamin Graham, the first intelligent investor. But the distinction is not understood by many commentators, who regard market judgements as a repository of wisdom not just about the market judgements of other market participants but about the real economy.

The distinction between the anticipation of events and the anticipation of beliefs about events is elided by most finance academics. They understand that there might be such a distinction, but have developed a group of arguments – known, in extreme form, as ‘rational expectations’ – to suggest that the difference does not matter. The rational expectations school is associated with the strong form of the efficient market hypothesis – all information that is capable of being known is already incorporated in prices.

But the distinction between market judgements and underlying realities, the distinction between prices and values, and the distinction between the mind of the market and economic and business fundamentals manifestly do matter. By exploiting divergences between them, Buffett and Soros have made billions of dollars. Both individuals recognise that such divergences are the basis of their success. Buffett shouts from Omaha that markets are only imperfectly efficient. Soros, quoting Keynes’s metaphor of the beauty contest, writes that ‘The fact that a theory is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced … we are ahead of the game because we can limit our losses when the market also discovers what we already know’ (Soros, 2003, p. 25).

The essence of Soros’s investment strategy is to read, and anticipate, the changing mind of the market more successfully than other traders. The essence of Buffett’s investment strategy is to emphasise fundamental values and use the volatile mind of the market as an opportunity to buy assets that are underpriced relative to their fundamental value. I’ll discuss these two broad approaches in the two chapters that follow.