John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Enron and WorldCom: They are two of the most infamous names in stock market history. Both of these apparent growth dynamos went up in flames amid major accounting frauds in the early 2000s, dealing investors painful blows.
What's amazing is that if the investing world had paid a little more attention to quantitative models, a lot of that pain could've been avoided. That's one of the many interesting things I've learned from Wesley Gray and Tobias Carlisle's book Quantitative Value. They highlight several studies, largely unknown to investors, in which academics developed models that do a very good job identifying companies likely to be manipulating their financials and/or in danger of going bankrupt. The models they turned up, some of which were several decades old, indicated that both Enron and WorldCom were flashing clear warning signals before their demises.
So, why didn't these models get more attention prior to those companies' bankruptcies?
I think the answer involves the same reasons that investors habitually underperform the broader market averages. People are emotional creatures, and we love stories that tug on our emotions. Quantitative models may have cold, hard data, but they don't excite us.
Another reason investors turn a blind eye to models: People like to do things themselves, and they are overconfident in their abilities to do those things. As Philip Tetlock wrote in his book Expert Political Judgment, "Human performance suffers because we are, deep down, deterministic thinkers with an aversion to probabilistic strategies that accept the inevitability of error." We humans want to be right every time. And we think we can be. It's just a matter of learning enough, gaining enough experience, or focusing well enough, we think. We surely have far greater and more complex analytical abilities than some silly formulas, we believe.
We also think that, unlike models, we can improve our predictive abilities exponentially over time. When it comes to the stock market and all of its unpredictable drivers, however, we just can't. Mr. Tetlock's research detailed a seven-year study he conducted in which supposed experts and non-experts were asked to predict an array of political and economic events. His findings: The best human forecasters "were hard-pressed to predict more than 20 per cent of the total variability in outcomes" of events. Mr. Tetlock found that sophisticated algorithms could explain 47 per cent of outcomes – more than twice as much as "expert" human forecasters.
In What Works on Wall Street, James O'Shaughnessy cites one study that reviewed 45 different studies comparing human and actuarial predictive ability. Humans lost every time – even if they had access to the actuarial models before making their predictions.
How can this be? Mr. O'Shaughnessy explains: "Models beat human forecasters because they reliably and consistently apply the same criteria time after time. Models never vary. They are always consistent. They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They don't favour vivid, interesting stories over reams of statistical data. They never take anything personally. They don't have egos. They're not out to prove anything."
The boring consistency of models is why they beat humans – and why humans avoid models. And their boring consistency highlights a great irony of the stock market: The investors who produce the flashiest returns usually do so in the unsexiest of ways. They don't load up on high-risk, exciting tech stocks, or try new, flavour-of-the month strategies. They stick to the basics. Whether they use models or not, they analyze a company's balance sheet, competitive position, and valuations. And when the numbers tell them to buy, they buy – regardless of what their own fickle emotions might be saying. As hedge fund guru George Soros once said, "If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring."
Fundamentals and balance sheets and quantitative models may sound boring. But in the market, it turns it turns out that boring is beautiful.
John Reese