Steve Forbes Interview: Michael Mauboussin, Professor and Investor (2)? ~ MAKE MONEY BLOG$

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Mean Revision Does Not Mean Mediocrity

Forbes: So let’s get back, again, to looking at managers, skill versus luck, and reversion to the mean. You point out reversion to the mean does not mean mediocrity.

Mauboussin: Right.

Forbes: Explain that – that it’s if you traditionally do well, there are going to be times when you do less well, but you’re still going to be taller than the other person.

Mauboussin: Exactly. So there are a couple important ideas here. First is that, systems that are all skill don’t really revert to the mean at all, right? So, in other words, if we ran a running race, maybe one of us would get fatigued, but if we ran a running race five times in a row, basically, the faster fellow is going to win every single time. So when there’s no luck, there’s really very little mean reversion. But if there’s any contribution of luck and skill together, you’re going to get mean reversion.

The question then becomes: What mean? And to your point, what happens is the skill; the degree of skill defines where our means are set. So that’s if there’s a high-skill player, they may come down a bit from very good peaks, but they won’t go all the way back to the average of the broader population.

I think you alluded to this metaphor of height, but that’s a good way to think about this. So what we know in mean reversion in height is tall parents will tend to have tall children, but not quite as tall as them. So you don’t expect them to go all the way down to the average of the height of all populations, but rather, to something below their parents and in between those two things. So that’s a good example of how to think about that. But mean reversion is a very, very powerful force in investing and something that our minds are not good at getting wrapped around. So it’s crucial for people to understand what it really means and doesn’t mean.

Forbes: So even Warren Buffett can have a cold hand?

Mauboussin: Yeah, folks like Warren Buffett not only can have a cold hand, he will have a cold hand – and by the way, just to clarify on this, I would not say that investing is all luck. There have been some academics that have made that case. I’m just saying it’s toward the luck side of the continuum. But I think there’s evidence, and we’ve seen it in a number of different ways to prove it, that there is skill in investing.

Forbes: So in terms of, again, the investor evaluating the manager. Since we know three years, five years may not do justice, focusing on the process, you have to have faith that they know how to pick the value stocks.

Mauboussin: Exactly. And you’re just saying, “Which poker player would I like to back?” or, “Which blackjack player would I like to back?” How would you think about that? You might look at how they’ve done in recent tournaments. But the most likely approach that would make sense is to look how they think about the problems. Do they understand the mathematics? Do they understand the psychology?

The same applies for investing. There are behavioral aspects as well – a lot of it has to do with psychological make-up. Are they aware of sort of the latest findings in behavioral psychology and how that applies to the world of investing? And then there are a lot of organizational pressures as well. There are a lot of money manager firms that they’d be more content to sort of stay with the pack, sort of do what everybody else is doing versus being too extreme in one way or another.

And that, of course, is going to mean almost by definition your results will be more toward average, and when you’re charging fees to do that, that’s unlikely to lead to very satisfactory results in the long haul.

The Coffee Can Approach

Forbes: In one of your papers, you cite the story of a fellow who managed his own money and also managing his wife’s money. With his wife’s money, he took the very cautious approach of following the recommendations of the firm, and with him, he just in effect, as you put it, threw it in the coffee can. Bought something and just forgot about it. Turns out, the coffee can approach vastly exceeded the very sensible approach of buy, sell, follow recommendations. Again, explain how that unfolds.

Mauboussin: Yeah, isn’t that just a wonderful story? People now have been very down on the idea of buy and hold, especially since we’ve had roughly a decade of flat stock price performance. But it’s really not buy and hold that matters. It’s buy cheap and hold.

And I think that story really illustrates that point. The fellow you’re talking about is Bob Kirby, who is one of the founders of Capital Guardian out in California. And to your point, he was running the wife’s portfolio and he was following all of the firm’s advice for buying and selling.

So he was very meticulous in making sure that they did all the right things. It turns out he was placing the orders through the husband. Every buy recommendation he’d take $5,000, buy the stock, and chuck the stock certificate into a vault – never paid any attention to it. And unfortunately, the husband passes away and the wife says we’re going to converge this. And when Bob looked at the husband’s account, he was both appalled and he was shocked.

He was shocked first, because he had followed all the recommendations only on the buy side. But he was appalled to see that the account had risen to much greater value than his wife’s. So basically doing nothing, paying no attention to it, had built a lot more value. And it turns out there was one company in particular that did extremely well in there

Forbes: Xerox.

Mauboussin: A company called Xerox, which in the day was a really hot stock. So the idea is, not recommending that people go out and find the next Apple or Google or whatever it is, but rather to say that buying things cheap and just holding them – and by the way, that’s classic Warren Buffett, right? He’s got these great lines about sitting around and doing nothing is kind of our investment strategy. If we buy them right, the businesses create value, and over time they’ll compound and create a lot of wealth. So I think that is the major message: Often we make moves to try to improve our stead, and in fact, we detract from our position.

Forbes: So what’s an investor to do? You are, in effect, saying indexing – even though indexing has its problems because it rides with the winners and underplays the losers.

Mauboussin: Yeah, so I would say that much of this is idiosyncratic. Different people have to do different things, but by and large, people should certainly save as much as they possibly can and they should have some percentage of it in the stock market. I think indexing does make a lot of sense, basic indexing – and obviously diversified now, increasingly globally as well. And that, for most people, will be fine. But, again, the only way to generate returns above the benchmark is to have active management.

And the only way to do that is to find managers who themselves are making very good decisions that over time will play out well. So for those individuals that are motivated, I would try to use that template of saying, “Are they making good analytical decisions? “Are they making good behavioral decisions?” And, “Is their organization conducive to them doing well over time?”

And if those things click into place, then you probably allocate some percentage of your portfolio to those kinds of folks. It’s just like saying, “Hey, I’m going to bankroll a guy playing poker, he or she may not win every single night, but if their process is good, over time they should do fine.”

Older Investors

Forbes: Now, what’s an older investor to do? Take somebody who’s 60. What would you recommend? I mean, with all the caveats, you know, depending on the person, blah, blah, blah, but the tendency for older investors is to say go more short term. Yet we now know, given a little luck, it’s probably going to be around another 20, 25 years.

Mauboussin: Yeah, I heard once Jim Grant – have you heard him talk about it? He said, “Roll back the calendar 30 years, and that’s your best advice. Go back to being 30.” It’s a very difficult spot, I think, for many older investors.

I guess one of the things I would probably look to is the equity markets, but in particular, high-dividend-yielding stocks. I think that’s one part of the market. The market itself doesn’t seem to have onerous valuations, certainly in my view, and high-dividend-paying stocks may be one of the ways to generate that income, have relative safety. Of course the market always has its vagaries, but that might be one strategy that would make sense. It’s very, very difficult, certainly, with fixed income instruments.

The yields that we’re seeing today with the 10-year Treasury Note below 3%, there’s just not a lot of yield out there for folks that are looking for shorter time horizons.

Still A Blue-Chip Market?

Forbes: Now, a question on the market today. You still think this is a market for big capitalization stocks, dividend-yielding stocks? Hear a lot of that. Is there a consensus emerging that should make us cautious?

Mauboussin: Exactly. I think there’s been a consensus about this that’s made us cautious for some time. Yeah, it’s very difficult to know, right? One of the things I know by studying expert performance is no one really does know what’s going to happen. But you can start to say things or look at things probabilistically. And I would just say that given prevailing interest rates, given the implied equity risk premium, given the performance of a lot of these companies and their cash positions, they still do look to be attractive values.

I would be encouraged if more companies chose to be more systematic in returning cash to shareholders, either via dividends or share repurchases. I think they’ve been slow to do that, in part because they’re still cautious out there.

But we’re seeing some positive signs. I mean, if you believe the earnings consensus numbers for 2012, we’re under 13 times earnings. We’re seeing the M&A market here pick up. The economy is improving. It will always have fits and starts, but it seems like the general trend is okay. So it seems to me a fairly constructive backdrop, but as always, who knows the answer?

Forbes: So what you seem to be saying is if you feel good, don’t; if you feel bad, do it.

Mauboussin: That’s usually right. And Warren Buffett’s got a pithier way of saying that, which is, “Be fearful when others are greedy, and greedy when others are fearful.” And it’s very, very difficult to do in terms of our own human emotions. But that really is the idea. When everyone’s despondent, it’s time to load up the truck. And when everyone’s feeling very good about things, it is time to be cautious or selling.

So that is right. And I think my sense is when I go talk to people, they’ve really had it with, certainly, the U.S. stock market. They’ve had it. It’s been a dismal decade and people have a hard time seeing brighter days ahead. But one of the lessons from mean reversion, by the way, is it would say that after having suffered a ten-year poor period – and by the way, it’s one of the worst ten years we’ve had in the last 150 years – we do tend to mean revert back up. Which would give you expected returns from the market of 7% or 8% over the next decade. Which is not shooting the lights out, but it would be a lot better than what we’ve been through.

Forbes: So in conclusion, give us your three main lessons. Reversion to the mean.

Mauboussin: Sounds like you might have them better than I do.

Forbes: All right, reversion to the mean. And as you just said, dismal decade doesn’t mean the next couple of decades are going to be dismal. Doing my job – call it the Steinbrenner principle. Bad start doesn’t mean the Yankees are going to have a bad season.

Mauboussin: That’s right, yeah. So mean reversion is just a very big idea that’s very hard to implement mostly for psychological reasons. By the way, you see this in sports all the time. People get very caught up in short-term statistics that don’t really reveal the ultimate system.

And that’s very important for the world of investing. You have to take a step back and say, “What does the long-term look like? What do the structural trends look like?” And see where you stand relative to those basic trends and try to take advantage of them.

Forbes: This leads also, doing my job, into what you call recency bias, which is another way of saying rear-view mirror investing.

Mauboussin: That’s right.

What About Institutions?

Forbes: How do you advise institutional investors – especially a CIO who knows that even though he shouldn’t be judged on the last game, he is going to be judged on the last game – to get a more sensible horizon?

Mauboussin: It’s a very hard thing to do. By the way, I’ve also studied and written about investment committees. Investment committees aren’t going to let you off the hook easily on that as well. I mean, the key is to always say, ‘What are the facts before us today?”

We always work with incomplete information in markets and say, “What were the facts, what behaviors do the facts dictate?” Your point is exactly right. The recency bias or the rearview mirror phenomenon is extremely powerful for all humans. What’s happened recently, we tend to extrapolate as to what’s going to happen in the near term. And so an ability to try to separate yourself from that every day in a sense is brand new. Every day we say, “What facts do we have before us, what information do we have?” And try to make the best decision possible.

Forbes: So even if you pick good value, cheap can become cheaper.

Mauboussin: Cheap can become cheaper, and in that case, by the way, time can often be on your side – you can buy more of that, in that case, if you believe that nothing else has changed. But patience is the key issue, and it’s very difficult to do in this day and age. But that’s how the great investors have made lots of money over the years.

Forbes: Michael, thank you very much.

Mauboussin: My pleasure, Steve.

source: forbes.com
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