Speed Traps and Value Traps
Two finance professors from UCLA and the Helsinki School of Economics released a study exploring the correlation between individuals prone to getting speeding tickets and the tendency to churn investment portfolios. They conclude that an average investor’s portfolio saw an 11 percent increase in the turnover ratio for each additional ticket received. This is a highly significant finding according to statistical methods.
A couple of possible explanations the academics propose are overconfidence and thrill seeking behavior. Although overconfidence might play a small explanatory role, they find that the trait of thrill seeking behavior is the greatest determining factor for over-trading and portfolio turnover. The cumulative cost of transactions plays a big role in keeping performance down. Maybe the stereotype of the Ferrari-driving, rapid-fire hedge fund trader strung out on cocaine is appropriate after all.
I think their study is on to something but I do have a few points to add to their conclusions. My good friend and I have always thought that we could learn more about an individual by watching him drive than by sitting in a conference room interviewing him. We had discussed hiring future analysts or portfolio managers for my fledgling private investment partnerships by taking them out on “test drives.” The candidate would not know his driving would be scrutinized; we would just be taking a circuitous route to lunch. However, I would not be as concerned about speeding as I am about the driver’s ability to anticipate and assess his environment. I want to see someone who tries to minimize his braking and increase fuel efficiency by looking ahead and anticipating the rhythm of the traffic lights. What I don’t want to see is someone speeding to an intersection only to see at the last minute a red light that had already been there for the last 30 seconds and subsequently coming to a hard stop. That is a sure sign of a dumb driver who only sees 5 feet in front of him, analogous to an investor or trader that only sees the next up-tick or down-tick in the stock market while missing the big picture. Speeding in and of itself is not a problem for me. If a driver is speeding just for the sake of speeding, then he may not be a good potential hire. If he is speeding up to time the traffic lights and ensure an efficient ride, he is demonstrating forethought, anticipation, and awareness of the situation. I believe that such a driving test can reveal far more about a person’s investment temperament and fitness for managing capital than a series of interviews where the candidate is putting forth his best (read phony) image.
Here are a few good tips from Uncle Bob’s 70 Rules of Defensive Driving along with their investment parallels:
Rule 17 - Know Your Blind Spots: An investor must overcome centuries of evolutionary development and neurological “hardwiring” in order to outperform the market. For example, humans have evolved to become social animals for survival reasons; it is much easier to hunt antelope with a team than to do it alone. Unfortunately, this evolutionary trait does not translate well to investing as we become lemming-like in our behavior. That goes for both growth and value investors. We witness growth investors piling onto a skyrocketing stock only to buy at the peak before a precipitous plunge. We also see value investors copying value gurus and getting into deservedly cheap companies on their way to getting cheaper. There are many other such hardwired cognitive tendencies that lead us to poor investment practices. Always attempt to be aware of what your brain is doing to blindside you.
Rule 13 - Create Space & Use the Two-Seconds-Plus Rule: I just talked about not copying value gurus, but I’m about to cite Benjamin Graham’s Margin of Safety, most famously practiced by Warren Buffett. Margin of safety implies that an investor leave enough space between the stock’s current price and his perceived intrinsic value. If the perceived intrinsic value is only slightly higher than the stock’s price, then there is virtually no margin of safety. If the perceived intrinsic value is double the stock’s current price, then the margin of safety may be large enough to warrant an investment.
Rule 18 - Avoid Distractions: Peter Lynch of Magellan Fund fame recommended investing in what you know. Buffett called this staying within your circle of competence. Thrill-seeking investors might want to dabble in futures or commodities to juice the returns on their stock portfolios; this path leads to near certain destruction. Distractions take time away from what you know best; the subsequent loss of focus and concentration means that you have more positions of average or sub par investment merit.
Rule 16 - Always Signal Your Intentions: Don’t do this; this is one rule good investors do not follow. From Warren Buffett to the top hedge fund managers, telling others what you’re about to invest in is simply something not done. Revealing what you hold after you’ve established your position might make sense in some situations. Competition for assets leads to average or poor performance, best to stay secretive or discreet.
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