Jim O’Shaughnessy is the Chairman and Chief Investment Officer of O’Shaughnessy Asset Management (OSAM). He was a pioneer in quantitative equity research, part of an early group of explorers who combed through data to find factors which predicted future stock returns. O’Shaughnessy is the author of four books on investing.
- “Mandelbrot basically demonstrates that markets are not log normal but chaotic normal. They have much more of a peak and the tails are much longer.” “We are, by our very nature, story-loving animals, and we create stories to create narratives that help us make sense of what is going on around us in the world, and many times, those stories are wrong. And so, from our perspective, trying to make a successful forecast, short-term forecast, is a virtual impossibility, because, in the short term, there’s quite a bit of noise in the marketplace. And people mistake noise for signal, and they have a narrative about it, and it’s very believable, but unfortunately, often wrong. So we don’t make forecasts in terms of what the market’s going to do over short periods of time because quite frankly, we don’t know. And if others were honest, they would have to admit that they don’t know, either. However, we do make forecasts based on very long-term time in the market.” “I don’t know how the market will perform this year. I don’t know how the market will perform next year. I don’t know if stocks will be higher or lower in five years. Indeed, even though the probabilities favor a positive outcome, I don’t know if stocks will be higher in 10 yrs.”
O’Shaughnessy recommends the book “The Misbehavior of Markets” by Benoit Mandelbrot and Richard Hudson. I second that recommendation. Given what Mandelbot identified in his work on financial markets, how should an investor respond? One approach is to limit your investments to areas where you can use statistically determined factors in domains where you have very large amounts of long-term data from the past to gain an investing edge. Another approach is to use an analytical style to find an investing edge that is behavioral, analytical or informational that does not involve statistical factors. I favor an approach to investing that involves an obsessive focus on microeconomic factors. Rather than focusing on “the market” I focus on “the business.” Charlie Munger has said: “Micro is what we do and macro is what we put up with.” Like Howard Marks I believe that: “the investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the great the likelihood you can learn things others don’t.” For someone like me, focusing on the simplest possible system (an individual business) is the greatest opportunity for an investor since a company is understandable in a way which may reveal a mispriced bet. Macroeconomic shifts are highly impactful, interesting and fun to watch, but the more profitable investing edge for someone like me is in understanding a specific real business.
Part of what I find interesting about what people like O’Shaughnessy do in making investments is that it is so much unlike what people like me do as part of our day-to-day work in an operating business. Of course, the executives at O’Shaughnessy Asset Management run their own business and must make many operational decisions that are not solely based on statistical factors. Sometimes people like me have enough data to make decisions based on statistical factors, but is not the normal case.
Like Michael Mauboussin, O’Shaughnessy is very much focused on the need to have a sound investing process. In his book More Than You Know, Mauboussin writes:
“In too many cases, investors dwell solely on outcomes without appropriate consideration of process. The focus on results is to some degree understandable. Results — the bottom line — are what ultimately matter. And results are typically easier to assess and more objective than evaluating processes. But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field — such as investing, sports-team management, and parimutuel betting — all emphasize process over outcome.”
Someone like Charlie Munger has a similar view to O’Shaughnessy about the importance of a sound process even though Munger uses a margin of safety approach when investing. Munger has said: “Let me put it this way. As long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds.” Munger and O’Shaughnessy have the same objective: “favorable odds,” but they seek those odds in different ways. My view is: Vive la difference when it comes to investing styles. In other words, there is more than one way to outperform a benchmark financial return (generate alpha) as an investor. This blog has hundreds of profiles of different successful investors and no two of them follow exactly the same process. As I noted in my blog post on Cliff Asness, I own index funds as part of my portfolio that use statistical factors in making investments. I also own individual stocks and other assets like real estate.
Some investing styles will be right or possible for you and some will not. Among the critical gating questions for any investor no matter what their style may be: Are you willing to do the necessary work? Do you have enough time to do so given your other commitments? Do you have a temperament that will enable you to be successful?
- “I think I know that no matter how many times you ‘prove’ that we are saddled with a host of behavioral biases that make successful long-term investing an odds-against bet, may people will say they understand but continue to exhibit the biases.” “A long-term perspective is required. Yet the odds are stacked against us.”
A metaphor that O’Shaughnessy uses to explain behavioral bias is that humans have “hardware” that has not evolved sufficiently to deal with a very different world. For example, human decision-making heuristics that evolved more than 50,000 years ago when it was a good idea to do things like run away when you saw a rustle in the bushes don’t always serve humans well in a modern world. Biases like loss-aversion, recency and availability cause humans to repeatedly make mistakes in activities like investing. Understanding this reality is helpful for an investor since it should help teach you the importance of being humble about your ability to make forecasts successfully and the value of consistently avoiding stupidity. Overcoming these biases is far harder than most people imagine. Daniel Kahneman points out that a person like him can study sources and causes human psychological bias for decades and yet still fall for these same biases in their own lives. Kahneman has admitted that even after decades of study he still makes poor decisions based on the factors that he has studied extensively. As an example, Kahneman has said that overconfidence bias caused him to radically underestimate how long it would take him to write his book Thinking, Fast and Slow.
- “I think I know that the majority of active stock market investors—both professional and aficionado—will secretly believe that while these human foibles that make investing hard apply to others, they don’t apply to them.”
Human overconfidence is one of the most powerful human heuristics and if that overconfidence is not properly taken into account by an investor it can lead to significantly unfavorable outcomes. People can believe, like Charlie Munger does, that only a low single digit percentage of managers can beat the market and yet also believe that they are included in the small group of people who can actually do so. This overconfidence can create problems if 60 percent of people believe they are in the top 3 or 4 percent of investors. One of the most helpful approaches to mitigating the harmful effects of overconfidence and other biases is to write down your investing outcomes (after fees and expenses!) and force yourself to confront the results of the application of your skills in real world markets on a regular basis. If you do not actually write your results down, you will tend to forget your losers and glorify and amplify your winners. Denial is not just a river that runs through Egypt, so working hard to avoid it is a wise practice.
- “It seems that the one thing that doesn’t change is people’s reaction to short-term conditions and their axiomatic ability to perpetuate them far into the future.”
The adverse effects of recency bias which can be amplified by availability and other biases. Morningstar describes it here:
“Recency bias occurs when people more prominently recall and emphasise recent events and observations than those in the near or distant past. Humans have short memories in general, but memories are especially short when it comes to investing cycles. During a bull market, people tend to forget about bear markets. As far as human recent memory is concerned, the market should keep going up since it has been going up recently. Investors therefore keep buying stocks, feeling good about their prospects. Investors thereby increase risk taking and may not think about diversification or portfolio management prudence. Then a bear market hits, and rather than be prepared for it with shock absorbers in their portfolios, investors instead suffer a massive drop in their net worths and may sell out of stocks when the market is low.”
- “Arbitrage human nature. It’s not going to change any time soon.”
There are at least three sources of investing edge: informational, behavioral and analytical. Human behavioral bias represents the most lasting edge can be found for the reason O’Shaughnessy notes, as long as the investor has the discipline to actually stick with a well-constructed system. In other words, it is human “hardware” that has not been updated for 50,000 years that creates the lasting opportunity for an investor or arbitrage behavioral factors. In contrast to a behavioral edge, informational and analytical edges are far more fleeting and must continually be refreshed since other people find them and the disappear. The more an investor moves into private markets the less data is available and the more they can find a behavioral, analytical or informational edge. For example, someone thinking about buying another cement truck for their business or paying developers to create a new financial services offering can’t very often make decisions based on statistical factors. They can look at data on things like the overall success rates of a type of business historically, but decisions on questions like where to locate a business like a restaurant, what food to serve and at what prices is best accomplished by creating a behavioral, analytical or informational edge over competitors.
- “The model never varies. It never has an ego problem; it never has a fight with its spouse; it never wants to prove that it’s right. The model is never hung-over after a night of partying — it just does the same thing, time and time again. Very boring, very profitable.”
Certain people are more rational that others. These relatively more rational people have an easier time doing what O’Shaughnessy talks about above. Other people are incapable of separating their decisions from their emotions. For example, I have a friend who is a doctor who is still so traumatized from the financial market corrections in 2001 and 2008 that he is unwilling to buy anything but bank certificates of deposit. He would rather play golf and walk his dog anyway. His strategy is to work longer to finance his retirement. This doctor’s approach is, shall we say, “suboptimal,” but it is what it is. I once said to this friend “If you can’t finish reading my Charlie Munger book you should buy a diversified portfolio of low cost index funds. If you can muster the effort to read a book written by a friend you should not be picking investments on your own.” He didn’t finish reading my book and still exclusively buys bank certificates of deposit. Would he benefit from consulting a capable wealth manager who charges a reasonable fee who can help him with his emotional limitations when it comes to investing? Yes. Is he even remotely willing to do so? No.
- “It is the emotional side of investing that destroys even the greatest minds. If you can’t master your emotions all the data in the world can’t save you.” “I know that, as a professional investor, if my goal is to do better than the market, my investment portfolio must look very different than the market. I know that, in the short-term, the odds are against me but I think I know that in the long-term, they are in my favor.”
O’Shaughnessy’s method of arbitraging human behavior is: (1) to have a statistical model that identifies factors that generate “alpha” and (2) sticking with that model. In at least two podcasts he refers to a study that showed that 60% of managers using statistical factor-based investing methods don’t stick with their model when things get tough because they are at that time underperforming some well followed benchmark. O’Shaughnessy uses the analogy of diet books to make this point. He has said: “In the battle between the brownie and the dieter, the brownie always wins.” There are lots of formulas that can help people lose weight. In other words, it isn’t the diet’s formulas or strategies that are the problem, but dysfunctional mental processes and human emotions that are the problem.
- “Approaches like buying an index based on the S&P 500 are strategies. The strategy is: buy big stocks based on market capitalization. We have found that there are very many other factors that work significantly better than ‘buy big stocks based on market capitalization.” The challenge is by definition our portfolios are very different from the benchmark of the S&P 500.”
Investing based on statistical factors requires an investor to not only know the right factors but to stay with them when the market drops if the strategy is underperforming a well-known benchmark like the S&P 500. O’Shaughnessy puts it this way: “If you don’t have the discipline to stick with your strategy, factor investing won’t help you.” What does the data say on this so-called “behavior gap”? A study by Hsu, Myers and Whitby concludes:
“By examining the difference between mutual funds’ reported buy-and-hold or time-weighted returns, and the average dollar-weighted returns or IRRs end investors earn, the authors quantify the consistently negative effect of value investors’ market-timing decisions: from 1991 to 2013, value mutual fund investors underperformed the funds they invested in by 131 basis points. Their analysis also reveals that investors in growth, large-cap, and small-cap funds are similarly prone to unproductive allocation timing. They also find that less sophisticated investors tend to make poorer timing decisions. Investors who hold funds with high expense ratios had larger return gaps than those who chose less costly funds, and investors in retail funds underperformed by a greater margin than those who qualified for institutional share-class funds.”
- “I think I know that, at least for U.S. investors, no matter how much stocks drop, they will always come back and make new highs. That’s been the story in America since the late 1700s.” “Since the founding of the New York Stock Exchange in the late 1700s, US stock returns have been positive 71% of the time, negative just 29% of the time, and that’s a great probability to have on your side.”
Anyone who is not very long term bullish on the economy and the stock market is swimming against the tide. Investors like Jim Chanos write and talk about the fact that the inevitable rise of stocks as a whole over time makes shorting stocks particularly hard. Chanos puts it this way: “As Warren Buffett has acknowledged… shorting stocks is a tough way to make a living, because over time stock markets rise more than they fall, the transaction costs are high, and the risks great.”
- “I know I don’t know exactly how much of my success is due to luck and how much is due to skill. I do know that luck definitely played, and will continue to play, a fairly substantial role.” So many people refuse to own their own mistakes, blaming others, bad luck, bad timing, you name it. If life give you a choice to compete against any type of person, always pick the ones that think most outcomes are due to luck. Does luck play a part? Almost always, but I rarely think—outside of lottery tickets—it’s ever the overriding reason for an outcome. Having the ability to learn all the lessons you can from mistakes you’ve made makes you better prepared for the next time. For as Isaac Asimov said, “in life, unlike chess, the game continues after checkmate.”
In a podcast interview with his son, O’Shaughnessy talks about how luck is the cards you are dealt and after that how they are played is what determines outcomes. He mentions what Warren Buffett calls “the genetic lottery” (for example, where and when you were born and in what financial circumstances) while also acknowledging that this alone is not enough to create success in life or as an investor.
- “If you look back to the most spectacular blow ups in history, you can always tie them to a couple things: They were extraordinary complicated strategies that maybe even the practitioners themselves didn’t understand, and they were overleveraged.”
O’Shaughnessy lived and worked through the internet bubble and you can’t do that without acquiring some muscle memory. He was the founder of this company:
Netfolio works thus: An investor gets started on its Website by filling out a personal financial profile, which includes a couple of psychological questions meant to get at one’s risk tolerance-queries about when you’d sell a losing investment and the like. In an exclusive run-through for Barron’s , the questionnaire took less than 10 minutes to complete. Once the profile is done, the system instantly generates a suggested asset allocation, including a single recommended basket of five to 40 stocks derived from one of Netfolio’s 90 quantitative strategies.
O’Shaughnessy tells a great story about not accepting a buyout offer for this business before the correction. He kept the letter from a big Wall Street bank that wanted to buy Netfolio to make sure he learned from the experience. Marc Andreessen said once that ideas for businesses like Netfolio were not wrong, but rather too early. There was also a lot of leverage that caused the Internet bubble. O’Shaughnessy tells great stories about the experience:
“Obviously, I was as wrapped up in the zeitgeist of the times, which thought that only “pure” online companies would go on to receive multi-billion-dollar valuations. At the time, venture capitalists and professional investors thought it beyond idiotic to have any association with “bricks and mortar” companies. They were so 20th Century. The rules were quite simple (and in retrospect, insane) that only pure-play Internet companies could get the backing to move to IPO, and so, I went against every instinct I had, and said no. So, incredibly bearish on the Internet and the overpriced names, I nevertheless seemed to believe (hope?) that my Internet company was the exception to the rule. After all, there were a number of other VCs who were confidently saying they could offer even better terms without me having to link the company to the offending “bricks-and-mortar” legacy firm, which was, you know, a hugely successful actual business with actual revenues and earnings! Shudder. But such was the mania of the moment that it had all of us—even those of us who in our saner moments had looked at the actual numbers—and determined that the entire thing was unsustainable.”
Anyone who lived and worked through the 1997-2001 internet and telecom bubbles and was not involved in some way missed out on accumulating experiences that make for great stories. That O’Shaughnessy was “wrapped up in the zeitgeist of the times” makes him interesting! If you are living your life and are not accumulating some good stories, you might want to think about whether you are boring. In his short story entitled “Mayhew” Somerset Maugham writes:
“[Most people] accept the circumstances amid which fate has thrown them not only with resignation but even with good will. They are like streetcars running contentedly on their rails and they despise the sprightly flivver that dashes in and out of the traffic and speeds so jauntily across the open country. I respect them; they are good citizens… and of course somebody has to pay the taxes; but I do not find them exciting.”
One of the many things I admire about O’Shaughnessy was his decision to create his current business (OSAM). When I was interviewed earlier this years by his son on a podcast I was asked when I felt most alive. I answered that it was in 1994 when I was part of a team that was creating a business from nothing. I would guess that O’Shaughnessy feels the same way about the early years when he was creating OSAM.
- “Tip number one is you have to start saving immediately.”
Spending less that you earn is a foundational part of achieving financial freedom. Using that process to acquire a “grubstake” that gets the investor into the investing game is hard, but essential. Charlie Munger put it this way once:
“The first $100,000 is a bitch, but you gotta do it. I don’t care what you have to do—if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000. After that, you can ease off the gas a little bit.”
That $100,000 target was a long time ago and would need to be adjusted for inflation, but you need to figure out your own number anyway given your circumstances. But in any event you will need a substantial sum of money to get yourself in the investing game and the way to get that started is to start saving.
Everyone has a reason for wanting to be a successful investor. Some people want to own more things. Other people like me want to have better choices in life. Clint Eastwood famously once said in a Dirty Harry movie: “You’ve got to ask yourself one question: ‘Do I feel lucky?’ Well, do ya?” The more money you save and the earlier you do so, the better your choices in life will be. You do not have to rely as much on the luck Dirty Harry was asking about if you have money in the bank. Thinking about questions like this probabilistically is wise. For example, being unable to help someone you love is a much less likely outcome if you make the choice to maintain a healthy saving rate and put limits on your spending. Do you really want to risk not being able to help someone you love? Saving money is simple to say, but hard to do. Life is better if you have great choices and sucks if you don’t.
Epic Tweetstorm: https://twitter.com/jposhaughnessy/status/994631936181264384
Podcast with his son: http://investorfieldguide.com/jim/
Talk at Google: https://talksat.withgoogle.com/talk/what-works-on-wall-street
My post on Cliff Asness: https://25iq.com/2018/06/30/lessons-from-cliff-asness/
Behavioral Gap: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2560434
Hsu, Myers and Whitby: http://jpm.iijournals.com/content/42/2/90