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Nonetheless, the underlying concept—mathematically linking the degree of probability to investment size—carries important lessons.
There are risks to employing the Kelly approach, and investors would be wise to understand its three limitations:
1. Anyone who intends to invest, using the Kelly model or not, should have a long-term horizon.
2. Be wary of using leverage. The danger of borrowing to invest in the stock market (with a margin account) has been trumpeted loudly by both Ben Graham and Warren Buffett. The unexpected call on your capital can occur at the most unfortunate time in the game.
3. The biggest danger in playing high-probability games is the risk of overbetting. If you judge that an event has a 70 percent chance of success when in fact it is only a 55 percent event, you run the risk of so-called gambler’s ruin. The way to minimize that risk is to underbet, by using what is known as a half-Kelly or fractional-Kelly model. For example, if the Kelly model would tell you to bet 10 percent of your capital, you might choose to bet only 5 percent (half-Kelly) instead.
Both the half-Kelly bet and the fractional-Kelly bet provide a margin of safety in portfolio management; that, together with the margin of safety we apply to selecting individual stocks, provides a double layer of protection.
Because the risk of overbetting far outweighs the penalties of underbetting, I believe that all investors, especially those who are just beginning to use a focus investment strategy, should use fractional-Kelly bets.
It appears to me that the most sensible way to approach horse racing, or the stock market, is to wait until the good horse comes to the post with inviting odds.
Beyer, who understands the psychological urge to get into the game, advises players to accommodate it by dividing their strategy between action bets and prime bets. Prime bets are reserved for serious players when two conditions occur: (1) confidence in the horse’s ability to win is high, and (2) payoff odds are greater than they should be. Prime bets call for serious money. Action bets, as the name implies, are reserved for the long shots and hunches that satisfy the psychological need to play. They are smaller bets and never are allowed to become a large part of the player’s betting pool.
The mutual funds with the highest active share, funds that were the most different from the index, significantly outperformed their benchmark, whereas those with the lowest active share underperformed their benchmarks.
Today, just 25 percent of mutual funds are considered truly active. “Both investors and fund managers have become more benchmark-aware,” says Cremers. “As a manager, you want to avoid being in the bottom 20% or 40% (of your peer group). The safest way to do that, especially when you’re evaluated over the shorter time periods, is to hug the index.”40 Because investors habitually take money away from underperforming mutual funds, portfolio managers have increasingly made their portfolios more similar to indexes, thereby reducing the chance they will significantly underperform the index.
as we learned, the more your portfolio resembles the index, the less likely you are to outperform it. It is important to remember that any portfolio manager who has a portfolio that is different from the benchmark, however small a difference, is an active portfolio manager.
Warren Buffett said many important things, none more profound than this: “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”41
if price is not the measuring stick, what are we to use instead? “Nothing” is not a good answer. Even buy-and-hold strategists don’t recommend keeping your eyes shut.
Fortunately, there is one, and it is the cornerstone of how Buffett judges his performance and the performance of his operating units at Berkshire Hathaway.
If you owned a business and there were no daily quotes to measure its performance, how would you determine your progress? Likely you would measure the growth in earnings, the increase in return on capital, or the improvement in operating margins. You simply would let the economics of the business dictate whether you were increasing or decreasing the value of your investment. In Buffett’s mind, the litmus test for measuring the performance of a publicly traded company is no different.
But can we count on the market to reward us for picking the right companies? Can we draw a significantly strong correlation between the operating earnings of a company and its share price? The answer appears to be yes, if we are given the appropriate time horizon.
When we set out to determine how closely price and earnings are connected, using our laboratory group of 12,000 companies, we learned that the longer the time period, the stronger the correlation. With stocks held three years, the degree of correlation between stock price and operating earnings ranged from .131 to .360. (A correlation of .360 means that 36 percent of the variance in the price was explained by the variance in earnings.) With stocks held for five years, the correlation ranged from .374 to .599. In the 10-year holding period, the correlation between earnings and stock price
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This bears out Buffett’s thesis that, given enough time, the price of a business will align with the company’s economics.
To help shareholders appreciate the value of Berkshire Hathaway’s large common stock investments, Buffett coined the term look-through earnings.
Berkshire’s look-through earnings are made up of the operating earnings of its consolidated businesses (its subsidiaries), the retained earnings of its large common stock investments, and allowance for the tax that Berkshire would have to pay if the retained earnings were actually paid out.
“The goal of each investor,” says Buffett, “should be to create a portfolio (in effect, a company), that will deliver him or her the highest possible look-through earnings a decade or so from now.”53
According to Buffett, since 1965 (the year Buffett took control of Berkshire Hathaway), the company’s look-through earnings have grown at almost the identical rate of the market value of its securities. However, the two have not always moved in lockstep. On many occasions, earnings moved ahead of prices; at other times, prices moved far ahead of earnings. What is important to remember is that the relationship works over time.
“For an ordinary individual, the best thing you already have should be your measuring stick.” What happens next is one of the most critical but widely overlooked secrets to increasing the value of a portfolio. “If the new thing you are considering purchasing is not better than what you already know is available,” says Charlie, “then it hasn’t met your threshold. This screens out 99 percent of what you see.”55 You already have at your disposal, with what you now own, an economic benchmark—a measuring stick. You can define your own personal economic benchmark in several different ways:
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The job of a portfolio manager who is a long-term owner of securities, and who believes future stock prices eventually will match with underlying economics, is to find ways to raise your benchmark.
Focus investing is necessarily a long-term approach to investing. If we were to ask Buffett what he considers an ideal holding period, he would answer, “Forever”—so long as the company continues to generate above-average economics and management allocates the earnings of the company in a rational manner.
Of course, if you own a lousy company, you require turnover. Otherwise, you end up owning the economics of a subpar business for a long time. But if you own a superior company, the last thing you want to do is sell it.
The Morningstar study found that, over a 10-year period, funds with turnover ratios of less than 20 percent were able to achieve returns 14 percent higher than funds with turnover rates of more than 100 percent.
taxes are the biggest expense that investors face—higher than brokerage commissions and often higher than the expense ratio of running a fund.
Buffett asks us to imagine what happens if you buy a $1 investment that doubles in price each year. If you sell the investment at the end of the first year, you would have a net gain of $0.66 (assuming you’re in the 34 percent tax bracket). Let’s say you reinvest the $1.66 and it doubles in value by the second year-end. If the investment continues to double each year, and you continue to sell, pay the tax, and reinvest the proceeds, at the end of 20 years you have a net gain of $25,200 after paying taxes of $13,000. If, instead, you purchase a $1 investment that doubles each year and is not
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it is critically important that you think seriously about what exactly a focus investing approach entails: Do not approach the market unless you are willing to think about stocks, first and always, as part-ownership interests in businesses. Be prepared to diligently study the businesses you own, as well as the companies you compete against, with the idea that no one will know more about your business than you do. Do not even start a focus portfolio unless you are willing to invest a minimum of five years (10 years would even be better). Never leverage your focus portfolio. An unleveraged focus
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“You don’t need to be a rocket scientist,” confesses Buffett. “Investing is not a game where the 160 IQ guy beats the guy with the 130 IQ. The size of an investor’s brain is less important than his ability to detach the brain from the emotions.”
we will study the debilitating effect that short-term changes in stock prices often have on investor behavior. This takes us into the fascinating realm of psychology.
The study of what makes us all tick is endlessly fascinating. It is particularly intriguing to me that it plays such a strong role in investing, a world that is generally presumed to be dominated by cold numbers and soulless data.
Graham figured that an investor’s worst enemy was not the stock market but oneself. They might have superior abilities in mathematics, finance, and accounting, but people who could not master their emotions were ill suited to profit from the investment process.
As Warren Buffett, his most famous student, explains, “There are three important principles to Graham’s approach.” The first is simply looking at stocks as businesses, which “gives you an entirely different view than most people who are in the market.” The second is the margin-of-safety concept, which “gives you the competitive edge.” And the third is having a true investor’s attitude toward the stock market. “If you have that attitude,” says Buffett, “you start out ahead of 99 percent of all the people who are operating in the stock market—it is an enormous advantage.”
In Graham’s view, an investor’s appropriate reaction to a downturn is the same as a business owner’s response when offered an unattractive price: ignore it.
Along with good business judgment, then, investors need to understand how to protect themselves from the emotional whirlwind that Mr. Market unleashes. To do that, we must become familiar with behavioral finance, that place where finance intersects with psychology.
Behavioral finance is an investigative study that seeks to explain market inefficiencies by using psychological theories.
Overconfidence is at work here, of course; people believe they understand the data more clearly than others and interpret it better. But there is more to it. Overconfidence is exacerbated by overreaction. The behaviorists have learned that people tend to overreact to bad news and react slowly to good news. Psychologists call this overreaction bias. Thus, if the short-term earnings report is not good, the typical investor response is an abrupt, ill-considered overreaction, with its inevitable effect on stock prices.
“Invest in equities and then don’t open the mail.”5 To which we might add, “And don’t check your computer or your phone or any other device every minute.”
Loss Aversion
loss aversion, and it is, in my opinion, the single most difficult hurdle that prevents most investors from successfully applying the Warren Buffett approach to investing.
the pain of a loss is far greater than the enjoyment of a gain. Many experiments have demonstrated that people need twice as much positive to overcome a negative.
On a 50/50 bet, with precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss. This is known as asymmetric loss aversion:
The impact of loss aversion on investment decisions is obvious, and it is profound. We all want to believe we made good decisions. To preserve our good opinion of ourselves, we hold on to bad choices far too long, in the vague hope that things will turn around. By not selling our losers, we never have to confront our failures.
loss aversion can affect you in a more immediate way, by making you irrationally hold on to losing stocks. No one wants to admit making a mistake. But if you don’t sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.
evaluating performance over shorter periods of time increases the chances that you will see a loss in your portfolio. If you check your portfolio daily, there is a 50/50 chance you will experience a loss. The odds don’t improve much if you extend the evaluation period to a month.
the two factors that contribute to an investor’s emotional turmoil are loss aversion and a frequent evaluation period. Using the medical word for shortsightedness, Thaler and Bernatzi coined the term myopic loss aversion to reflect a combination of loss aversion and frequency.
How long would investors need to hold stocks without checking their performance to reach the point of being indifferent to the myopic loss aversions of stocks versus bonds? The answer: one year.
