Kabosu, the Shiba Inu dog made famous by the cryptocurrency Dogecoin, died recently at the age of 18 – a good run for even a famous dog. Dogecoin itself is far from its April 2021 market capitalization of $50 billion, although its current $8.8 billion ranks it a very respectable ninth on the cryptocurrency league table. A new movie “Dumb Money” celebrated the GameStop/ Dogecoin retail-driven stock and crypto- boom of 2021; a blistering review by hedge-fund manager Clifford Asness in the Wall Street Journal denounces the movie vitriolically, mostly for its assumption that amateurs could beat the “People who have spent their entire careers committed to the practice” of investing. However, institutional investors have always underperformed the market on average and the “wisdom of crowds” is generally wrong. It is worth trying to explain why.
By referring approvingly to the “wisdom of crowds” (provided they each make their own decisions and do not communicate) Asness is setting up a Platonic ideal no more real than the shadows on the walls of Plato’s cave. He appears not to have read Charles Mackay’s 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds.” Crowds are mad, not wise, and that applies not only to teams of over-excited crypto bros communicating through social media but also, even more crucially, to the professionals with lifetimes of experience that Asness so naively celebrates.
Maynard Keynes described the process of investing as akin to a beauty contest, in which readers were asked to pick the most attractive from photos of 100 young ladies. He claimed the process thus described to be exceptionally difficult:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
As usual with Keynes’ obiter dicta, there are several flaws in his argument, the most obvious being that no sane person would ask an ugly intellectual like Keynes to judge a (presumably) female beauty contest. In reality, a judge with good taste who, unlike Keynes, actually likes young ladies will find little difficulty in discriminating between them and will be confident that other judges of taste and discernment will come to a very similar ranking of them, differing only at the margins. Keynes was a better investor than a beauty contest judge, but mostly through insider trading via his extensive network of government and other connections, which was not then illegal.
In theory, this should also be true of professional investment managers. Most of them are intelligent people, well educated in the conventional wisdom about investment selection and portfolio management. If it were possible for all professional investment managers to outperform the market, you would think these capable people would on average do so. There are two reasons why they don’t.
The first is their warped incentive structure. They are assessed every three months against the common stock indexes, which itself makes them try to match the index, since in such a short period, anomalies may happen that cause them to underperform. For example, a modest portfolio about which I write to another audience substantially under-performed the market in the second quarter of 2023 – the big tech stocks had a very good quarter, because of the hype about AI, whereas my investment style tends to avoid the fashionable and overvalued. However, in the third quarter the position was reversed; tech stocks did poorly and the portfolio did relatively well, making up the deficit of the previous quarter.
That was fine for my readers, assuming they did not despair at the end of June; it would not have been fine had I been a professional investment manager, since my second quarter under-performance would have got me fired. In general, people do not work well when subjected to such short-term stress; in investment management, the actions they take to avoid this problem tend to lead to under-performance in the long run (someone who bought tech stocks at the end of the second quarter of 2023 would have lost money badly in the third quarter, for example).
The other reason why investment managers do not outperform the market is their intellectual herd instinct. They have nearly all been trained in financial analysis by the same system, with the same cognitive biases. In addition, they all read the mainstream financial media, getting from it the same conventional ideas as do their competitors. It really does not matter whether those ideas are good or bad; the result of all this cognitive symbiosis is that the vast bulk of the market’s money tends to move in the same direction at the same time.
If Big Tech is fashionable one year, the money moves into Big Tech and the FANGs share prices zoom up. This of course justifies those who bought, and therefore reinforces the cognitive wave. In the other direction, those who had doubted the cognitive wave underperform the market and are therefore weeded out (since evaluators focus on short-term performance and on relative rather than actual investment results). Self-reinforcing cognitive waves of this kind always go too far, because the wall of money outweighs the intrinsic merit of the information itself, and so when the market turns, the “smart money” is always positioned wrong.
You can call this the “Cathie Wood” effect; her ARK Invest funds specialize particularly in fashionable “momentum” stocks and therefore lost 53.53% per annum on average over the three years to June 30, 2023, even though the last quarter of that period will have been favorable to her investing style – the results for the third quarter of 2023 will not have been so pretty.
There is a formula for investment success, but it is not an easy one to follow. You can see it if you examine the career of Warren Buffett, which you can track using the share price of Berkshire Hathaway (NYSE:BRK-A). (The BRK-A share price trades at a premium over net asset value that has tended to increase over time, this somewhat exaggerates Buffett’s performance, but over several decades, not by much per annum.) Since 1993, around the time he became one of the richest and most famous men in the world, his investment performance has been good but not outstanding; over the 30 years to October 2023 his return was 12.2% per annum compared to 10.0% per annum on the Standard and Poor’s 500 Index over the same period. That is an outperformance of 2.2% per annum, by no means to be sneezed at, but his performance has tended to decline over time – in the 10 years since October 2013 BRK-A’s return is 11.8% per annum, somewhat below the S&P 500 annual return of 13.1%.
However, before 1993, Buffett’s investment performance from the end of 1964, when he took control of Berkshire Hathaway, was truly spectacular, increasing shareholder wealth by 28.2% per annum compared to 10.3% per annum on the Standard and Poor’s 500 Index (more than half of which was inflation). The effect of compounding is hugely important here; $1,000 invested in BRK-A at the end of 1964 would have been worth $1,347,500 in 1993 compared to $17,200 if you had invested in the index.
Examining Buffett’s record in this way tells you the secrets of investment success. From 1993, or more properly from his bailout of the investment bank Salomon Brothers in 1991, Buffett was universally known and admired with excellent contacts on Wall Street and in Washington. In those circumstances, whatever his intelligence, his investment strategy was unlikely to differ much from the norm – though his 2009 acquisition of BNSF Railway was greatly helped by his political connections. His political connections may thus have boosted his returns, but it is clear that his network and frequent contacts with the titans of Wall Street prevented any exceptional investment performance.
Before 1991, however, Buffett was relatively little known (very little known before the mid-1980s) and operated almost entirely in Omaha, Nebraska, without much contact with the financial or political world. In those circumstances, his exceptional ability to analyze investments could be given full rein. He took in what information he wanted to take in, and with few distractions could devote the lengthy periods of very hard work needed to unearth and analyze it. To the extent he was investing other people’s money, he had shareholders who were either supportive of his long-term, value-oriented approach or altogether passive.
A brilliant loner, operating through the power of his own intellect and knowledge, with no significant outside constraints on his operations: that is the picture of a successful investor. Neither Keynes nor the well-connected garrulous denizens of Wall Street, private equity or the hedge funds fit this template very well. Kabosu, the dog that spawned a billion-dollar crypto-currency, may well have fitted it better.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)