On the Hazards of Confidence, Bonds vs Stocks and an Ayurvedic Home Remedy!

There comes a time to step back from one’s daily activities in the market and reflect philosophically on one’s “method”. Usually, this is triggered by reading an interesting book or article – and today I present you a fascinating extract from a new book (“Thinking , Fast and Slow”) written by Nobel Laureate Daniel Kahneman, one of the leading lights of behavorial economics. To summarise;

-As a young psychology student in Israel , he was assigned to assess leadership qualities of candidates for the army’s officer training programme. This involved observing their behaviour in a “leadership group challenge” played out on an obstacle course.

-They found out that their ability to predict performance at the training school was not much better than blind guesses. However, (more surprisingly) having this knowledge did not have any effect on how they evaluated future candidates and on their confidence levels in their predictions-i.e. the “cognitive illusion”.

-Their knowledge of the general rule that they could not accurately predict did not affect their confidence levels in predicting individual cases. Confidence is only a feeling, and declarations of high confidence indicates only the construction of a coherent story in the individual’s mind and not necessarily its truth.

-The theory that the market price is always right, as it incorporates all available knowledge about the stock’s price, implies that no one can expect future gains or losses from trading. However, this is not correct as many individual investors loose consistently by trading.

-This was first borne out by a study which analysed the performance of individual investors over a seven-year period, where investors sold a stock and soon followed with a purchase of another stock, with the returns for the stocks compared a year later. The study found, on average, that the stocks which were sold outperformed the ones subsequently bought by 3.2% over a year!

-Later studies also showed that the most active traders had the poorest returns while investors who traded the least had the best results. They also showed that men acted on their useless ideas more often than women, and therefore underperformed women!

-In general, financial institutions and professional investors profited by being on the other sides of these trades and took advantage of the mistakes made by individual investors who (over the short run) typically sold “winners” too early and hung onto “losers” for too long.

-Professional investors and fund managers also fail the test of persistent achievement –50 years of research points out that for a large majority of fund managers, stock selection is more like playing dice than playing poker (which requires skill), and 2 out of 3 fund managers underperform the market every year.

-The year-to-year correlation of returns for fund managers is almost zero implying that successful funds in any given year are mostly lucky. Nearly all stock pickers, whether they know it or not, are playing a game of chance. Educated guesses are no more accurate than blind guesses!

-They also did a study of the performance of 25 wealth advisers over eight consecutive years, and found that there was no correlation between different pairs of years implying that there were no differences in skill and, in essence, the results were no different from what you would expect from a game of dice.

-This illusion of skill, was deeply ingrained in their culture, and facts which challenge such beliefs – and thereby threaten people’s livelihood and self-esteem- are rejected. People generally ignore fact based information when it clashes with their personal experiences.

-Why do investors, amateur and professional, believe that they can beat the market which is contrary to both economic theory and an analysis of their past performance?

-The psychological cause for this illusion is that people who pick stocks are exercising high-level skills – by analysing economic data, income statements and balance sheets, evaluating quality of management and assessing the competition.

-Unfortunately, skills in evaluating a business are not sufficient for successful stock trading and the key question is whether the information about the firm is already incorporated in the stock price. Traders apparently lack the skill to answer this crucial information and are typically ignorant of their ignorance.

Fascinating stuff, and herein lies a key lesson for all of us – investing (for the long haul) is not about trying to appear (and acting !) smart and trying to beat the market –it is about having reasonable expectations, a lot of humility, and a rigorous discipline in following (and periodically re-evaluating) an individual investment method with honesty. Having the courage to go against the herd (with a calculator in hand!) , and consequently the stomach to withstand market volatility and underperformance, is also an absolutely critical requirement for long term investment success. Constructing a well diversified portfolio is crucial, as you can never be sure which trades will work out and which will not. Asset allocation decisions based on historical valuation trends and their mean reverting tendencies , rather than individual stock picking, is a method which provides a superior risk/reward profile (unless you are Warren Buffet!). Periodic rebalancing (quarterly?) rather than active trading, as the above studies have proven, is also a must. Lastly, do not underestimate the role which chance plays in your success (or lack of it!) – but that doesn’t mean hard work doesn’t count – keep in mind the old saying – “fortune favours the prepared’!

The above view is age-old, but unfortunately ignored by most – to quote from the Bible: “ I returned and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.”

Having said that, we are all likely to nod in agreement, and (rather quickly) go back to our own ways and continue searching for (or believing in) the magic formula to “beat the market”!

Bonds versus stocks:

It’s now official-bonds have been more fun than stocks over the last 30 years!

“The biggest bond gains in almost a decade have pushed returns on Treasuries above stocks over the past 30 years, the first time that’s happened since before the Civil War. Long-term government bonds have gained 11.5 percent a year on average over the past three decades, beating the 10.8 percent increase in the S&P 500, said Jim Bianco, president of Bianco Research in Chicago.”

“The generation-long outperformance of bonds over stocks has been the biggest investment theme that everyone has just gotten plain wrong,” Bianco said. “It’s such an ingrained idea in everyone’s head that such low yields should be shunned in favour of stocks, that no one wants to disrupt the idea, never mind the fact that it has been off.”

Income inequality (via Paul Krugman):

A graph below which illustrates quote vividly the growing divide in the “haves” and the “haves-nots” in the US – the real income of the top 1% has risen by almost 3 times over the last 30 years, while that of the chunk of the population below (21st to 80th percentile) has risen by only about 40%.

An Ayurvedic Home remedy (Dr. Vasant Lad):

I had covered the vata type of allergies based on aggravations of the three doshas (or the bodily constitution) as per Ayurvedic principles in my previous email, and present below remedies for the second type – pitta allergies:

Pitta-type allergies can cause an inflammation of the skin as the allergen (such as chemicals, ragweed or synthetic fibres) aggravates the pitta dosha which is already present below the skin. The pitta then penetrates through the capillaries, and due to its hot and sharp qualities, creates a rash, itching, hives, allergic dermatitis or eczema. Treatments are as follows:

Take 1/2 tsp of the herbal formula: shatavri (8parts), kama dudha (1/2 part), guduchi (1 part), shankha bhasma (1/4 part), 2 to 3 times a day after meals with warm water.

-For hives, rash, urticara, dermatitis or eczema, apply neem oil on the skin.

-Take 1/2 tsp of the blood cleansing formula: manjistha and neem in equal parts, 3 times a day with warm water after meals.

Here is wishing that fortune smiles on you!




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