On A Framework for Long-Term Investing and the Rice Diet!

From: adityarana
Date: Sat, Mar 22, 2014 at 1:36 PM
Subject: On A Framework for Long-Term Investing and the Rice Diet!

Hi!,

"Investing for the long term" is an oft repeated phrase, but is usually difficult to put into practice as one tends to be overly swayed by recent market events. It can therefore be useful to develop a framework which can help mitigate the tendency to put too much weight on recent events with regards to investing decisions. Michael Mauboussin, Chief Strategist at Credit Suisse (and author of numerous books on behavioural investing), wrote an interesting piece in the Credit Suisse 2014 Yearbook which outlines such a framework – to summarise:

-It is well documented that investors tend to buy after a market has risen and sell after it has fallen. This results in an underperformance by investors in the funds they invest in when compared with the simple historical performance of the same funds.

-Neuroscientists have identified a part of the left hemisphere of the brain as "the interpreter" – which assigns a cause to every effect it observes. It generally associates good results with skill and poor results with a lack of skill.

-The interpreter is usually effective in performing this task most of the time but stumbles when confronted with randomness – and views results which arise from good luck with a good outcome and tries to avoid bad outcomes.

-The reason behind the differences in returns between the market, active investment managers and investors is important to understand – for example while the S&P has returned 9.3% per annum over the last 20 years, the average mutual fund has returned 1.0-1.5% less (due to fees and expenses), but investors have earned 1-2% less than mutual funds (i.e. 60-80% of the market return).

-This stark underperformance is mainly due to bad timing, as investors (overly influenced by the interpreter) tend to extrapolate recent returns and buy when the market is up and sell when its down. The graph below, comparing net new investor cash flows in mutual funds and market returns, illustrates clearly the pattern of investor flows following returns. In particular, total flows over the last 5 years has been negative while the market has done well.

-The simple "buy-and-hold" strategy outperforms (by 1.5%) actual returns for investor across countries around the world as the chart below illustrates:

-To avoid this inherent bias it is helpful to look into how one should make a thoughtful prediction and the seminal paper on the subject ("On the Psychology of Prediction"-1973) by the Nobel Laureate Daniel Kahneman and Amos Tversky provides a useful framework.

-The authors argue that three types of information are required to make a good prediction: 1) the "base rate" or the outcome of an appropriate reference class (i.e. long-term historical returns) , 2) the specific information about the case being examined (i.e. valuations and their implications on future returns), and, 3) the weights assigned to the base rate and the specific information in order to make a sensible prediction. The authors suggest that we tend to underweight the base rate in our predictions.

-For example, if we are engaged in an activity where luck is the predominant factor then we should place most of the weight on the base rate (i.e. the roulette table or rolling dice where the best estimate is a measure of the average outcome, with an appropriate variance factor). However, if luck plays no role in that activity then we should put all the weight on the specific information (i.e. a race between a world class sprinter and the average man on the street).

-The role of luck can be quantified – by the correlation coefficient designated as r. It measures the degree of the linear relationship between two variables – when it’s zero what happens next is unrelated to what happened before, and when it’s one then what happened before tells you what will happen next.

-Correlation has important implications for investment decision making – when the r is zero rely on the base rate and when it’s 1 the specific information is all you need. The r gives an indication of the rate of reversion to mean.

-A few examples can clarify the above concept:

-The chart below depicts a correlation of 0.5 between the heights of fathers and sons. Part of a son’s height is hereditary and part is the environment. So if a father’s height is 76 inches (specific information) versus an average height of 70 inches (base rate), the son’s height can be predicted as 73 which is an equal eight between 76 and 70. This prediction does not hold for every son but is the best prediction for a population of fathers of that height.

-The chart below depicts the correlation between the year-on-year returns for the S&P since 1928 as well as the MSCI World Index from 1970, which shows a correlation close to zero. This implies that the best prediction for next year’s return is something close to the base rate – which for the S&P has been a nominal arithmetic return of 11.3% since 1928, with a standard deviation of 20%.

-In 2013, most developed markets achieved above average returns, driven by the S&P gain of 30% and Japan’s gain of 50%. The MSCI world index gained by 27.4% while EMs were down 2%. For 2014, CS forecasts a 9% gain for the S&P and 13% gain for global equities as equities remain attractive relative to bonds and flows into equity are likely to continue.

-The lessons for investors is clear – it’s important not to be swayed by last year’s good results or repelled by poor returns – it’s better to focus on long-term averages and maintain consistent exposure.

A very helpful tool to utilise when making asset allocation decisions – the key requirements here are consistency and patience- even when the strategy may not seem to be working in the near term. Stay with EM equities as part of a well diversified portfolio-as the chart below from BCA illustrates – EM equities are currently at a 10-year valuation discount to DM.

The Rice Diet:

To gain insights into the relationship between diet and health, it can sometimes be helpful to look at studies done by researchers in the years gone by. One such pioneer was Dr. Walter Kempner, a doctor and research scientist at Duke University in the 1940s and ’50s, who is considered to be the father of modern diet therapy and the creator of the Rice Diet, and the inspiration to subsequent well-known diet therapists. One of them, Dr. John McDougall wrote a recent note on Kempner and the Rice Diet which is summarised below:

-The Rice Diet, consisting of white rice, fruit, juice and sugar was started at Duke University in 1939 for only the most seriously ill patients. The simple Rice Diet benefited such patients more than any drug or surgery prescribed for numerous chronic illnesses like heart disease, heart and kidney failure, hypertension, diabetes, obesity and arthritis.

-Originally used for only short periods and under close supervision due to concerns about nutritional deficiencies, subsequent research showed that it was safe and adequate for most patients.

-This major breakthrough occurred in 1942, when one of his patients with (serious kidney and eye disease) mistakenly heard his instructions to come back in two weeks as two months (due to his German accent!), and returned with a remarkable improvement in her health with a significant reduction in blood pressure, a reduced heart size and a correction of the eye damage. This incident inspired Dr. Kempner to both extend the time period for the treatments, as well as to treat relatively minor illnesses which included routine hypertension, headaches, chronic fatigue, chest pains, oedema and psoriasis.

-Dr. Kempner documented the benefits of his treatment and tracked changes in cholesterol, blood pressure, blood sugar and body weight – 93% of his patients showed significant improvement in cholesterol (from average of 273 to 177), improvements in blood sugar, curing of pre-diabetes and hypertension, reversal of heart, kidney and eye disease, and a significant reduction in weight for highly obese patients (average reduction of 63.8kg).

-The composition of the diet was:

-250-350 grams of white rice forming the basis of the diet – boiled in water or fruit juice with no salt, milk or fat – approx 20 grams of protein, 225 grams of carbohydrates, 1.5 grams of fat implying about 1,000 calories.

-The total caloric intake was 2,400 calories comprising 94% carbohydrates, 4% protein, 2% fat (and 140 mg of calcium and 150 mg of salt) versus a normal 2,400 calorie diet comprising 50% carbohydrates, 17% protein, and 33% fat.

-Fruits and juices were allowed but no avocados, dates, nuts, tomatoes or vegetable juices.

-100 grams (or even more if underweight) of white sugar providing 400 calories.

-Supplementary vitamins and minerals were added later though none of the patients showed any signs of vitamin deficiency after five-months.

-Once the patient’s health returned to normal small amounts of non-leguminous vegetables, potatoes, lean meat or fish (prepared with no salt or fat) could be added but if the patient’s health markers deteriorated these were removed.

-The reason for using white rice was because the proteins were easily assimilated and all the essential amino acids were provided. In addition white rice was palatable and more than half the world’s population consumed large amounts of rice (even up to 70-80% of a diet).

-The addition of white sugars brought down the protein intake from 8% of calories (for rice) to below 5% as the body needed less than 5% of calories as protein. Excess protein must be processed and eliminated by the liver and kidney, causing extra strain and organ damage.

-The primary benefits of the Rice Diet are accomplished by easing the workload on damaged tissues and organs by providing them with sufficient clean-burning energy from carbohydrates so as to allow the body’s healing powers to work efficiently.

-Today, Dr. John McDougall recommends the Rice Diet for only seriously ill patients, while the rest are advised to consume whole grains and starches, vegetables, legumes and fruits.

Here’s to keeping it simple and going back to the basics!

Regards,

Aditya

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