On Core Investment Beliefs; Expected Asset Class Returns; How to Prevent Heart Disease – Part II !

From: aditya
Date: Sat, Nov 29, 2014 at 1:27 PM
Subject: On Core Investment Beliefs; Expected Asset Class Returns; How to Prevent Heart Disease – Part II !


It is important, to periodically step-up back from the day-to-day activities in the investment world to rethink, and reaffirm, your core investment beliefs. Charles Brightman, the CIO of the $177 Billion advisory and asset management firm Research Affiliates, wrote a note recently which sets out their core investment beliefs which have served them well in the past and should continue to do so in the future. To summarise:

-Starting with their central investment philosophy – “The largest and persistent active investment opportunity is long-horizon mean reversion”, which implies buying assets with relatively low prices (and correspondingly high yields) and having the conviction to hold them over time, thus providing higher risk adjusted returns, albeit at a high emotional cost. This is a direct consequence of three core beliefs.

-Belief One Investor preferences are broader than risk and return:

-Investors make investment decisions based on myriad factors beyond merely weighing risk and return – the desired safety of following the herd and the fear of being an outsider, the pride and status from owning a stock of a successful firm, avoiding assets which receive negative press, the attraction of gambling and skewed return distributions, the aversion to losses versus gains etc. These factors have been observed over decades of investment management and by behavioural economists.

Belief Two – Prices vary around fair value:

“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” — Attributed to Benjamin Graham

-As a direct result of the complex and time-varying preferences of investors, at any given point of time, all assets are not at unbiased estimates of fair value and can deviate significantly from fair value over prolonged periods (i.e. they exhibit noise).

-By looking at the path which asset prices have taken to reach the current point, they can gauge which assets are likely to be overpriced or underpriced, and over time can expect them to revert to fair value and allowing one to benefit from the strategy of buying low and selling high.

-This concept has been clearly supported by research work done on the future performance of winners and losers in equities market. Sorting stocks by their most recent three-year performance (and labelling them winners and losers), and tracking their subsequent performance over three-years, one can see that the losers outperformed the winners by a whopping 25%.

Belief Three – Lack of conviction (and/or internal governance constraints) restrict/prohibit investors from exploiting long-term value.

“…it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism…. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” — J.M. Keynes

-Reflect on the above quote and ask yourself the question – which asset manager or investor will continue investing in a particular strategy after it has disappointed over a number of years, or risk aligning themselves with unconventional and rash eccentrics who recently have had embarrassingly poor returns. This lack of conviction on part of individuals and asset managers allows for successful exploitation of mispricings over unknown and potentially long horizons.

-These three beliefs form the basis of their central investment philosophy: “The largest and most persistent active investment opportunity is long-horizon mean reversion”.

-“Industry need not wish, and he that lives upon hopes will die fasting. There are no gains without pains.” — Benjamin Franklin.

-Having great resolve, perhaps even more so than skill or insight, is critical to be able to achieve superior performance over time by buying assets which have low prices/high yields and selling assets which have high prices/low yields. This resolve allows one to stay the course and even rebalance into assets that continue to get cheaper.

-Staying the course is feasible by having an analytical framework to provide a road map to anchor one’s views on, such as provided by their asset allocation strategy which provides long-term capital market expectations across a broad variety of assets (see chart below).

-These expectations are created to inform their behaviour in the context of their three core investment beliefs, and are their best estimates of future returns. However, that is not to say that they actually expect future returns to follow their forecasts, but they are the most probable and defensible expectations of the future.

-Their core investment beliefs certainly resonate with me and “reversion-to-mean” is a time-tested and iron clad principle of investing (and applies to most other areas of life as well!). As the above chart illustrates, EM equity (+6.3%) offers by far the highest 10-year expected real return (but with also the highest volatility), while EM local currency debt (+4.7%) offer the highest 10-year expected real return in the bond sector (followed by EM currency+4.4%, US High Yield+2.1% and EM foreign currency debt+1.8%).

-The above note reinforces what I believe to be the five basic tenets of investing:

-“Be a contrarian, armed with a calculator”in the words of legendary hedge fund manager Seth Klarman of Baupost Group.

-“To control risk, diversify. Diversification is the only free lunch in investing and all sensible investors diversify”in the words of the veteran financial advisor and author Charles Ellis.

-“Be patient and focus on the long term- "The individual is far better-positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals” in the words of the legendary value investor Jeremy Grantham.

Neither a lender nor a borrower be: Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor’s critical asset: patience."in the words of the legendary value investor Jeremy Grantham.

-“Believe in history: history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away"in the words of the legendary value investor Jeremy Grantham.

How to prevent Heart Disease-Part II:

To follow-up on last week’ note on preventing heart disease, below is Part II from Dr. Greger’s blog on the subject.

-Many of the diseases that are common in the developed world are rare or even nonexistent in populations eating mainly whole plant foods.

-A landmark study in 1959 for example, suggested that coronary heart disease was practically non-existent among those eating traditional plant-based diets in Uganda.

-“Doctors in sub-Saharan Africa during the ‘30s and ‘40s recognized that certain diseases commonly seen in Western communities were rare in rural African peasants. Even the teaching manuals stated that diabetes, coronary heart disease, appendicitis, peptic ulcer, gallstones, hemorrhoids, and constipation were rare in African blacks who eat foods that contain many skins and fibers, such as beans and corn, and pass a bulky stool two or three times a day. Surgeons noticed that the common acute abdominal emergencies in Western communities were virtually absent in rural African peasants.”

-Major autopsy studies were performed. In one thousand Kenyan autopsies, there were “no cases of appendicitis, not a single heart attack, only three cases of diabetes, one peptic ulcer, no gallstones, and no evidence of high blood pressure” (which alone affects one out of three Americans).

-Maybe the Africans were just dying early of other diseases and so never lived long enough to get heart disease? No – in the age-matched heart attack rates in Uganda versus St. Louis : out of 632 autopsies in Uganda, only one myocardial infarction. Out of 632 Missourians—with the same age and gender distribution—there were 136 myocardial infarctions. More than 100 times the rate of our number one killer. In fact, researchers were so blown away that they decided to do another 800 autopsies in Uganda. Still, just that one small healed infarct (meaning it wasn’t even the cause of death) out of 1,427 patients. Less than one in a thousand, whereas in the U.S., it’s an epidemic.

-The famous surgeon Dr. Denis Burkitt insisted that modern medicine is treating disease all wrong:

“A highly unacceptable fact—that is rarely considered yet indisputable—is that, with rare exceptions, there is no evidence that the incidence of any disease was ever reduced by treatment. Improved therapies may reduce mortality but may not reduce the incidence of the disease.”

“If an engine repeatedly stops as a consequence of being exposed to the elements, it is of limited value to rely on the aid of mechanics to detect and remedy the fault. Examination of all engines would reveal that those out in the rain were stopping, but those under cover were running well. The correct approach would then be to provide protection from the offending environment. However, considering the failing engine as the ailing patient, this is seldom the priority of modern medicine.”

-“If people are falling over the edge of a cliff and sustaining injuries, the problem could be dealt with by stationing ambulances at the bottom or erecting a fence at the top. Unfortunately, we put far too much effort into the provision of ambulances and far too little into the simple approach of erecting fences.”

-Take cancer, for example, where the vast majority of effort is devoted to advances in treatment, and second priority is given to screening programs attempting early diagnosis. Early diagnosis may reduce mortality rates, and medical services can have a profoundly beneficial effect on sick people, but neither have little (if any) effect on the number of people becoming ill. No matter how fancy heart disease surgery gets, it’s never going to reduce the number of people falling victim to the disease.

Here’s to not following the herd – when investing or when making dietary and lifestyle choices!




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