´´ Value Investing And The Virtue of Not Being That Stupid

Tuesday, September 1, 2015

Value Investing And The Virtue of Not Being That Stupid

Are you suffering the Dunning-Kruger Syndrome? And no dear reader it is not a highly virulent venereal disease. So there is no need to call your doctor. It is rather a highly virulent cognitive bias spreading around the financial centers of this world.

It explains why the majority of investors, may they be institutional or individual, are incapable of beating the market indices. It explains why so many are unable to part from the unknowledgeable crowd. It explains why so few mastering the art of doing nothing and have the virtue of being lazy.

We Are All Incompetent And Ignorant Idiots 

 

The genesis of the study by Dunning- Kruger was a bank robbery in Pittsburgh in 1995. The robbery appeared to be more like a cinematic slapstick ala Laurel and Hardy than a well thought and well executed bank robbery.

A man called McArthur Wheeler robbed two banks in a very short period during the daytime. He did this foolish action without any precautionary measures. He did not even bother wearing a mask in the service hall under camera surveillance. Thanks to the images he was caught the very same day.

Esecially his explanation of rubbing his face with lemon juice in order to become invisible to surveillance cameras contributed to joviality to the officials. He explained that he read about this theory and verified it at home by taking a Polaroid picture of himself. Unfortunately, he took his selfie at the wrong angle and was not on the picture. Apparently, he was just another dweeb the majority of my readers will say. Fortunately, Dunning and Kruger saw it differently and started investigating.

They came up with the Dunning–Kruger syndrome. The syndrome is also often described as “the Anosognosia of everyday life.” Whereby, Anosognosia is a condition in which a person who suffers from a disability seems unaware of it or denies the existence of his or her disability. Hence, they are ignorant.

Dunning and Kruger found out that relatively unskilled individuals, whom they call poor performers, often suffer from illusory superiority. They mistakenly assess their ability at certain activities to be much better than objectively true and underestimate those of their competitors.

Highly skilled individuals, on the other hand, often underestimate their relative competence and overestimate those of their competitors. They erroneously assume that tasks that are easy for them are also easy for others.The miscalibration, or better ignorance, of the incompetent stems from an error about the self. Those of the highly competent, on the other hand, stems from an error in the evaluation of others.

The Lack of Knowledge About His Very Limited Knowledge of The Poor Performer 

 

Poor performers have a lack of self- insight and it is almost impossible for them to overcome their ineptitude and incompetence. To overcome it requires them to possess the very expertise they lack. For example, to know how skilled or unskilled potential value investors are in successfully implementing the framework of value investing outlined by Graham and Dodd, it is not enough to have a good working knowledge of Graham and Dodd's quantitive principles.

It also means knowing what you know and can do, as well as what you do not know and what you cannot do. It requires being comfortable with the knowledge of how limited the prospective value investor's abilities and knowledge really is. It is what Warren Buffett calls being aware of your circle of competence and staying within your comfort zone. If the concept of limited knowledge is successfully implemented it will result in embracing the diminishing amount of confidence in one’s own abilities. An almost impossibility among the incompetent.

Furthermore, what make the incompetent so dangerous for themselves and for the people listening to them is that in most cases the lack of their self-reflection, i.e. the lack of their knowing about their limited knowledge, does not manifest itself in their behavior. Unfortunately, incompetence does not leave those people disoriented, or even cautious. Rather on the contrary. The incompetent is often blessed with an inappropriate amount of confidence. They are further buoyed by something that feels to them like knowledge, which in reality is just irrelevant information, most of it second hand and often put out of context.

In addition, the incompetent will always find the mistakes that other people make. But the incompetent is unable to see those very same mistakes in their own actions. Most of the incompetent are highly educated, but not knowledgeable. Because they are not able to differentiate between what they know and what they do not know. They are like a little child, and not realizing it. Like little children when asked why tigers exist, i.e. they exist for being in a zoo, the incumbent will succumb to purpose- driven reasoning.

Purpose driven reasoning will never really leave the human. Even professional scientists start making purpose-driven mistakes, especially when under pressure. Only when the incumbent is able to embrace the concept of limited knowledge wholeheartedly. When he realizes that not knowing does not constitute failure, but rather is a crucial signpost that shows him that he is traveling in the right direction towards true knowledge, will he become a knowledgeable idiot. And being a knowledgeable idiot is all he needs to be ahead of the pack.

Data Is Not Information And Information Is Not Knowledge


Many will now claim that more information and education is the natural antidote to the Dunning- Kruger Syndrom. Wrongly so. More information alone cannot overcome the Dunning- Kruger effect. Because data is not information and information is not knowledge. Rather more information works the opposite way around for the poor performer. It makes the ignorant even more over-confident, a personal trait he already posses in overabundance. More information makes him even more prawn to taking stupid actions. It makes him even more of a prig.

Dunning (2014) points out that: " Some of our most stubborn misbelieves arise not from primitive childlike intuitions or careless category errors, but from the very values and philosophies that define who we are as individuals. Each of us possesses certain foundational beliefs—narratives about the self, ideas about the social order—that essentially cannot be violated: To contradict them would call into question our very self-worth. As such, these views demand fealty from other opinions. And any information that we glean from the world is amended, distorted, diminished, or forgotten in order to make sure that these sacrosanct beliefs remain whole and unharmed." In short we are all hopelessly biased, and ignorant and dangerous as hell. As the humorist Josh Billings once put it, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so."

A particularly frightful example of the paradox of information, education and eventual outcome are driver’s education courses that are aimed at handling emergency maneuvers. It is well documented that they tend to increase, rather than decrease, accident rates. They do so because training people to handle precarious driving conditions (like water, snow and ice) leave them with the impression that from now on they are permanent experts on the subject. They are unaware that the skills learned usually erode rapidly after they leave the course. As months pass by, a toxic combination is brewing. Over- confidence meets little competence. When their wheels begin to spin the outcome more often than not is disastrous.

People on Wall Street Do Not Learn Anything And Forget About Everything


Those findings by Dunning-Kruger are significant and irrefutable. And they are extremely relevant in the field of investing. Dunning and Krugers finding explain why so many people fail in investing.

What else than the Dunning-Kruger effect would explain the very existence of active money management and its allegiance. In a field where facts and figures have shown that fewer than 15% of money managers can beat the index on the long run, but the vast majority of the managers and their clients believe they can beat the index. Almost everyone just believes they will be in that top 15%. I suppose if money managers and their clients would be less ignorant the majority would be more humble and stop trying.

In addition, The Dunning- Kruger effect shows why most investors are overactive and constantly make changes to their portfolio. Those investors are highly confident that they are making a change for the better. It explains the ever-increasing portfolio turnover rates. In 1959, the turnover rate for the average mutual fund was 16.4%, which roughly equates to a six-year holding period. By 1979 the turnover rate increased to 63.3%. In 1998 it was already 83%. In 1999 it exceeded 100% and since than keeps accelerating at an ever faster rate.

It is the ever-increasing flow of data and information meeting an ever-increasing crowd of ignorant and incompetent market participants. To those market participants the future seems closer and more knowable than ever. They attempt to "time the market" and make ever shorter-term bets. They mistakenly assess their ability at information processing and certain investment activities to be much better than objectively true. It seems logical that a money manager who turns over his or her portfolio at a high rate must have confidence that all the individual investment decisions he or she is making must be right. Unfortunately, it ain't just true. Numerous studies have showed that they merely diminish long-term returns.

If those investors want to become more successful they have to calibrate their confidence. They need to work on their incompetencerecognitioncompetence.  If successful it will result in a lack of confidence and being more reflective in one’s abilities. In the field of stock investing usually this lack of confidence transmutes in a lack of activity.

The investor now is ready in mastering the art of doing nothing and the virtue of being lazy when it comes to investing. The art of doing nothing and being lazy has proven over a long time to produce better returns. It is high time you admitted being stupid. Because we all are. Than you are not that stupid anymore, and almost a genius! At least when it comes to investing. Or are you still rubbing your face with lemon juice?

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Source:

Dunning Kruger - We Are All Confident Idiots

The Anosognosic’s Dilemma: Something’s Wrong but You’ll Never Know What It Is

Ben Carlson - The Value of I Don’t Know

VALUE INVESTING and BEHAVIORAL FINANCE; Presentation by Christopher H. Browne to Columbia Business School Graham and Dodd Value Investing 2000; November 15, 2000







3 comments:

  1. "The art of doing nothing and being lazy has proven over a long time to produce better returns." I managed the first part already!

    ReplyDelete