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February 18, 2006

Hard-wired to Fail: Why We Need Contrarian Managers
by Doug Wakefield

"A mutual fund's past performance, which is the first feature that investors consider when choosing a fund, doesn't predict future performance. Funds buy expensive ads in newspapers and magazines to tout their performances over the past one, three, five, and ten years. The mutual fund industry irresponsibly promotes this 'culture of performance,' even though it knows perfectly well that it misleads investors. When it comes to mutual funds, the past is not prologue."¹ [Emphasis mine]
- Former SEC Chairman, Arthur Levitt

In the fall of 2004 I had just completed a talk for a group of accountants and attorneys who work with several foundations. I told them, prior to my presentation, that the material would not be comforting, but that since there were substantial implications to those who depended on their leadership, we needed to address these dilemmas. When I finished, one gentleman said something interesting to me. He said,

"The institutional consultant we work with today reviews hundreds of managers and tons of information. They look at market information through historical averages, and operate from the premise that we can't know what will happen in the future. It always feels like they're trying to drive down the highway, looking in the rearview mirror. But your presentation was different. It's like you are saying, "look dead ahead."

Perhaps he had heard the same bromide that Robert Prechter refers to in the statement below.

"'Economic Forecasting' goes the old joke, 'is like trying to drive a car blind-folded and following directions given by a person who is looking out the back window.' With socionomics, we are no longer looking out the back window; we are facing forward. With the Wave Principle, we are no longer driving blind. We can see enough about the road ahead to negotiate the car."²

While some may dismiss the study of socionomics and wave principles, we can hardly deny that our investments decisions are affected by our emotions.

We have met the enemy, and he is us.

Undoubtedly, we are all familiar with the right-brain, left-brain concept of an emotional and a logical side of our minds. From the highest paid CEOs and the most powerful politicians to the lowest paid fast food workers and the smallest children, we observe both emotional and logical actions and reactions. Indeed, we see the same thing in our own every-day behaviors.

Yet, when it comes to investing, the vast majority of investors fail to recognize the power and influence our emotions exert on our decisions. In our discussion of how our emotions affect our investment decisions, we will start with three terms used by Dr. Paul MacLean, former head of the Laboratory for Brain Evolution at the National Health Institute. He notes three parts of the brain: the logical part of the brain, which is housed in the neocortex, the emotional part of the brain, found in the limbic system, and the instinctive part of the brain, located within the basal ganglia.³

The hindrances to logical, or unemotional, investing would be difficult to overstate. In short, the basal ganglia and limbic system are the parts of the brain that guide the behaviors that are required for self-preservation, and since money is something we need to survive, these emotional and instinctual forces exert a very strong influence on our investment decisions. To make matters worse, research shows that these two parts of the brain do not learn from experience. Also, since flocking or herding is part of the self-preservation dynamic in mammals, going against the crowd is completely unnatural. This is why it is easy to intellectually agree with Buffet's or Templeton's admonitions to invest oppositely of the crowd, and so extremely difficult to actually do it. In other words, whether we are professional or retail investors, we are hard-wired to fail.

As we try to understand our predicament, consider Harvard psychologist Daniel Goleman's words:

"Certain emotional reactions occur before the brain has even had time to fully register what it is that is causing the reaction: the emotion occurs before thought."⁴

And, in most areas of our lives, this serves us well and is essential to our survival. Indeed, if when we were presented with a life-threatening situation, we had to stop and mull over our thoughts, the human race would be hard pressed.

However, when it comes to investing, if we never stop and ponder how our emotional and instinctual tendencies affect us, we will eventually fail. We ride the wave of current success, drawing comfort from the fact that so many others agree, with us, that the "good returns" will continue, and are dumbfounded when we crash. Many of us are so averse to the negative feelings, of anxiety and fear that the consideration of a crash conjures, that we avoid even thinking about the possibility⁵ much less preparing for it ahead of time.

Don't get me wrong. In some ways, not wanting to consider a severe downturn makes sense. We all want our jobs and futures to be secure and successful. It is inherent that only a few would suggest it could be otherwise, and since it's only a few, it's much more comforting to rationalize that the masses supporting our optimistic view must be right. It's easier to label something or someone "pessimistic" and dismiss those unpleasant thoughts right out of mind. Yet, this is the reason that millions of investors will lose substantial amounts of funds in the years ahead. And, to me, that doesn't make sense.

Contrary to popular belief, investing opposite of the crowd is even harder for professional managers, because their livelihoods are contingent on their short-term performance. Again, in speaking about the shortcomings of the mutual fund industry, Levitt states:

"Then there's the herd mentality of active fund managers. Most of them flock to the same familiar companies and often overlook the new, obscure companies that show great promise. But they take comfort in knowing that, even if their fund misses out on a great opportunity, most of the others in its peer group will too."⁶

During an interview for our research paper, Riders on the Storm, renowned short seller, Jim Chanos addressed the difficulties most managers face when they attempt to invest opposite of the crowd.

"Most human beings perform best in an environment of positive reinforcement. We like to be told we are smart, we're on the right track, we're doing the right thing, and that the stocks we bought are cheap and are going up and that their earnings are going up as well."

"Wall Street is a giant positive reinforcement machine. That's why it exists. If you're a short seller, you're coming in everyday, and out of the fifty names in your portfolio; you can count of ten names where there will be some noise. Stocks recommended, re-recommended, earnings estimates raised, CEO on CNBC: whatever it is, you'd be facing that noise. And, a lot of very good value managers completely break down when confronted with the fact they have to invest against the grain in front of all that noise."⁷

Avoiding the noise of the crowd is a rigorous test of any money manager's skills. But, someone will ask:

"Might the rare nonherding professional fund manager rise above this dynamic? In most cases, he cannot. His choice is this: He can raise cash in a bull market and buy stocks in a bear market, which would be prudent investing, or he can stay in business. This is his choice. If he acts counter to the market's trend, then his customers leave in droves. Rationality, to most managers, means getting rich giving customers what they want, not losing most of them with prudent investing. Regardless of the market outlook of any specific fund manager, then, the herding majority remains inn complete control of the bulk of professionally managed money."⁸

And, now we see why Excellent Managers are such a rarity. The following comment, by Robert Prechter, summarizes all that we have covered to this point and why there are so few successful investors.

"Unfortunately, independence is excruciatingly difficult for most people to assert in socially charged situations because the effects of the patterns are so pervasive and the power of the unconscious so strong. Hope, fear, denial, and inertia are all part of the process. It is work to exercise and train your neocortex to overcome these influences and act independently. The number of consistently successful traders and investors is infinitesimally small compared to the total number of participants in markets.⁹

Now, let's change gears and see how this has played out over the last several months in the real world of the stock market. Before we do, let's remember that, according to the Efficient Market Hypothesis, investors are all rational actors responding to the unfolding whims of the market.

"Security prices themselves are rationally and efficiently determined by such fundamental considerations as earnings, interest rates, dividend policy, and the economic environment. Changes in these variables are quickly reflected in a securities price, and only new information will alter that price."¹⁰

Okay then; let's look at the market's reactions to some of the negative news that has come out over the last several months. We'll start with the January 30th announcement that our nation's GDP grew an abysmal 1.1 percent during the last quarter of 2005.

"Even the pessimists were too optimistic on fourth quarter growth, which slowed to 1.1 percent, less than half the consensus forecast and about one-fourth the third quarter's 4.1 percent pace."¹¹

So, on the day that we realize our economy slowed more than twice the amount that was expected, the day the Gross Domestic Product growth of our entire nation is reported to be 75 percent lower than the previous quarter, it has little, if any, effect on the markets, and two days later is a distant memory.

Or, let's consider Hurricane Katrina's influence on the markets. Remember, Hurricane Katrina made landfall on Monday, August 29th.

So, immediately following the most destructive hurricane to ever hit an American coast, the Dow rallied over the next two weeks. Does this move in the Dow reflect investors who were rationally and efficiently adjusting their positions as reports of this event continued to dominate our news channels?

Actually, the Dow's rallies in the face of bad news are really not that surprising. The chart below shows that there have only been eight weeks since 2000, where there were more bears than bulls. That means that while the Dow was crashing, from 2000 to 2002, there were only eight weeks when investors were bearish about the future direction of the market. In the same chart, we can also see that bulls have outnumbered bears every week since late 2002. This 173-week run of more bulls than bears is an all-time record.

Source- www.decisionpoint.com

Most of us are convinced, by the rhetoric, that the last 3 years have "proven" that the markets can overcome anything. And, why wouldn't we be convinced. The Dow lost 201 points on Friday, January 20th. Outside of that, the Dow has not seen a move of more than 2 percent in almost 3 years. In this type of environment, it is easy to forget 2000 to 2002 and to be lulled into thinking that the last three years are the norm.

We are all pretty comfortable. The chart to the left shows that the volatility index is trending near a 15-year low. Since we see no reason for alarm, many of us have relegated advisors and managers to a position where we believe that their primary function is to make us feel comfortable. We do not realize that comfort can be very deceiving.

For your own benefit, I implore you to shake off the lethargy these last few years created, and to rigorously pursue actions to safeguard your capital. We cannot count on an extrapolation of the past three years. We must engage our minds and we must seek contrarian managers with proven track-records to help us navigate the storm ahead.

I leave you with this. The statement below was made less than eighteen months before the onslaught of 2000 to 2002. Many of us were fortunate enough to recoup some of our losses from that time. Are we foolish enough to let our financial futures ride on the roulette wheel again?

"This expansion will run forever. We will not see a recession for years to come...as we have the tools to keep the current expansion going. Policy levers and our policy team... will keep it from happening."¹²

Sources:
1. Take on the Street: What Wall Street and Corporate America Don't Want You to Know, What You Can Do to Fight Back (2002) Arthur Levitt, pg 56
2. The Wave Principle of Human Social Behavior and the New Science of Socionomics (1999) Robert R. Prechter Jr., pg 388
3. Ibid, pg 149
4. Ibid, pg 150
5. Dialectical Behavior Therapy in Private Practice (2005) Dr. Thomas Marra, PhD, pg 18 (a special thanks to Dr. Robert Hay, Denton Texas, for this contribution)
6. Take on the Street, Levitt, pg 56
7. Riders on the Storm: Short Selling in Contrary Winds (2006) Doug Wakefield with Ben Hill, pg 50
8. The Wave Principle of Human Social Behavior, Prechter, pg 355
9. Ibid, pg 415
10. Investments: An Introduction, Seventh Edition -Custom Edition for the College for Financial Planning, pg 272-273
11. "The Worst News Wasn't even the GDP Report", Bloomberg, Caroline Braum, January 30, 2006
12. These comments were made by an economics professor at MIT, "Growth Forever" by R. Dornbush, July 30, 1998, The Wall Street Journal.

Doug Wakefield,
President
Best Minds Inc., A Registered Investment Advisor

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.

Copyright © 2005-2009 Best Minds Inc.

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