End of history, probabilities, David Einhorn and the death of value?
The best investment research, blogs and podcasts this week
Back in 2013, a group of psychologists came up with something called the end of history illusion. It’s all about the perspective that people have of themselves.
The study by Jordi Quoidbach, Daniel Gilbert and Timothy Wilson found that people tend to think that they’ve changed a lot in the past. They see the present moment as the culmination of those changes and their present self as the person they will always be from now on.
In other words, people underestimate how much they will keep changing. Thoughts, beliefs and behaviours are all likely to evolve - but people don’t see things that way and they don’t make allowances for it. The illusion affects people of all ages, but it’s particularly strong in young people.
A consequence is that we don’t take enough account of the future. All the way through life we find ourselves having to undo previous poor decisions - from suspect tattoos and misguided partner choices to not saving enough for retirement. We all indulge too much in the present, which can make life tricky in the future.
Morgan Housel wrote about the end of history illusion in his book The Psychology of Money, and he mentions it in his most recent post here: Mental Liquidity. In there he explores why changing your mind is such a hard thing to do, and why people go to great lengths to avoid the uncertainty that comes when you have to re-evaluate prior beliefs.
This leads me to something similar I saw this week from Dan Rasmussen of Verdad called Memory and Probability. In it he reports on how research is coming up with new models for understanding how people assess probability. It’s different from the end of history illusion, but it leans on how age and perception play tricks when it comes to making predictions.
The research he recounts was done early in the Covid pandemic and asked people about how lethal they thought the illness was:
Old people underestimated their own risk
Young people dramatically overestimated their own risk
People who overestimated the number of Americans with red hair were the most pessimistic about their own risk
I’m paraphrasing Rasmussen here, but the responses didn’t fit a recognised model. The researchers concluded that it was down to how we use memory to shape our views of the present and predict the future. In other words:
Old people made judgments based on wide experience of surviving adversity in the past
Young people have very little experience of previous adversities so they overestimated the risks
People who overestimated the number of people with red hair were swayed by personal experience and tended to overestimate rare events
In an update, the researchers behind this study have used the findings to build a model of under and over-reaction. It hinges on people drawing selectively from previous experiences in order to make decisions.
Rasmussen writes: “According to their model, our memory is triggered by similarity, and we tend to overestimate the frequency of things that are easy to recall.”
What could all this mean? Well, according to Rasmussen, the research could help develop “a better model of how human cognition works and how humans make decisions.” And for investors, there could be alpha opportunities for quantitative investors:
“Fundamental investors will likely rely on their memories to make probability judgments, matching prospective investments to similar ones that worked in the past. And they are more likely to project the recent returns and correlations of different asset classes to remain constant. Quantitative investors, in contrast, will draw on a fuller probability distribution and, ideally, be able to make more accurate probability assessments that are not as biased by recent experience and human memory.”
Will value investing ever recover?
One of the classic claims of battle-hardened value investors is that value investing will never really stop working because it periodically goes through phases of underperformance. The very fact that it suffers difficult spells keeps the cycle going: things get expensive and bubbly, they collapse and value investors step in. It’s a virtuous circle.
Except maybe the last ten years or so really did change the nature of value investing. In interviews in recent months, David Einhorn, who runs the long/short hedge fund, Greenlight Capital, has hinted that he thinks it might have done. It’s strange to hear someone say it out loud. Especially a value investor like him.
Einhorn built his reputation on the strength of his company analysis. He buys cheap quality when the market isn’t interested and sells when it is - the age-old value approach. He’s made a fortune doing it. But listening to him in conversation with Patrick O’Shaughnessy, it feels like he’s not sure that approach works so well any more…
Invest Like the Best with Patrick O'Shaughnessy - David Einhorn - The Long and Short of Investing - [Invest Like the Best, EP.322]
At about 17 minutes in, O’Shaughnessy asks how his approach to portfolio management has changed over the years.
Einhorn says he learnt a tough lesson in the 2008 financial crisis. At the time, Greenlight could see what was going on and had shorted a number of banks and other financial stuff. But the crisis ended up having a big impact on the firm’s long positions, which were exposed to the tightening credit conditions and the recession.
So 2008 was Einhorn’s worst year. Greenlight lost 18% (while many others lost a lot more than that) but he felt that seeing as they saw the crisis coming, the result was unacceptable.
Another change in his thinking is that he feels he can’t rely on the market recognising the value in his positions. In other words, he’s done all the analysis and valuation work, but the market isn’t catching on and pushing the prices up.
He says: “...in the last couple of years I’ve had the realisation that with some of these stocks nobody’s ever going to care. Nobody’s paying attention, nobody’s doing the work, nobody cares what the company says, there’s just nobody home. So we can’t make money by trying to buy something three months or six months or a year before other long-only investors figure it out because they either aren’t there or don’t have any capital or they’re turning into index funds.”
As a result of this, Einhorn says they’ve reconstructed their long book so that, in theory, it earns a return just on what the companies are able to pay them, as opposed to relying on other investors to figure it out.
That feels much more like a buy-and-hold quality approach than a traditional own-it-until-the-value-outs value investor’s approach. And as he says himself, it’s certainly going to involve longer holding periods.
Another interesting moment is when he’s talking about Greenlight’s difficult performance in 2018, when they were losing money on the long and the short side. He says it felt like one of the few viable options was to liquidate the fund and go to cash.
He regales getting consultants in to analyse the firm’s strategy, including factor specialists and technical analysts. But at the end of the day, they were just in an impossible environment - and now fortunately they’ve made it to the other side.
Have a great weekend,
Ben
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