Chart Fun | Mirror, Mirror On The Wall, Who Is The Best Of Them All?
Mirror, Mirror On The Wall…
Everyone’s familiar with the tale of the Magic Mirror wielded by the Evil Queen in Snow White. The Magic Mirror tells the Evil Queen what she wants to hear; until one day it doesn’t.
This pushes the Evil Queen down a gory path resulting in an unhappy ending for the Evil Queen.
This edition looks at a Magic Mirror question faced in the investing world.
Separating luck from skill is the Holy Grail in investing. In keeping with our natural preference for privatizing credit and socializing losses, most of us tend to ascribe good outcomes to our skill, and bad outcomes to luck.
Who is a “good” investor?
Judging Investment Performance is akin to peering through a kaleidoscope. Turn the instrument a bit, and the whole view changes; quickly turning this process into a bewildering exercise.
How does one judge investors/investment performance?
This post takes a look at this critical nuance. It also focuses attention on the behavioral aspects that influence decision making.
Who Is A Good Investor — I?
Here’s a snapshot of three public market investors with long track records over the same time-frame.
The third row is seen rarely in claims of investment records. It happens to be one of the most critical questions that one should pose before judging investor records.
As you may have noticed already, the inclusion of the third row helps shape the decision in our heads. A good example of how looking at relevant information is a critical component of decision making.
A has held many securities, B has a concentrated bias, C takes the concentration to an extreme. The Worst Loss profile reflects this effect. However, all 3 have generated the exact return.
- If you had allocated equally across these 3 investors, and ended with the exact same return; would you care about the path taken to deliver your outcome?
- Suppose you now had to allocate a new round among these investors? Who would you pick, and would your allocations change?
Before reading further, think of your answers (welcome to share in the comments).
Time to unleash the kaleidoscope.
Those of us bred on a diet of Warren Buffett/Charlie Munger would point to either B or, perhaps C, as the better investor. After all, their concentrated portfolios perhaps indicate a finely honed punch card. They seem to know what they are buying. However, A has demonstrated tremendous Consistency. They have owned a lot of names, and yet churned out the same performance.
The above table, while idealized, mimics the records of real-life investors. A = Walter Schloss, B = Warren Buffett, C = Charlie Munger.
While B and C have demonstrated a talent for betting on a winning horse, A has demonstrated a talent for betting on a number of winning horses.
Who is better?
A’s diversification may be a function of risk aversion (shows in their Worst Loss Behavior), or “not knowing enough about what they own”.
As an allocator, which one would you prefer?
The answer often reveals more about the allocator than the investor. We tend to invest with folks who think like us.
Who Is A Good Investor — II?
Time to dig a little deeper, and make things more interesting.
Here’s a snapshot of three different investment strategies over the same time-frame.
The Short-Only strategy has delivered the lowest return of the three, but has the best Worst Loss record. It has demonstrated great Consistency (Low Top 5 contribution to return). Moreover, it has delivered on its basic premise. Short Contribution to Return is positive (compared to negative Short Contribution for the Long/Short strategy).
The Long/Short has delivered the same overall return as the Long Only. However, it has taken a dramatically different path to the same destination.
The Long/Short too has demonstrated Consistency, and has exhibited better Loss behavior than Long Only. Moreover, its Longs have a higher contribution to overall return than the Long Only. A remarkable feat. However, the Shorts have subtracted from overall return (“why did they even do it?”). The Shorts may have dragged overall return, but they have served to mitigate Worst Loss. A good trade-off!
The Big Question.
Who is better?
The Behavioral Angle
Often, the solution to such vexing questions is to compare a strategy with its own cohort. This makes it easier to effect the cliched Apples to Apples comparison.
On many occasions, though, there is not much of a cohort to work with!
What does the allocator do in such instances?
The headline Investment Return becomes the overarching vector driving decision making. However, here are some pointers to focus on that could help make this decision easier.
- A long investment record.
- The Worst Loss behavior.
- The investor’s personality type.
- The investment strategy behavior.
- Minimizing the Big Errors, rather than maximizing Return.
Tail-risk strategies behave differently from “normal” strategies. Put Writing strategies have similar payoff profiles to High Yield/Merger Arbitrage strategies.
Increasing one’s investing repertoire (“circle of competence”) is a time-tested method of increasing odds of success.
The Magic Mirror that we typically use in markets tends to reflect what we want to see; unlike the Evil Queen’s Magic Mirror that reflected the truth.
