Beware False Prophets Bearing Profits

Monday, May 17, 2010

Investment adviser write-ups can give us valuable insights, particularly in times like these. Remembering that honesty and humility are key characteristics of top advisers, we can use their newsletters, articles and blogs to judge those qualities.

As we know, the US stock market has been buffeted by these major factors recently:

  1. Better-than-expected economic measures
  2. Better-than-expected earnings reports
  3. The European Union’s vacillating reaction to Greece (and Greek “contagion”)
  4. The stock market’s 1000-point gyration on May 6 and lack of information

The first two items underlie company and stock performance. Analyzed and acted upon well, the investment adviser can produce good performance over time.

The last two items are different. They are examples of abnormal events and reactions – low probability risks that periodically show themselves. And these can allow us to gain insight into an investment adviser.

Before discussing evaluating an adviser, I want to spend a moment describing those last two risks in general.

No risk is predestined. Potential risks are being described daily. Many (or most or all) are correct explanations of possible outcomes, but few will actually occur. When something does happen, the probability of that risk obviously rises to 100%. However, that does not mean the risk was preordained. Nor does it mean the non-occurring risks had probabilities of 0%.

Profit requires both “what” and “when.” Timing compounds the problem of making money from anticipating risks. That’s why the media puts forecasters of an unusual event on a pedestal if their pronouncements immediately preceded the event. For others who predicted it, but earlier, they’re out of luck. Like in “The Price Is Right,” the spoils go to those who were closest to the event without going past.

When unusual risks happen, how investment advisers deal with them and explain their actions can give us the insight we’re looking for. What we want to see, whether or not the investment adviser profited, is a sound explanation of the event, how it affected the portfolio and what actions the manager took as a result.

If the adviser profited, we then want to see a good dose of humility – an expression of being fortunate. What we don’t want to see is an interpretation of luck as skill. Regarding the 1000 point gyrations, here are three examples:

  • Adviser #1 said he dodged a major bullet through luck. He had made some new trades, but had not yet entered his normal stop-loss orders (you can read more about orders and the lessons learned by the May 6 events in “Trading Strategies for Today’s Markets” – May 13). So, when the drop occurred, his positions remained intact.
  • Adviser #2 said he was fortunate to have placed some buy limit orders well below the current price levels in case the market sold off. He then benefited when the stock market dropped quickly, even though he hadn’t anticipated the reasons for it.
  • Adviser #3 is the antithesis of those two. He talked about how well he had done, first by shorting stocks at higher prices, then by earning profits and going long on that Thursday selloff. The heavy implication was that his skill and wisdom had produced the profits and that this proved his superiority.

In my 30-year experience running and working with multi-management funds (where I selected independent investment managers to run the funds), I had an ironclad rule. If a potential manager said the reason for his/her superior performance was a higher intellect or skill level, I crossed the person off the list. Such a statement showed both hubris and a lack of understanding about risk’s fickleness.

So, read those recent event write-ups by investment advisers you use or are interested in. If they express humility about any seemingly wise moves made, put them at the top of the pile. If they tout their brilliance, cross them off the list.

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