You, Investing vs. the Institutions

From 9/11 to 20-second stock holding...

On 10 JULY 2001 an Arizona-based FBI field agent called Ken Williams filed a warning with his bosses in Washington and New York, writes Tim Price at Price Value Partner.



It was a six-page document that began as follows:



"The purpose of this communication is to advise the Bureau and New York of the possibility of a coordinated effort by USAMA BIN LADEN (UBL) to send students to the United States to attend civil aviation universities and colleges."



As Steven Johnson, author of 'Where Good Ideas Come From' points out, this was the infamous "Phoenix memo", in which Williams had been compelled to draft his warning after detecting an unusually high number of people of "investigative interest" who had signed up at various flight schools in Arizona.



Among the people Williams had interviewed was Zakaria Mustapha Soubra, an aeronautical engineering student on an F-1 visa from the UK. Soubra had pictures of bin Laden at his home. But after sitting on Williams' memo for three weeks, the agency assigned it to an analyst, who labelled it "routine".



One month after Ken Williams filed his memo, Zacarias Moussaoui enrolled at Pan Am International Flight Academy at St Paul, Minnesota, where he started training to fly a Boeing 747-400 on a simulator. Onlookers grew suspicious after Moussaoui paid his entire $8,300 fee in cash, and claimed to have no interest in ever flying a real plane. Pan Am contacted the FBI. The FBI in Minnesota then tried frantically to obtain a search warrant to examine files on Moussaoui's laptop. That search warrant would not be granted until the afternoon of September 11, 2001.



Our point is not to criticise the FBI or its role in US homeland security – they're tasked with a huge, difficult and complex job. But it is to highlight that in large organisations, things get missed. It wasn't that the FBI was unaware of a possible plot involving foreign students and aircraft – to their very great credit, an agency staffer reported his concerns. But the agency was too big, or too bureaucratic, to act sufficiently quickly on that information.



The history of the financial crisis that erupted in 2007/8 and which continues to cast a long shadow over global monetary policy, fiscal policy, interest rates and stimulus-out-of-desperation, is a history of failing institutions. Central banks and government regulatory agencies conspicuously failed to understand, oversee or control commercial and investment banks during a historic property and credit bubble. And banking institutions, as we know only too well, by and large completely failed to manage their own balance sheets and risk exposures. Worse still, the markets have become hijacked by institutional entities with little or no interest in investing for the longer term.



Happily, that could create some great investment opportunities for us in the years ahead.



Consider the following astonishing statistic. Michael Hudson, a professor at the University of Missouri, has suggested that the average holding period for a US stock is 22 seconds. The average foreign currency investment lasts for 30 seconds. The markets have become playgrounds for what are called High Frequency Traders, in most cases computer-driven algorithmic models.



The average holding of period for US stocks has collapsed. From the 1940s to the 1960s, the average holding period of US stocks – in months – was between 60 and 100. Within the space of a few decades that average holding period has gone from many months to just a few seconds.



By the same token, Dollar trading volumes vs GDP have exploded. The 1929 US stock market peak coincided with a peak in this ratio: of over 100%. But having been well below that level for the rest of the last century, Dollar trading volumes relative to GDP in the US ballooned higher in the 1990s, and from 1999 vaulted over that 1929 level to over 400% in recent years.



We're no Keynesians, but we will grant that the old economist had something to say on the subject of speculation:



"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."



Here's the good news



We happen to think there's something positive in these otherwise malign trends. We're not traders either, and we have no interest in the minute-to-minute (and now second-to-second) gyrations of the market. Trading is best left to the alleged professionals. But it may well be that with all these computers and algorithms trading against each other solely with a view to getting an edge over a time period that might only be a few seconds long, they give rise to occasional opportunities for genuine value investors to prosper, particularly when favoured stocks get driven down to unusual levels. These systems are not interested whatever in longer term value, but only in short-term speculation and accumulating multiple numbers of relatively tiny trading profits. They have reduced the market, in their terms, to a casino in all but name. Rather than be buffeted about by the 'noise' players in the high frequency trading arena, we'd rather stay out of the way and bide our time.



Jesse Livermore was a famous stock trader during the early 20th Century, who made and lost several fortunes during a turbulent career. But he had a rare insight into the psychology of successful investing:



"The big money is made by the sittin' and the waitin', not the thinking. After spending many years in Wall Street and after making and losing millions of Dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting."



As a private investor you have one enormous advantage over the professional trader. You can invest when you like – and you can sit on your hands for as long as you like. The professional trader, especially if employed by an investment bank or hedge fund, is more or less compelled to trade. We alluded to this disparity in our recent commentary 'The smartest guys in the room'. As the US author and asset manager Jim O'Shaughnessy puts it,



"Markets change minute by minute. Human nature barely changes millennium by millennium. There's your edge."



Or as the popular Liverpool beat music combo 'Frankie' once advised: Relax.



In 1972, the great 'value' investor and our preferred investment guru, Benjamin Graham, wrote:



"The speculative public is incorrigible. In financial terms it cannot count beyond three. It will buy anything, at any price, if there seems to be some 'action' in progress."



Be careful what you wish for. The 1990s' wave of disintermediation of bankers and full-service brokers brought with it stock trading in real time. Gone were the days when you could only access stock prices by telephoning your broker or waiting to read the market reports in the next day's Financial Times. Thanks to firms like Charles Schwab, the stock market could now be played like a computer game. Stock prices became animated, visual and constantly changing: green for up, red for down.



We're not Luddites, and we happily concede that there can be no uninventing the web. The point is that the immediate gratification of online share dealing is not an unalloyed boon to investors. It comes at a price – the price being the fact that our brains are insufficiently evolved to deal dispassionately with losses visible in real time. Our brains are also hard-wired to practise pattern recognition and prediction. This served our ancestors well when we roamed the savannah searching for food and learning to avoid predators. It serves us as investors less well when we 'see' patterns in stock prices that aren't really there, or when the amygdala in our brain, the seat of our 'fight or flight' response, is stimulated almost beyond endurance by a loss-making online transaction.



Using MRI scans, leading brain researchers including Jordan Grafman at the National Institutes of Health and Hans Breiter of Harvard Medical School have demonstrated that the more frequently people are told that they are losing money, the more active their amygdala becomes. Jason Zweig, a columnist for the Wall Street Journal, observes:



"There can be no doubt that online trading, by displaying stock prices in a dynamic visual format that can directly activate the fear centre of the brain, made losing money more viscerally painful than it had ever been before. Once the arrows (denoting stock prices) turned red, investors could not help but panic. And the red arrows were everywhere: on their computer screens and financial television programmes in pubs and restaurants, bars and barbershops, brokerage offices and taxicabs. Investors no longer had the option of simply not opening the newspaper. Technology had turned financial losses into an inescapable, ambient presence."So what's the solution?



The business of investing is not meant to be exciting. Rather than falling prey to sensation-seeking behaviour, the practical response to the temptations of the digital age is almost comically simple. Just turn the computer off.



To some, depriving oneself of trading info will be unthinkable. But consider Nassim Taleb's retired dentist. Showcased in Taleb's excellent book, 'Fooled by Randomness', our hypothetical friend is destined to earn, on average, 15% per annum from his portfolio, with an associated volatility (annualised standard deviation of return) of 10%.



If our retired friend monitors his portfolio in real time, however, the (entirely random) short-term oscillations of the market, and therefore of his portfolio, are bound to trigger extreme anxiety. Depending on the frequency with which he observes his portfolio, our friend can precisely control the extent of heartache and distress to which he will expose himself. The following table makes the risk/reward outlook quite clear.



Frequency of monitoring the portfolio Probability of pleasurable outcome



1 second 50.02%

1 minute 50.17%

1 hour 51.30%

1 day 54%

1 month 67%

1 quarter 77%

1 year 93%

Source: 'Fooled by Randomness' by Nassim Nicholas Taleb.



The lesson is clear. Too much portfolio monitoring can be injurious to your health. If Taleb's dentist simply moderates the frequency with which he checks his portfolio, he will boost his chances of incurring a positive emotional outcome from that monitoring. And note that nothing changes about the composition of his portfolio – only the frequency with which he checks it.



The same holds when it comes to consuming financial news. The continuing enhancement of digital communication technologies is a double-edged sword. It means that absorbing financial and investment information from the web, or from the world's various news media or cable channels, is like drinking from a fire hose. Here is one of the funniest things ever said by an asset manager:



"Whenever I go into a brokerage office and see that the brokers are all watching CNBC, it feels like walking into the Mayo Clinic, and finding that all the doctors are watching 'General Hospital'."



Again, the solution is plain. Whether it's a TV screen or a computer screen, just turn it off.