史蒂夫·福布斯访谈

July 11, 2011

Steve Forbes: Michael, good to have you with us. Before we begin the interview: Investors Think Twice, great book.

Especially chapter 8, “Sorting Luck From Skill,” which we'll get to in a moment and will be the basis of a new book yet to come.

Three numbers: 9, 7.5 and 6. You've made the point the S&P averages, say, about 9% growth. Mutual funds maybe 7.5%.

Individuals, even if they invest in mutual funds, 5.5% to 6%. What is going on here?

Michael Mauboussin: Yeah, Steve, those are the most probably depressing statistics in all of investing, right? As you point out, 9% is what the market does over the long term. 7.5% is what mutual funds earn, and the difference is primarily fees that mutual fund managers charge. But that we could probably live with because, on balance, the only way to get excess returns is through active management.

The most depressing one is the bottom one, right? Which is what investors earn, which is typically about 60% to 70% of the market's returns. And you say, ‘Well, why are they doing so much worse than mutual funds?”

Because they're probably investing in mutual funds.

And the answer is: Timing. Or I should say, bad timing. That is, most individuals tend to buy when things have done well and sell when things have done poorly. So they miss out on the subsequent rises when they sell, and of course the subsequent reversals when things have done very well in the past. They buy high and sell low instead of what you're supposed to do.

Forbes: That gets to a paradox, by the way, of mutual funds – that is, people who are in load funds tend to do better than those in no loads. Why? Even though they're getting shafted by high fees, they don't move their money as much, precisely because they do know they're going to pay a penalty.

Mauboussin: Exactly right.

The American Ethic Forbes: Now, you said the word "individuals," but you also make the point institutional investors are prey to this. That they leave – you've calculated or others have calculated – $170 billion. They have a short-term time horizon, by your likes, three years. And you say one third of the relative underperformance is asset allocation and two thirds is individual managers.

Mauboussin: Also a crucial point. So you could understand why mom and pop mutual funds maybe would do poorly, but this pervades institutions as well. And it's interesting. The American ethic, or probably Western ethic, is hard work equates to better outcomes. So doing things tends to be a good thing.

That's not always true in the world of investing. I think many managers or endowments and pension funds feel like moving money around is a really crucial way to improve the performance. But again, their timing tends to be very poor. You cited that number, $170 billion. Researchers studied this that they left, well, the opportunity cost in effect was $170 billion. Now, the base is still trillions, but it's not an insubstantial sum of money that they're leaving on the table. So, yes, our time horizons tend to be too short, and we've got this sense of activity equating to results, which in the world of investing simply doesn't work.

Forbes: So the hot hand. In other words, a manager who does well will get the job; a manager who underperforms will lose the job, even though the underperformer may come back. How do investors learn to accept the fact even skilled managers – and we'll get to skill in a moment – have periods of underperformance?

Mauboussin: Right.

Forbes: A baseball team is going to have a period where it's not going to do well.

Mauboussin: Exactly. I love talking with sports metaphors. The hot hand, by the way – most sports fans and certainly athletes believe

in the notion of a hot hand. That is, if you've done well recently, you've made your recent shot, you'll make the next one with a higher probability. Where the inverse, of course, is where if you've missed it, you're going to miss with a higher probability.

But statisticians have poured over this for a number of years, and I think, at best, there's little evidence for the hot hand. The problem is, though, we still act as if it occurs. And to your point, there was a really fascinating study. It was over 3,000 plan sponsors – these are endowment funds and pension funds, the folks that are doing this for a living.

Forbes: They're supposed to know what they're doing.

Mauboussin: They're supposed to know what they're doing. And what they did is they typically hired folks that had outperformed the market recently. And they fired them for a bunch of reasons, but the number one reason they fired them is they had underperformed their benchmarks recently. And to wit, of course, the next 24 months, the folks that they fired did better than the folks that they hired. So had they simply sat on their hands, they would have been better off.

So that is the message of the hot hand. And it’s mean reversion as well; when things have done very well in a mean reverting system, be cautious, because the most likely next move is down. And when they've done poorly, the next likely move is up.

Boy, the Boston Red Sox; people don't like talking about that in New York, but the Boston Red Sox are a great case. They started off the season I think 0-6, and I think at one point were 2-10.

Forbes: 2-10, yeah.

Mauboussin: But of course now, at least at this moment, they’re leading the American League East. So short time periods in mean reversion series can be very misleading.

Time Horizons Are Too Short Forbes: Now, one can understand individuals being prey to their emotions.

But why this short-term time horizon among institutional managers. And is it getting worse, not better?

Mauboussin: That's a tough one to answer. I think that the typical horizon – and there's been academic research on this as well – is about three years. So an institutional manager will say, "I'll give my money manager about three years." But it turns out, that is too short a period of time.

And, by the way, three years sounds totally sensible, especially in the career path of a chief investment officer of one of these funds. But it is too short for many, many strategies.

So whether it's getting worse or better, I think there are debates on both sides. I think the general sense is that there's more short-termism in the world today, both at corporations and at money managers, than we've seen in the past. Although I think if you go back in history, in almost any decade there was lamenting about short-termism. So the complaint itself is not new, but certainly it seems to be continuing.

Investing Is More Luck Than Skill

Forbes: Now, we get to something that'll make a headline, but you've got to explain this. You say that in investing there is more luck than skill, which will have all professionals ready to strangle you. We will protect you.

Mauboussin: Right. Well, thank you, first of

all. But in the sense, it's almost a compliment, not something that's so negative. And here's one of the ways I will explain this: The first thing I would like to say is you can think about any activity in life as having a continuum from pure skill and no luck to pure luck and no skill.

Forbes: Pure luck being the slot machine.

Mauboussin: Yes.

Forbes: And pure skill?

Mauboussin: That would be if we go play a chess match or we play tennis or run a race – the better fellow is going to probably win, will win. And then slots as you point out, lottery, these things are pure luck. And almost everything in life is somewhere in the middle of these two extremes. The question is:

Where does it lie?

Now, there's a really interesting idea called the “paradox of skill.” And what that says is when people compete with one another, the more skillful they are the more uniform their results become – the more luck becomes important. This is another way of saying the efficient market hypothesis, which is if it's a very competitive world out there – there are low barriers to entry, everybody's got the same information, the same computers and reading the same academic research – it's going to be very, very competitive. And then luck is going to become very important.

Forbes: You use your sports analogy: Ted Williams, .406, 1941.

Mauboussin: Right.

Forbes: They've wondered why no one in baseball has hit .406 or broken .400 since then, and the point has been made, and you and others have cited it: Playing is much more skillful today than it was then.

Mauboussin: Exactly. So here's the way to explain Ted Williams, perhaps. You think about batting averages – it's a sort of normal distribution, right? The mean is about .260 when pitchers are hitting, about .260 with a standard deviation. In 1941, the standard deviation of batting average was about 31%.

So Ted Williams, I don't know what that comes out to, about a five standard deviation event. He was, obviously, extremely, extremely good. What's happened in the subsequent period is that standard deviation has come down.

So, if Ted Williams had the same standard deviation performance today, he would hit about .385. Which would still be off the charts, but it would be under 400. So why are there no 400 hitters today? It's not because, as you point out, players are worse. In fact, indeed, almost by any measure they're going to be better. It's because the standard deviation of performance has narrowed and hence no one can get to that extreme performance.

By the way, there's a way to test that in other realms as well, and that would be things where there is no luck – running races, swimming races. And what we've seen consistently is the times are collapsing. The difference between gold, silver, and bronze is much narrower today than it was a generation, two, or three

ago. So that's the prediction of the paradox of skill, and you can see that in all the numbers as well.

Forbes: Now, when you look at a manager, you make the point, “Three years: No.”

Five years, maybe, ten years, yet research shows that ten years ain't going to predict the next ten years. So what's an investor to do? How is an investor to find real skill or just luck with a hot hand?

Mauboussin: Another great question. First, I should say, for investing, we always talk about years, which is natural. One, three, five, ten years. But, in fact, what you're really trying to do is gather the sample size. So how many decisions that manager is making. So there are some strategies, if it's generating lots of decisions or trades, you can evaluate it in a fairly short period of time. But for, for example, a long-only mutual fund manager who's not making that many decisions, then you really do need to extend the time horizon.

But the essential answer to that is to focus on process, not outcome. And by the way, this is another thing; I think broadly speaking our society has gotten very outcome focused. I'm just going to give you a trivial example.

Let's say we're playing blackjack in Las Vegas and the dealer deals you a 17, what should you do in that situation? Well, you could ask for a hit, he could flip a four, and you can make your hand.

Forbes: 17 or over, stick with it.

Mauboussin: Exactly.

Forbes: Under 17, go with the hit.

Mauboussin: Well, that’s the rule, right? But that would have been a bad process, but an excellent outcome for you, right? What we really want to focus on is the process: That you're making those good decisions. Of course, standard blackjack strategy tells you what to do to maximize your probabilities of success.

So to me, it's focusing on the process. And for investing, that process typically boils down to three specific things: One is a focus on the analytical process of that manager. The second would be the focus on the behavioral aspects, psychological. And the third, I would say, would be organizational – are there constraints within the organization that impede that manager's ability to perform?

So How Do We Find Skill?

Forbes: How does an investor cope with what you just said?

Mauboussin: Right.

Forbes: I mean, what, let's go down that list. Take the first one on process.

Mauboussin: Analytical.

Forbes: Is this how they find value versus running the business? Walk us through.

Mauboussin: Let me first say that for the average investor, if he or she is interested in doing this, it takes a lot of work to really sort out what managers are doing. If you're not interested in doing that, or not compelled to do that, indexing makes an enormous amount of sense. For average people, indexing is a logical strategy. But if you want to roll up your sleeves a little bit, here's how I might think about that.

For analytical, I would look for two things: The first is always looking for what we would call an edge. And an edge means that there's a difference between the fundamentals and the expectations.

Let me bring in another metaphor here to make that a little clearer, and it's not too far afield.

That would be horse racing. So you go to the horse race and there are odds on the tote board. That is the expectation of the performance of the horse. And then there's fundamentals: How fast that horse is going to

run. Now, if you studied tens of thousands of horse races, it turns out the markets are pretty efficient. The ordinal finishes of the horses, first, second, third, as predicted by the odds, is pretty much what happens. But from time to time, we know, there are mis-pricings. There are odds on the tote board that just don't well describe how that horse is likely to run. And that's what the sharp handicappers are after.

Bring that over to the world of investing, and that's the same thing. We don't have odds on the tote board, but we have something called the stock price. So we reverse engineer the expectations built into that price. We say, “What has to happen for that to make sense?”

And then we look at how the fundamentals are likely to unfold. It's a probabilistic exercise. That would be the first piece. The second piece, analytically, is bet size, which is once you have an edge, how much do you bet in your portfolio? That's a second key component which is often overlooked.

Looking For An Edge

Forbes: Now, so how do you define value?

How do you get the edge? Or is this one of those situations where there are various ways you can get value, the key is just to stick to the discipline?

Mauboussin: Well, I teach at Columbia Business School, so I have to come back with a classic Ben Graham kind of answer to this. Value, to me, is the present value of future cash flows, which would be relevant for any financial asset – present value of future cash flows.

Value would be buying something for substantially less than what it’s worth, based on that stream of cash flows. It's as simple as

that. And the margin of safety, of course, reflects the distance –

Forbes: How do you know what the cash flows are going to be?

Mauboussin: You don't. It's probabilistic, so you don't know what the cash flows are. So this is what I would say: An expectations approach which would take three steps. Step number one is to say “Here's the stock price, let me reverse engineer what has to happen for that stock price to make sense.”

Let me just pick an example. No recommendation, but Cisco, say, is at $14 a share. What has to happen for its financial performance to make sense? The second thing I'll do is try to do some research and analysis of the financial and strategic characteristics of that company and say, “Are they likely to do better or worse than what the market implies?”

And then, third and finally, I can make the decision to buy, to sell, or to do nothing, which in many cases is the right answer. So figure out what's built in, figure out what's likely to happen, and then it becomes almost an over-under, versus saying I know precisely what those cash flows will be in the future.

Mean Revision Does Not Mean Mediocrity

Forbes: So let's get back, again, to looking at managers, skill versus luck, and reversion to the mean. You point out reversion to the mean does not mean mediocrity.

Mauboussin: Right.

Forbes: Explain that – that it's if you traditionally do well, there are going to be times when you do less well, but you're still going to be taller than the other person.

Mauboussin: Exactly. So there are a couple important ideas here. First is that, systems that are all skill don't really revert to the mean at all, right? So, in other words, if we ran a running race, maybe one of us would get fatigued, but if we ran a running race five times in a row, basically, the faster fellow is going to win every single time. So when there's no luck, there's really very little mean reversion. But if there's any contribution of luck and skill together, you're going to get mean reversion.

The question then becomes: What mean?

And to your point, what happens is the skill; the degree of skill defines where our means are set. So that's if there's a high-skill player, they may come down a bit from very good peaks, but they won't go all the way back to the average of the broader population.

I think you alluded to this metaphor of height, but that's a good way to think about this. So what we know in mean reversion in height is tall parents will tend to have tall children, but not quite as tall as them. So you don't expect them to go all the way down to the average of the height of all populations, but rather, to something below their parents and in between those two things. So that's a good example of how to think about that. But mean reversion is a very, very powerful force in investing and something that our minds are not good at getting wrapped around. So it's crucial for people to understand what it really means and doesn't mean.

Forbes: So even Warren Buffett can have a cold hand?

Mauboussin: Yeah, folks like Warren Buffett not only can have a cold hand, he will have a cold hand – and by the way, just to clarify on this, I would not say that investing is all luck. There have been some academics that have made that case. I'm just saying it's toward the luck side of the continuum. But I think there's evidence, and we've seen it in a number of different ways to prove it, that there is skill in investing.

Forbes: So in terms of, again, the investor evaluating the manager. Since we know three years, five years may not do justice, focusing on the process, you have to have faith that they know how to pick the value stocks.

Mauboussin: Exactly. And you're just saying, “Which poker player would I like to back?” or, “Which blackjack player would I like to back?” How would you think about that?

You might look at how they've done in recent tournaments. But the most likely approach that would make sense is to look how they think about the problems. Do they understand the mathematics? Do they understand the psychology?

The same applies for investing. There are behavioral aspects as well – a lot of it has to do with psychological make-up. Are they aware of sort of the latest findings in behavioral psychology and how that applies to the world of investing? And then there are a lot of organizational pressures as well. There are a lot of money manager firms that they'd be more content to sort of stay with the pack, sort of do what everybody else is doing versus being too extreme in one way or another.

And that, of course, is going to mean almost by definition your results will be more toward average, and when you're charging fees to do that, that's unlikely to lead to very satisfactory results in the long haul.

The Coffee Can Approach

Forbes: In one of your papers, you cite the story of a fellow who managed his own money and also managing his wife's money.

With his wife's money, he took the very cautious approach of following the recommendations of the firm, and with him, he just in effect, as you put it, threw it in the coffee can. Bought something and just forgot about it. Turns out, the coffee can approach vastly exceeded the very sensible approach of buy, sell, follow recommendations. Again, explain how that unfolds.

Mauboussin: Yeah, isn't that just a wonderful story? People now have been very down on the idea of buy and hold, especially since we've had roughly a decade of flat stock price performance. But it's really not buy and hold that matters. It's buy cheap and hold.

And I think that story really illustrates that point. The fellow you're talking about is Bob Kirby, who is one of the founders of Capital Guardian out in California. And to your point, he was running the wife's portfolio and he was following all of the firm's advice for buying and selling.

So he was very meticulous in making sure that they did all the right things. It turns out he was placing the orders through the husband.

Every buy recommendation he'd take $5,000, buy the stock, and chuck the stock certificate into a vault – never paid any attention to it. And unfortunately, the husband passes away and the wife says we’re going to converge this. And when Bob looked at the husband's account, he was both appalled and he was shocked.

He was shocked first, because he had followed all the recommendations only on the buy side.

But he was appalled to see that the account had risen to much greater value than his wife's. So basically doing nothing, paying no attention to it, had built a lot more value. And it turns out there was one company in particular that did extremely well in there

Forbes: Xerox.

Mauboussin: A company called Xerox, which in the day was a really hot stock. So the idea is, not recommending that people go out and find the next Apple or Google or whatever it is, but rather to say that buying things cheap and just holding them – and by the way, that's classic Warren Buffett, right? He's got these great lines about sitting around and doing nothing is kind of our investment strategy. If we buy them right, the businesses create value, and over time they'll compound and create a lot of wealth. So I think that is the major message: Often we make moves to try to improve our stead, and in fact, we detract from our position.

Forbes: So what's an investor to do? You are, in effect, saying indexing – even though indexing has its problems because it rides with the winners and underplays the losers.

Mauboussin: Yeah, so I would say that much of this is idiosyncratic. Different people have to do different things, but by and large, people should certainly save as much as they possibly can and they should have some percentage of it in the stock market. I think indexing does make a lot of sense, basic indexing – and

obviously diversified now, increasingly globally as well. And that, for most people, will be fine. But, again, the only way to generate returns above the benchmark is to have active management.

And the only way to do that is to find managers who themselves are making very good decisions that over time will play out well. So for those individuals that are motivated, I would try to use that template of saying, “Are they making good analytical decisions? “Are they making good behavioral decisions?” And, “Is their organization conducive to them doing well over time?”

And if those things click into place, then you probably allocate some percentage of your portfolio to those kinds of folks. It's just like saying, “Hey, I'm going to bankroll a guy playing poker, he or she may not win every single night, but if their process is good, over time they should do fine.”

Older Investors

Forbes: Now, what's an older investor to do? Take somebody who's 60. What would you recommend? I mean, with all the caveats, you know, depending on the person, blah, blah, blah, but the tendency for older investors is to say go more short term. Yet we now know, given a little luck, it’s probably going to be around another 20, 25 years.

Mauboussin: Yeah, I heard once Jim Grant – have you heard him talk about it? He said, "Roll back the calendar 30 years, and that's your best advice. Go back to being 30." It's a very difficult spot, I think, for many older investors.

I guess one of the things I would probably look to is the equity markets, but in particular, high-dividend-yielding stocks. I think that's one part of the market. The market itself doesn't seem to have onerous valuations, certainly in my view, and high-dividend-paying stocks may be one of the ways to generate that income, have relative safety. Of course the market always has its vagaries, but that might be one strategy that would make sense. It's very, very difficult, certainly, with fixed income instruments.

The yields that we're seeing today with the 10- year Treasury Note below 3%, there's just not a lot of yield out there for folks that are looking for shorter time horizons.

Still A Blue-Chip Market?

Forbes: Now, a question on the market today. You still think this is a market for big capitalization stocks, dividend-yielding stocks? Hear a lot of that. Is there a consensus emerging that should make us cautious?

Mauboussin: Exactly. I think there's been a consensus about this that's made us cautious for some time. Yeah, it's very difficult to know, right? One of the things I know by studying expert performance is no one really does know what's going to happen. But you can start to say things or look at things probabilistically. And I would just say that given prevailing interest rates, given the implied equity risk premium, given the performance of a lot of these companies and their cash positions, they still do look to be attractive values.

I would be encouraged if more companies chose to be more systematic in returning cash to shareholders, either via dividends or share repurchases. I think they've been slow to do that, in part because they're still cautious out there.

But we're seeing some positive signs. I mean, if you believe the earnings consensus numbers for 2012, we're under 13 times earnings. We're seeing the M&A market here pick up. The economy is improving. It will always have fits and starts, but it seems like the general trend is okay. So it seems to me a fairly constructive backdrop, but as always, who knows the answer?

Forbes: So what you seem to be saying is if you feel good, don't; if you feel bad, do it.

Mauboussin: That's usually right. And Warren Buffett's got a pithier way of saying that, which is, "Be fearful when others are

greedy, and greedy when others are fearful." And it's very, very difficult to do in terms of our own human emotions. But that really is the idea. When everyone's despondent, it's time to load up the truck. And when everyone's feeling very good about things, it is time to be cautious or selling.

So that is right. And I think my sense is when I go talk to people, they've really had it with, certainly, the U.S. stock market. They've had

it. It's been a dismal decade and people have a hard time seeing brighter days ahead. But one of the lessons from mean reversion, by the way, is it would say that after having suffered a ten-year poor period – and by the way, it's one of the worst ten years we've had in the last 150 years – we do tend to mean revert back

up. Which would give you expected returns from the market of 7% or 8% over the next decade. Which is not shooting the lights out, but it would be a lot better than what we've been through.

Forbes: So in conclusion, give us your three main lessons.

Reversion to the mean.

Mauboussin: Sounds like you might have them better than I do.

Forbes: All right, reversion to the mean.

And as you just said, dismal decade doesn't mean the next couple of decades are going to be dismal. Doing my job – call it the Steinbrenner principle. Bad start doesn't mean the Yankees are going to have a bad season.

Mauboussin: That's right, yeah. So mean reversion is just a very big idea that's very hard to implement mostly for psychological reasons. By the way, you see this in sports all the time. People get very caught up in short-term statistics that don't really reveal the ultimate system.

And that's very important for the world of investing. You have to take a step back and say, "What does the long-term look like?

What do the structural trends look like?” And see where you stand relative to those basic trends and try to take advantage of them.

Forbes: This leads also, doing my job, into what you call recency bias, which is another way of saying rear-view mirror investing.

Mauboussin: That's right.

What About Institutions?

Forbes: How do you advise institutional investors – especially a CIO who knows that even though he shouldn't be judged on the last game, he is going to be judged on the last game – to get a more sensible horizon?

Mauboussin: It's a very hard thing to do. By the way, I've also studied and written about investment committees. Investment committees aren't going to let you off the hook easily on that as well. I mean, the key is to always say, ‘What are the facts before us today?”

We always work with incomplete information in markets and say, “What were the facts, what behaviors do the facts dictate?” Your point is exactly right. The recency bias or the rearview mirror phenomenon is extremely powerful for all humans. What's happened recently, we tend to extrapolate as to what's going to happen in the near term. And so an ability to try to separate yourself from that every day in a sense is brand new. Every day we say, “What facts do we have before us, what information do we have?” And try to make the best decision possible.

Forbes: So even if you pick good value, cheap can become cheaper.

Mauboussin: Cheap can become cheaper, and in that case, by the way, time can often be on your side – you can buy more of that, in that case, if you believe that nothing else has changed. But patience is the key issue, and it's very difficult to do in this day and age. But that's how the great investors have made lots of money over the years.