Recently I heard a speaker refer to marrying a second time as “the triumph of hope over experience.” While I’m sure that we can all think of examples in our own circle of friends that would contradict the speaker’s observation, I’m also sure you can probably think of many couples that confirm it as well.
Last week we certainly saw an example of hope triumphing over experience. On March 31, the car company Tesla announced that over 325,000 people deposited $1,000 each with their preorder of the new electrified Model 3.
These consumers seemed undeterred by the fact that a working production model did not exist and would not exist until 2017 at the earliest. They ignored the fact that the company’s earlier Model X was actually sold 18 to 24 months after the originally announced production date—and that was actually a custom production run, not mass production as would be called for by for the Model 3.
Nor was the price of the new model certain. It was estimated to be $35,000, but Tesla admitted it could go higher. Still the preorders poured in. The company now expects preorders to top the half-million mark.
That would mean sales of $17.5 billion to satisfy just the expected preorders. And the preorders themselves would be putting $500 million into the Tesla coffers.
Yet Barclays estimates that gearing up for mass production could require Tesla to raise $11 billion in capital over the next five years. This would be entailed of a company that is already hemorrhaging $400 million in cash per quarter!
The difficulties likely to be encountered were confirmed at least in part by the Tesla announcement a few days later that only 14,820 Model 10s had been delivered in the first quarter due to “hubris in adding far too much new technology to the Model X in version 1.”
Wall Street has certainly jumped on the Tesla bandwagon. As the chart below depicts, the company already has a market cap (outstanding shares of stock times the current price of the stock) almost equal to that of established auto giants Ford and General Motors. Yet Tesla has negative cash flow, while its larger automaker brethren are both enjoying record revenues and billions in earnings.
This does appear to be an example of hope triumphing over experience.
Why do we as consumers and investors make this same mistake consistently over time?
Many financial behaviorists suggest that it is an example of overconfidence bias. This arises out of the tendency of many to be optimists.
Studies show that optimists tend to be overconfident and, as a result, take more risks than they realize. As Nobel Prize–winner Daniel Kahneman states it, “The evidence suggests that an optimistic bias plays a role—sometimes the dominant role—whenever individuals or institutions voluntarily take on significant risks. More often than not, risk takers underestimate the risks they face and do not invest sufficient efforts to find out what the odds are.”
There is no doubt that most of us are probably overconfident, at least with respect to the familiar. In an experiment repeated around the world, audiences have been asked how they rate their driving abilities. The result is always the same—above average. Of course, that is false. Not everyone can be above average. But we get these results because we are familiar with the concept of driving, feel we do moderately well, and can easily conjure up a bad example of another’s driving error.
Less well known is the experiment where audiences are asked to rate their ability to start a conversation with strangers. Because most don’t do so, the averages tend to be a rating of below average.
In a famous study at Duke University, over 11,000 forecasts of chief financial officers of large corporations were asked to estimate the return of the S&P 500 in the next year. The result was a resounding failure: The correlation between their estimates and reality were less than zero. And when their confidence was measured in their estimates, it was found to be three times higher than what would have been statistically expected.
Nassim Taleb, author of “The Black Swan,” has suggested that inadequate appreciation of uncertainty inevitably leads us to take risks that should be avoided.
In developing, marketing, and delivering investment strategies for more than 35 years, I’ve learned that the only (partial) cure to this overconfidence/optimist bias is the provision of more information. As a result, we not only provide GIPS audited and verified return histories, and model accounts that show how a strategy has performed in the past, but also research reports that tell how the strategy as presently configured and with the funds now available would have performed (something often omitted by those who trumpet their actual performance).
Yet as I examine the use of the reams of statistical data made available, the results are disappointing:
- Investors focus too much on returns rather than the risks being taken.
- The focus on the returns is often on last year’s returns or on a year-to-year basis rather than over a complete bull/bear market cycle. Realize that today’s bull market environment has now lasted for seven years. One needs to review a nine-year history to encompass a more than 20% bear market.
- The review of risk, to the extent it is conducted, is too abstract. Often the results are viewed as standard deviations, which is not understandable by most investors. And even if maximum drawdown is provided, it is usually in percentage terms. That’s too abstract. If you see a 30% loss, convert it to dollars. Think in terms of the actual amount being invested (with $30,000 to be invested, a 30% maximum loss would mean a $12,000 loss). If you have to use round numbers, simply convert the 30% loss to the equivalent amount on a $100,000 account. Can you live with losing $30,000 on that size of the investment?
- Few investors seem to realize that the maximum drawdown is only what was experienced in recent history, not over the entire course of human history—it is just an estimate based on recent times. Compare that to the amounts lost in passive index investing, where the S&P 500 in the same period lost 55% ($55,000 in our $100,000 example) and the NASDAQ lost over 70% ($70,000).
- In building a diversified portfolio of strategies, most investors seem to fill it with only strategies that have gone up recently. To be diversified, you have to have some losers, or at least mediocre performers, during the same time period being examined. Remember the future is uncertain, while the historical numbers you are using are subject to hindsight bias that gives the illusion of certainty. Recent studies show that the most profitable strategies all go through periods of nonperformance, while almost all below-average-performing strategies have periods of above-average performance. The longer time frame you can evaluate a strategy over, the better.
- In building a portfolio of strategies, investors fail to use strategies that differ in their methodology in achieving success. Don’t crowd a bunch of different trend-following strategies into a portfolio and think that you are now fully diversified. To reach that status, you must add in some strategic, rotational, and mean-reverting strategies that may not be working as well in the present environment but which may help protect you in future environments. And don’t just use strategies drawn from a single asset class. Diversify into foreign markets, government and corporate bonds, gold, and others.
A better use of the existing data can help make you less susceptible to the hope-versus-experience bias in your investing.
In the markets of late, the short-term downturn that I have been calling for has been playing itself out in real-time experience as stock prices on average fell for the third week in a row.
But rather than being persuaded by another behavioral bias, that of believing that what is going on recently will continue, I have been calling on investors to use this short-term setback to buy into what I believe will be a continuing rally.
As I said last week, a recession remains unlikely. And while earnings have been retreating, there are signs that earnings surprises this quarter are likely to continue to be positively skewed and guidance could actually improve despite some predictions to the contrary. Seasonality also remains positive until early May.
Interest rates and bullish investor sentiment (a contrary indicator) remains low. On the interest-rate front, it really is amazing to see rates retreat as they have since the December Federal Reserve tightening. They are back to last year’s lows. This is positive for stocks both on a comparative investment basis (stocks being more attractive than bonds even on a yield basis) and because of the increased opportunity that low rates extend to businesses across the board.
Finally, the charts of the S&P 500 remain of some concern. The Index looks more and more like it is experiencing a rounded top, and so far we have not broken above the downside trend line or last year’s highs on the Index. But as I demonstrated last week, the broader averages of stock-market activity (advance/decline line) has decisively moved higher and broken out of its downtrend. The S&P 500 usually follows the broader market higher when these breakouts occur.
Further evidence of the broader movement of stocks higher can be found within the composition of the S&P 500 itself. While the cap-weighted S&P 500 rose 1.3% in the first quarter, the broader-based equal-weighted S&P 500 more than doubled that return.
In 2004, Sir Richard Branson founded Virgin Galactic, which subsequently began offering the public the opportunity to buy tickets to experience six minutes of weightlessness and an incredible view from outer space. Over 700 pioneers have paid up to $250,000 per ticket for the experience.
In 2009, Branson predicted that the maiden voyage would occur within 18 months. A year later he was saying in two years. Hundreds of millions of dollars, four deaths, and 12 years from organization, the company just announced a new space craft to correct the errors that left its predecessor scattered across the floor of the Mojave Desert in October 2014. Years of testing probably remain before commercial passenger space flight will become a reality at Virgin Galactic.
Yet, in the wake of the crash, only a couple dozen of the paying customers have canceled—truly another triumph of hope over experience, and another example of why you have to do your homework even before hitching up and taking a leap of faith.
All the best,