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Thursday, July 20, 2006

More Than YOU Know

By The Average Joe Investor

No, that's not how I think about my knowledge base... In fact, quite the opposite, I've learned a heck of a lot from a lot of really sharp readers who have been kind enough to give me their thoughts on companies that I've posted on. There are a lot of smart people reading this blog and that makes me really happy!

So, no, I don't think I know more than you know, BUT, I do know a book that you may not know. The title of the book is "More Than You Know" and it's by Michael Mauboussin, the Chief Investment Strategist at Legg Mason Capital Management. Michael is also an adjunct professor of Finance at Columbia’s Graduate School of Business.The subtitle of "More Than You Know" is "Finding Financial Wisdom in Unconventional Places," and that is exactly what this book is about. Mauboussin's thesis is this: you can find insight into the financial markets in many different avenues from many diverse disciplines. And by different avenues we're not talking discounted cash flows versus P/E multiples or growth investing versus technical analysis; no, we're talking looking into fields like psychology and biology to get some fresh perspectives on the markets.

Don't get me wrong, I'm a big fan of finance books and I love diving into models and numbers - but sometimes you can just get into a rut going back to the same well too many times. Mauboussin's book is a true breath of fresh air for any investor looking for something to get them thinking in new and different ways. Similar to "Hedgehogging" which I also recently mentioned on this site, this book is a heck of a lot of fun to read whether or not you are an investing maniac. Even those with just a marginal interest in the equity markets can learn a ton from the various knowledge pools that Mauboussin pulls together here.

I could go on and on here, but it's tough to do a book like this justice as it reallybushwhackss its way into new territory. Let's do this, I'll give you a little bit of a taste here to give you an idea of what you're in for with "More Than You Know" - hopefully this little morsel will adequately whet your appetite.

In this excerpt the author highlights the importance of considering process over outcome in any decision-making exercise:"In a series of recent commencement addresses, former Treasury Secretary Robert Rubin offered the graduates four principles for decision making. These principles are especially valuable for the financial community:

1. The only certainty is that there is no certainty. This principle is especially true for the investment industry, which deals largely with uncertainty. In contrast, the casino business deals largely with risk. With both uncertainty and risk, outcomes are unknown. But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky.The behavioral issue of overconfidence comes into play here. Research suggests that people are too confident in their own abilities and predictions. As a result, they tend to project outcome ranges that are too narrow. Over the past seventy-five years alone, the United States has seen a depression, multiple wars, an energy crisis, and a major terrorist attack. None of these outcomes were widely anticipated. Investors need to train themselves to consider a sufficiently wide range of outcomes. One way to do this is to pay attention to the leading indicators of “inevitable surprises.”An appreciation of uncertainty is also very important for money management. Numerous crash-and-burn hedge fund stories boil down to committing too much capital to an investment that the manager overconfidently assessed. When allocating capital, portfolio managers need to consider that unexpected events do occur

.2. Decisions are a matter of weighing probabilities. We’ll take the liberty of extending Rubin’s point to balancing the probability of an outcome (frequency) with the outcome’s payoff (magnitude). Probabilities alone are insufficient when payoffs are skewed.Let’s start with another concept from behavioral finance: loss aversion. For good evolutionary reasons, humans are averse to loss when they make choices between risky outcomes. More specifically, a loss has about two and a half times the impact of a gain of the same size. So we like to be right and hence often seek high-probability events.A focus on probability is sound when outcomes are symmetrical, but completely inappropriate when payoffs are skewed. Consider that roughly 90 percent of option positions lose money. Does that mean that owning options is a bad idea? The answer lies in how much money you make on the 10 percent of options positions that are profitable. If you buy ten options each for $1, and 9 of them expire worthless but the tenth rises to $25, you’d have an awful frequency of success but a tidy profit. So some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis. Say there’s a 75 percent probability that a stock priced for perfection makes its earnings number and, hence, rises 1 percent, but there’s a 25 percent likelihood that the company misses its forecast and plummets 10 percent. That stock offers a great probability but a negative expected value.

3. Despite uncertainty, we must act. Rubin’s point is that we must base the vast majority of our decisions on imperfect or incomplete information. But we must still make decisions based on an intelligent appraisal of available information. Russo and Schoemaker note that we often believe more information provides a clearer picture of the future and improves our decision making. But in reality, additional information often only confuses the decision-making process.Researchers illustrated this point with a study of horse-race handicappers. They first asked the handicappers to make race predictions with five pieces of information. The researchers then asked the handicappers to make the same predictions with ten, twenty, and forty pieces of information for each horse in the race. Exhibit 1.2 shows the result: even though the handicappers gained little accuracy by using the additional information, their confidence in their predictive ability rose with the supplementary data.

4. Judge decisions not only on results, but also on how they were made. A good process is one that carefully considers price against expected value. Investors can improve their process through quality feedback and ongoing learning."And that's just the first chapter... Here's a link in case you want to get your groove on with Michael: "More Than You Know".

Of course, I do get compensated by Amazon if you follow this link and buy the book, but I could really care less about that (I make like $0.10 on every book!), so follow the link or just go to Amazon or even head out to your local bookstore (a brick and mortar retailer, imagine that!).

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