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The Grand National is too complex to predict. Just like investing.

‘Buywise’ may be a long shot for the Grand National this year but, as a one-word recommendation for the value investment process, it is ahead of the field

13/04/2018

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

So which horse should The Value Perspective back in Saturday’s Grand National?

'Buywise' seems about as good a one-word summary of value investing as you will find on any racecard but, of course, Valseur Lido is an anagram of ‘Solid Valuer’, which feels like a sign.

Then again, both are around the 50-to-1 mark with the bookies and, while we pride ourselves on being contrarian, that may be pushing it …

What's that you say?

If we were serious about making a bet, you think we should be looking at more than the horses’ names and odds?

You may well be right.

However now would seem an appropriate time to bring up a 1974 experiment by US psychologist Paul Slovic – a contemporary of behavioural science pioneer Daniel Kahneman.

Slovic's experiment was brought up in an episode of the Tribe of Mentors podcast where host Tim Ferriss and his guest, chess master turned professional investor Adam Robinson, started from the premise – who does not want to be better informed?

As Robinson acknowledges, most investors operate on the basis that, the more they understand the world, the more successful they will be.

“It makes sense, doesn’t it?” he continues. “The more information we acquire and evaluate, the ‘better informed’ we become, the better our decisions.

Accumulating information – becoming ‘better informed’ – is certainly an advantage in numerous, if not most, fields.”

The effect of information on decision-making

Of course, as regular visitors to The Value Perspective will be aware, investment is not most fields and this is where Robinson brings up Slovic’s investigation into the effect of information on decision-making.

Bringing together eight professional ‘horse handicappers’ – people who make their living solely on their gambling skills – he told them he wanted to see how well they predicted the winners of a series of races.

The experiment involved the gamblers predicting the results of 40 races over the course of four rounds.

In round one, each could have any five pieces of information they felt was important on the runners and riders – the horses’ top speeds, say, or the jockeys’ experience (though whether anyone asked for the horses’ names Slovic does not record) – and then they all had to call the winners of the various races.

Confidence and information

As an additional question, Slovic asked the eight gamblers to say how confident they felt about each of their predictions.

Since there were an average of 10 horses in each race, blind chance would suggest each gambler – or indeed a monkey with a pin – would be right 10% of the time.

Equally, one would expect their confidence about a blind guess would be 10%.

Still, as it turned out, with five pieces of information, the gamblers were 17% accurate, while their confidence in their predictions was 19%.

In subsequent rounds, however, with 10, 20 and finally 40 pieces of information on the runners and riders, their accuracy flatlined at 17% – and yet, by the time they had that additional 35 pieces of information in the final round, their confidence had all but doubled to 34%.

If this sounds familiar, it may be because we have touched on a similar experiment in Prediction addiction, which reached the same conclusion – essentially that there really is such a thing as ‘too much information’ because it can perpetuate confirmation bias (the behavioural finance sin of seeking out and processing information in a way that confirms one’s pre-existing beliefs or theories).

We might also point out that, in the world of professional investing, there can often be considerable cost when it comes to acquiring information – and if some of that information is merely gathered with a view to making you feel better about taking a particular decision, then there are clearly better ways of spending both your time and money.

As Robinson points out in the podcast, a big problem with trying to understand the world is it is just way too complex.

The world is too complex to explain

“The more dogged our attempts to understand the world, the more we earnestly want to ‘explain’ events and trends in it, the more we become attached to our resulting beliefs – which are always more or less mistaken – blinding us to the financial trends that are actually unfolding,” he continues.

“Worse, we think we understand the world, giving investors a false sense of confidence, when in fact we always more or less misunderstand it.

"You hear it all the time from even the most seasoned investors and financial ‘experts’ that this trend or that ‘doesn’t make sense’.”

But of course the world, in and of itself, makes sense – it is people’s models or ideas of how the world should be that do not.

“In fact,” Robinson explains, “because financial trends involve human behaviour and human beliefs on a global scale, the most powerful trends will not make sense until it becomes too late to profit from them.

"By the time investors formulate an understanding that gives them the confidence to invest, the investment opportunity has already passed.”

What's this got to do with value investing?

Here on The Value Perspective, we say something very similar when we talk about recovery companies – distressed businesses a close analysis suggests have the potential at some point (over the longer term) to bounce back

Anyone who waits until there is market consensus that the company really is on the mend – could in some cases miss out on the lion’s share of a rise in the share price. Waiting for ‘all the information’ out there could paralyse decision making, What you need is a process to follow. 

There are seven questions we ask in relation to every single cheaply valued company we analyse and which help us distinguish those likely to remain permanently cheap from those whose share prices have the potential to bounce back.

We do not believe we have to understand the world – only the potential rewards and associated risks of each business we buy.


 

The Value Perspective does not encourage gambling and any horse names in this blog are for illustrative purposese only and should not be interpreted as recommendations to bet. 

Author

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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