C. Thomas Howard began his presentation by challenging delegates with a proposition to invest $0.50 with one of four outcomes: the first option earns a dollar; the second earns two dollars; the third earns five dollars; and lastly, the fourth choice earns $20. Without any discussion of uncertainty, people choose the fourth option, to earn $20. However, when we introduce volatility, the desirability of the options gets turned on its head. Most choose the first option, some choose the second, and so forth, until virtually no one chooses the $20 option.
This exercise was used to illustrate Howard’s primary thesis: The interplay of uncertainty and emotions drives us to make suboptimal decisions. As a real world example, Howard cited a recent BlackRock study of 401(k) retirement plan allocations demonstrating the risk aversion many people hold. The average asset allocation of these plans was 50% cash, 30% bonds, and only 20% equities, despite the fact that such allocations virtually ensure that most people won’t meet their retirement goals. In Howard’s view, this is due to the role of emotion in our financial decisions.
Interestingly, he came to recognize the role of emotions in his own work. For much of his career, he had been a believer in modern portfolio theory, the efficient market hypothesis, and mean-variance optimization. As he studied the markets over time, however, he came to believe the evidence stacked up against his own beliefs. In Howard’s words, when real world evidence turns against you, reject the model, not the world. So that, in fact, is what he did.
The pièce de résistance came when he tested the role of emotions in structuring market portfolios. He found that investors exhibit emotional patterns. While conventional financial theory uses volatility as a proxy for risk, Howard suggests that volatility is merely a proxy for emotion. By defining emotion this way, it is measurable. Consequently, Howard has constructed a framework using volatility of stocks, bonds, currencies, sectors, and various groups of securities to identify these emotional signals and ultimately to trade around it.
So, what exactly is Howard doing? It’s hard to know exactly, but he does mention that he applies his techniques to both securities as well as broad market sectors. One of the slides in his presentation gave us some clues. He uses a ranking of 10 different investment strategies, ranging from future growth to competitive position to social considerations and risk. What data transformation technique he uses is unknown, but it is likely a comparison of trailing volatility of various groups of securities reflecting each strategy. He suggests that there is a natural order to the rankings. If the listed order remains intact, he is bullish on the market. If the order is inverted, he is bearish about the market. And if the order is mixed, he is neutral on market direction.
Having rejected the cornerstones of modern portfolio theory, Howard also rejects conventional notions of leverage and diversification. It is well know that the benefits of diversification decline markedly beyond 10 securities in a portfolio. It is less well known and understood that investment professionals actually do a good job of picking stocks. According to Howard, the top 10 ideas of fund manager portfolios outperform the market approximately 80% of the time. Nevertheless, these same fund managers tend to underperform the market. What Howard has inferred from the data is that fund managers are good a picking stocks but bad at constructing portfolios.
Consequently, he owns about 10 stocks in his portfolios, taking on more volatility, but, in his view, less risk. Moreover, he uses his market timing tools to amplify the upside with leverage. On the whole, his portfolios have performed well, both on a backtested basis as well as in the seven years since he launched his fund. Can it continue? Is there a flaw in his model? Perhaps he is avant-garde, or perhaps he is missing an important risk factor. Time will tell.
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Photo credit: W. Scott Mitchell