My pick for the single best short paper ever written for market participants of any skill level is “Decision-Making for Investors: Theory, Practice, and Pitfalls” by Michael Mauboussin, written in 2004 when he was chief investment strategist at Legg Mason. Now it appears he may have just published a better one.
The author is currently the head of research for asset management firm Blue Mountain Capital Management LLC of New York. He’s also an adjunct professor of finance at Columbia University and sits on the board of trustees for the Sante Fe Institute, an organization that facilitates multidisciplined research in complexity.
Mr. Mauboussin’s latest report – “Who is on the Other Side?” – distills the investment process down to one essential thing: “If you buy or sell a security and expect an excess return, you should have a good answer to the question ‘Who is on the other side?’ In effect, you are specifying the source of your advantage, or edge.”
For every buy and sell transaction an investor makes, there’s another investor on the other side of the trade, either selling them the asset or buying it from them. Mr. Mauboussin’s question forces investors to prove to themselves that they are more likely to wind up on the more profitable side of the deal.
The paper leans heavily on financial research – there are 19 pages of footnotes and references – to show that there are four basic categories of investor advantage: behavioural, analytical, informational and technical, summarized by the acronym BAIT.
In simpler terms, justified confidence for an investor can come from less emotion and more objectivity, better research and preparation, having information others don’t (legally, of course), or when taking advantage if a market participant is forced to make transactions for non-fundamental reasons.
Mr. Mauboussin provides remarkable insight while describing each form of investing advantage. In warning about the behavioural dangers of overconfidence, he references a study showing that 93 per cent of Americans believe they are better-than-average car drivers. Applied to investments, this means it’s highly likely that the investor on the other side of our trades believes they are smarter than we are.
In highlighting the analytical and informational advantages of institutions compared with individual investors, the paper cites data showing that initial public offerings of stock where retail investors are the main buyers underperformed IPOs where institutions were buying.
The concept of time arbitrage was also discussed as an example of analytical advantage. Successful time arbitrage involves the ability to filter valuable investment information from irrelevant short-term noise. Mr. Mauboussin uses coin tosses as an example: “An opportunity for time arbitrage exists if the market prices" the fair value of a coin "as if it is biased after seven of the first 10 flips are tails.” In other words, metaphorically speaking, a smart investor would know that over the long term, the coin would be priced for an equal number of heads and tails.
Forced selling by insurance companies is an example of technical advantage. Research indicates that because many insurance company investment portfolios are limited to investment-grade corporate debt, they are forced to sell debt holdings if they’re downgraded to high yield. Buyers of these downgraded bonds have historically generated strong returns.
“Who is on the Other Side?” is an accessible treasure trove of perspective, research and investment insight. Above all, the content reminds us that the investor on the other side of our transactions believes they are smarter than us. Thankfully, Mr. Mauboussin provides a road map allowing us to prove them wrong.
The full report can be found at bluemountaincapital.com.
Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.
Scott Barlow