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Making Better Investment Decisions

In this special one-hour presentation, Morningstar strategist Erik Kobayashi-Solomon describes how individual investors can overcome the structural and behavioral impediments that can be detrimental to their returns.

Erik Kobayashi-Solomon: My name is Erik Kobayashi-Solomon. For the last three years, I've been working on the Morningstar OptionInvestor newsletter and been involved in the option investor training course as well.

When I go around the country giving talks and talking to our own clients, I'm always kind of amused. People who are new to options, somehow kind of believe that options are like Harry Potter's wand. That they can just kind of whip the Harry Potter wand out of their waistcoat, and suddenly that stock position that is a losing stock position turns into something different. They can erase those losses and create income out of thin air or something like that.

What I tell everybody is that, in fact, options are just a tool, just like a hammer or a saw for a construction person, and what's really important is, options cannot save you if you're not making a good investing decision in the first place.

So today's talk is going to be mainly about how we can think about making, some of the limitations to making, good investment decisions, and then me proposing some sort of a structure that we can make better investment decisions. And then at the very end, I just introduce options a little bit. There is actually a Part 2 to this talk, and I'll be giving that in a couple of weeks.

So first part of the talk, I'm going to be mainly talking about structural impediments and behavioral biases. And when I'm talking about structural impediments, what I mean is, who are the players in the marketplace, and how do they perceive of risk, how do they perceive of reward, what's their investing paradigm?

And then behavioral quirks: I think of the players in the game as being the external environment, and then the behavioral biases as the internal environment. So, what are the things that are happening within us that are actually preventing us from making better investment decisions.

Now, why am I doing this, what is the real purpose of this? Well, the real purpose of this discussion actually was said best by the ancient Chinese strategist and general Sun Tzu, a few thousand years ago. I'll just put it up and you can read it for yourself:

"If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle." -- Sun Tzu The Art of War

So, the reason that I'm here today is to help you win 100 battles. In other words, to know your enemy, to know who the people in the market that you're competing against, and to understand yourself, so that you can be able to succeed in investing.


Let's start by knowing the enemy. I think that probably everyone here understands these terms pretty well, but let me just explain quickly. The principals are the owners of capital who put them at risk to try to generate some kind of return--that's you and me.

The buy side are the representatives of the principals. These are the people at funds who are hired to try to run money and to create some positive return for their clients, for the principals.

And then the sell side are the people who facilitate the buyside and the principal's investments. These are the brokers and the market makers and people like that.

So, just full disclosure, I've worked on both the buy side and the sell side, and of course, I'm also a principal. I spent about six years on the sell side, three years on a trading desk. I spent a little over three years on the buy side, as both a buy side trader and a buy side risk manager. And so in the next 15 minutes or so, I'm going to badmouth everybody on Wall Street. But I do it in a spirit of loving amusement. I tell you that when I show this presentation to former and present colleagues who have worked in these kind of jobs, I just get howls of laughter, because they say how can you tell it like that? How can you tell it the way it really is? Let's see.

So, let's start with knowing your enemy, the buy side. What I've done here on this slide is to try to show--well, first of all, I started thinking about, if we were in a schoolyard, what would be the schoolyard equivalent of each of these buy-side players? And then, I thought, well, it's good to describe who the clients are. And then what they think of as risk, and also their time horizon. And this leads through to what their investing paradigm is. In another words, how are they thinking about a good investment? And I think by looking at this, and comparing this at the end, we will have some interesting conclusions about how we should invest.

So, first let's start with mutual funds. These I call the joiners. These are the kids that don't really have an opinion of their own, but they want to go along with everybody else in the schoolyard. Their clients are people like, well my parents, my parents' friends. Back in the '80s, they got a few hundred thousand dollars worth of pension dumped in their laps and said, "OK guys, it's time for you to figure out how you're going to manage this, so you can have a nice retirement." So, honestly, I own mutual funds, a lot of people I know own mutual funds, and I think that in general I don't look at mutual fund prospectuses very carefully. I don't really know what's happening to the 25th largest allocation on my fund list. I'm just hoping that this kind of generally works out in the way that I think it's going to work out.

So for someone working at a mutual fund, that's a great sense of freedom, right? As long as you don't have a very large position, you're kind of under the radar. This actually leads to the next quote, which is a direct quote from a small-cap manager who is a good friend of mine. He gave me a bit of advice early in my career. He said, "Eric, nobody ever got fired for not making money." In other words, just don't mess up bad. At least try to be reasonable in comparison to the index. Basically for a mutual fund everything starts over from Jan. 1, or whenever your bonuses are paid out. So you care about the performance of your pick for one year. It's not really as easy as that, but basically this is what you're looking at. You're very conscious of your yearly performance and how that's going to reflect in your bonus at the end of the year.

So obviously, the paradigm in this kind of business would be, try to spread your bets out as much as you can. You're not making a deep bet. You're going to be kind of shallow, you are going to do what's called closet indexing. So, basically, what we used to call "alpha plus" strategies. So basically buy the index, and then just try to get a little alpha, a little extra return somewhere amongst your portfolio.

So now let's turn to hedge funds, and hedge funds hold a special place in my heart, because this is where I worked for a long time, too. They are the bullies. These are the tough guys, and like bullies, they are bullies because they are very insecure. It turns out that one of the huge drivers of the hedge fund market is hedge funds of funds. These are enormous funds that allocate money to different hedge fund managers. Well, guess what, they are completely ADHD. If you are not performing in a certain month, pop, there goes the money. If you underperform in a quarter, it doesn't matter what you did for the previous five quarters, you underperform one quarter, pop, let's take the money. And so, if you are working for a hedge fund, you have to be extremely aggressive, and you have to be keep trying to get any little source of alpha, even if that means insider trading, even if that means doing something silly when you place your mutual fund orders, or something like that, there's all sorts of things that happen in this environment, just people dying to get a little bit of extra juice each quarter.

So risk in a hedge fund--the first thing you have to understand about a hedge fund is you've got an owner of a hedge fund and then a manager, an analyst of a hedge fund. So the owner of the hedge fund, they only care about how much assets under management, AUM they have. They get paid on the basis of that. They don't really care about the performance as long as they get plenty of AUM. So, in hedge funds, 2% and 20% is the rule: 2% of assets under management and 20% of profits, right. So, the owners are getting the 2% part. So, as long as they can maximize the AUM, 2% of a lot is a lot, and they are happy with that.

Now for their portfolio managers and for their analysts, they are the ones getting the 20%. They don't get a share of the pie, but they get a piece of the profits. And so, what they are really concerned about is making their numbers, making a huge amount of money quickly, no matter the riskiness of the bet, so that they can get a seven-figure salary or bonus at the end of the year.

Now risk means not getting that seven-figure bonus and, guess, moving to another hedge fund, where you can start again the next year and try to get another seven-figure bonus. So obviously, the time horizon for this is going to be very short. When I was a trader for a hedge fund, I used to get these blast e-mails, "All you punters out there, take a look at this stock." Really, people who would just simply look at the ticker of a stock and a couple lines of information and then place some bet, because there is no downside to it, honestly. The worse thing is, is they get fired and they go to another hedge fund. Best thing is, the stock really does rally and they make a ton of money. So very short-term focused.

And the investing paradigm, you can't really say for sure. I mean there are some longer-term hedge funds, there are some "work-out" funds or merger arbitrage funds, things like that. So there is no one paradigm. But certainly the larger shops will need large stocks to get into. You just simply can't make very much money, if you've got a $20 billion portfolio, you can't make a lot of money on a stock that only has $14 million worth of market cap. So, you don't see a lot of action in smaller caps.

And then we get to the group that nobody ever thinks of when they think of investments. These are the insurance companies. How many people in here have insurance themselves, life insurance? How many people are worried about the rate of return on your insurance? Nobody, right--nobody even thinks about it.

So, this is kind of a mean thing to say, but I think of these guys as being like the football linemen of the schoolyards. They are really big, really powerful, but let's just say that they don't get the best grades in school, to put it nicely. So, the clients are, first of all, unaware of the investment, so really it doesn't matter. Here you can kind of just multiply the risk category in the mutual funds by two for these guys. Really, it doesn't matter at all. There are not concerned at all about making money. They are concerned about not losing money. The only way they can really make a mistake is if the actuarial calculations regarding the lifespan of people are wrong, or they can also make a mistake by not charging enough premium to their customers when they sign a contract. That's really it. There is not a lot of investing risk.

So, time horizon for these guys, unlike these shorter-term players, is really long. I've got life insurance. I am 46. I'll probably live until I'm early 80s, late 70s, something like that. So, that's the time horizon that they are looking at--the aggregate time horizons of the ages of their customers. So, it does tend to be a longer time horizon, and they tend to invest a lot more in bonds and the equities that they do invest in are much closer to a closet indexer again.

Anybody who has worked in these fields disagree with any of this? It looks pretty right?

Unidentified Participant: You are oversimplifying.

Kobayashi-Solomon: I'm oversimplifying, but this is kind of the story.

All right, the sell-side. This is my other favorite part. I used to work for an investment bank, both in Tokyo and New York, and I can honestly say that the sell-side is the drug pushers. These are the really dangerous people. They are very smart. They have a lot of power and money, and they are very aggressive.

In terms of their clients, just look at the previous slide, the hedge funds, the mutual funds.

The nice thing--well, lately it's changed a little bit--but on the sell side, originally there was no risk. In fact, there was a famous saying on Wall Street, "Bulls make money, bears make money, pigs get slaughtered." What that means is, is simply stand in the middle, buy one thing from one guy, sell it to another guy, and take the spread, and you're fine. Lately investment banks have started making their own proprietary bets, and we've seen a little bit of change to this. But basically risk for someone on the sell-side, there's not a lot of risk. You've got a 50% chance of being right. Once, when I was trading options for a hedge fund, just as an offhand comment when a guy was pitching an idea to me, I said, "Well I guess you've got a 50% chance of being right, right?" And he laughed, and he said how did you know we say that here? Apparently this is kind of the running joke on the sales desk at this bank. No matter what we recommend to our clients, at least half of them will like us at the end of the day.

Time horizon for a sell-sider is as long as it takes until the phone finally clicks and they get off the phone with the buy-side person. After the trade is made, and their sales commission gets credited or gets calculated, they are happy.

Now, of course, if an investment idea doesn't work out very well, then you get a very angry call from the hedge fund manager or the hedge fund analyst, and you have to put up with an earful for five or 10 minutes, and maybe you don't get a lot of business from them for the next three months. But basically what you're caring about is that you get the trade in the first place, and that you can talk them into that and keep them as happy as possible over the next few months or until that trade works out, or doesn't.

Now the stockbrokers, I would say there are the cute versions of the drug pushers, the investment banks. These are the guys who, really, their business is an AUM business as well. They are more responsible for handling their client psychology than they are for making splendid investment recommendations: "OK, don't worry about it. I know it's a down day today, but it will come back over the long term." The risk for them is that their assets under management actually shrink, that their clients start using Morningstar research and start directing their investment activities themselves. Of course, time horizon, on a day like today, where it's a nice day, until tee time, probably 1 in the afternoon, that's a good time horizon.

All right. So now we've got our enemy. Let's talk a little bit about knowing ourselves, the principals. So, I'm sorry to say, but most individual investors are the kids. You can think about them as the kids on the playground who get their lunch money stolen. These are the kids who follow pundits' advice, who follow spurious trends and so-called expert opinion.

They really confuse, a lot of times, data with information. This is one of the big problems of the information age is that now, especially financial information is almost free and completely ubiquitous. And there's so much data that it's hard to tell which is genuine information ... You can find a data point, but it doesn't actually help you understand about that company.

Now these principals, their clients are really themselves, their future selves, and their risk is the only substantial risk of the people that we've talked about or the groups that we've talked about so far. The risk, as I like to think of it, is living in my adult son's basement eating oatmeal three times a day, because I don't have a place to live, and I don't have medical coverage, and so forth.

So, this is a real risk. This is something that we as investors have to really worry about, unlike all of the buy-side and the sell-side quasi-risk.

Of course, the time horizon depends. And one of the big problems that I see, and we'll talk about this in just a minute, individual investors don't really focus on a certain time horizon. So maybe you buy that stock in 1997 for $20, and it's gone down now to $4.50, but you still keep on holding it and figure, "Well, one day it will come back up." Or you go down to the barbershop and you get a good stock tip, and you trade into something and then you decide you don't like that, and you trade it out the next day, and maybe make a little or lose a little. But the fact is, most of us don't have a sense of a time horizon, how we should think about that.

Now, even though individual investors often get a bad rap, I believe that they have a lot going for them, because they have virtually no size constraints. In other words, they don't have to only pick large-cap companies. They can pick small-cap companies. They don't have to beat the S&P every year. They don't even have to think about that. What they have to think about is not living in their basement with their adult children. So they're really, in terms of investing freedom and let's say investing mandate, they're in a much better place, I think, than a lot of institutional managers.

Now the large private investor, and in fact probably Joe Mansueto, the founder of Morningstar, was one of these kids. He is the kid who goes down to Office Depot before school starts and he buys a case of pencils, and then right before finals, sells those pencils at a 300% markup to everybody who forgot their pencil that day. I think, these are the people like a Warren Buffett, T. Boone Pickens, and people like that, who are kind of naturally entrepreneurial, who are naturally thinking about where I can make money and create wealth.

Now these investors have a lot more resources than the typical individual investor, and so their perspective, their paradigm for investing, is a lot different. Especially someone like Buffett, you'll see buying entire companies or very substantial portions in very large companies, getting special deals from Goldman Sachs or whoever to invest and kind of give a little bit of a halo effect to that company. These are things that you and I can't do. I really did try to call Goldman Sachs during the downturn and work the same deal that Buffett got, but surprisingly no one wanted to talk to me.

Really what their worry is, they tend to be concentrated, they tend to concentrate a lot of their wealth in a small number of bets, and so they have the risk that a couple of those bets will go to zero simultaneously, or really get hit simultaneously. This is why the 2008-2009 financial crisis was so devastating to people in this camp.

So what I've tried to do is think about a graphical summary of the players, and it's a little bit hard to see. Basically what I've done is I've put investment time horizon down here at the bottom, and I've shaded certain areas. I've got market cap, the companies that they can invest in, here on the Y-axis, and then I've shaded different regions that are supposed to correspond with kind of the general time horizon and the general market cap focus of each of these players.

It's very hard to see, but small private, the point that I was trying to make before, is very, very, very light blue and spread over everything. This is one of the big problems is a lack of kind of focus on a time horizon and a market cap and so forth.

So what I'd like you to do is burn this image into your mind for a second, because we will come back to it a little bit later.

Now, how does everybody feel? Do you feel that you know the enemy a little bit better? Sound good?

Let's go on to my next favorite part, which is behavioral quirks, knowing thyself. I'll also talk a little bit about some modern research into neuropsychology, X system and C system processes. It's great fun.

Ah! Paris in the spring. No. Paris in "the the" spring. How many people saw that? Not many, right? Oh, there, the editor. The editor saw "the, the." That's why she catches my mistakes, too. Most people when they look at that, and don't know what the trick is, they see "Paris in the spring," because we know that's what we are supposed to see.

It turns out that our eyes and our brains are closely connected, and that our eyes receive some visual information and then our brains go a long way to processing that information. So basically, the brain fills in a lot of the details that the eyes don't pick up, and we see something that we know and expect, and that’s what we see.

All right, you ready? Now you know I’m going to mess with you. Ready for the next slide?

OK. Short-term, long-term. Is this a buy or a sell? We’ve got this asset, you see the asset prices. It’s right around 100. I actually indexed these so it would be close to a 100, so you could see percentage easier. So this is a couple months' worth of prices. What do you think? Short-term buy? Who thinks short-term buy? One short-term buy, okay. So everybody else says short-term sell?

Unidentified Participant: Need more information.

Kobayashi-Solomon: Need more information. All right. Well, the stock analyst would say so.

How about long-term? Do we like this company long-term? This works tremendously better with people who are very invested in what they call technical analysis. People who believe that by looking at the history of a stock price, you can tell what the future of that stock price is going to be. I read something just recently, which I laughed at, technical analysis is neither technical nor analysis.

My view of technical analysis is actually little bit more nuanced, but let me give you the punch line to this slide. Are you ready? Is everybody curious about what happens to the stock?

It's created by a random number generator. So when I did this presentation in Atlanta, I was almost mugged when I showed that. Everyone was so upset that I would trip them in such a devious way, that this is a random number that just happened to look like something they were familiar with.

The point behind this is that a few hundred thousand years of evolution have conditioned us to see patterns. So I'm the friend of Og The Caveman, and I noticed that my friend Og ate a bunch of leaves one day and died clutching his stomach the next day. And so I think, here is a pattern that may be important to me. I'm not going to eat those leaves. Indeed, that's a really good survival strategy. We'll talk more about this when we talk about X system processes, but the fact is that we do, as humans, see patterns where there are no patterns.

So, this one is not from a random number generator. So, what do you think looking at this series. This is an actual series, I promise. What do you think are the highest and lowest points that this might go to?

Unidentified Participant: Go to zero.

Kobayashi-Solomon: Okay, so we have a zero. Zero is lowest. All right. Don't be so smart there, Alan. What do you think on the high side?

Remember, you should you should pick a number that ends with either zero or five, because we have five fingers that feels more comfortable to us.

Unidentified Participant: 50.

Kobayashi-Solomon: 50, All right. So, I hear a 50. Do I hear a 55? Lower? Higher? Let see what we get.

But, one other thing--this is kind of unfair because the highest number that I have put on the Y-axis is 35. So most people when I show them this, they say 35, because I didn't give them another choice.

Alright, so here… Oh, I guess it was 150.2, sorry. This is the precursor to the VIX, the VXO, the volatility index on the S&P 100. The VIX wasn't around during Black Monday, so I just picked this.

This is another very clear behavioral bias that we suffer from. We anchor on near-term results. It's hard for us to imagine something that's radically different from the situation that presents itself today.

Okay. Here's a good one, are you ready? Now you really know I'm messing with you, but still try to answer. What job does Steve do? Steve is a very shy and withdrawn, invariably helpful, but with little interest in the people or the world of reality. A meek and tidy soul, he has a need for order and structure and a passion for detail. What does he do?

Unidentified Participant: Creates Apple.

Kobayashi-Solomon: He creates Apple. That's right. He is Steve Jobs. All right. That choice is not up here.

Who thinks he is a librarian? Who thinks a librarian? Now you know, I'm trying to mess with you, but you would reasonably answer that he is a librarian, right? It sounds like the description of a librarian. Well, guess what he is? Anybody have another guess, before I show you?

Unidentified Participant: Farmer.

Kobayashi-Solomon: Oh, man, farmer. You are the first person to ever say that. He is indeed a farmer. So, it turns out that there are a lot more farmers than librarians. Statistically this fellow should be a farmer. He probably wouldn't have succeeded as a salesman, because you can't be meek when you're a salesman. But the point of this is that I've described Steve in a certain way, a way that matches what we call a heuristic, a mental picture of a person, and so it's very easy for us to believe that this person is a librarian.

It turns out that this question actually came from a fellow named Daniel Kahneman and his partner Amos Tversky. And I think it was Kahneman who received the Nobel Prize. Tversky actually passed away before he could receive it. But they were really giants in the field of behavioral finance. And they talked a lot about this heuristic.

So, anybody ever listened to somebody talk about a stock, and they tell a story about that stock, and they will weave a beautiful story: "There was this manager, and that manager really ran things into the ground, but now they have got a new manager, and that manager is turning everything around. They are cutting costs, and they're really operating in a professional way." Well, guess what? That's a heuristic. That person, that salesperson, is tying into your heuristic about what you think is a valuable and important and good strategic decision for a business to make. And so you're more likely to believe that story. This is why companies have IR departments. They like to spin the story.

All right, now you really know I'm messing with you. So, let's do another one.

What about Linda's job? Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and also participated in anti-nuclear demonstrations.

Which is more likely true?

A, Linda is a bank teller.

B, Linda is a bank teller and is active in the feminist movement.

Unidentified Participant: A.

Kobayashi-Solomon: Okay. I hear some As. Maybe someone who knows something about statistics.

Who thinks that B feels better? Feels better, right? Everybody is agreeing feels better. So, we actually have a picture about Linda right now. Linda is probably very active. She probably owns a Subaru, she probably eats granola a few times a week in the mornings. We have a picture of Linda because of this description. That's our heuristic.

Well, of course, Linda is a bank teller. Why? Well there's some probability that she's a bank teller. The joint probability with that probability and anything else is going to be less. Right? So, the funny thing about this question is that Kahneman and Tversky administered this question, administered this task to people who are majoring in social science, getting their Ph.Ds in social sciences and economics and psychology. These are people who spend their life doing nothing but sorting through statistics, and who should really understand this.

And I won't say everyone got it wrong, but a huge number of these very intelligent and very well-informed people got the answer wrong. This is the power of heuristics.

So, what's happening in all of these cases? It turns out that human beings have two kinds of mental processes, and one neuropsychologist's work that I read calls these X-process and C-process. The X is the RefleXive process. C is the RefleCtive process.

So here's the best example for a RefleXive process. Does everybody see that object over there? It's a big glass panel and it's got a metal bar attached to it. We all know what that object is, right. We all know that if we walk toward that and push with force on the metal bar, that object will allow us to leave this auditorium. This is what the X process does very well. It identifies familiar things and allows us to compare symmetric situations. This is what we're really good at, and the X process happens in a different part of the brain, an old part of the brain, an animal part of the brain.

The other process, the C system process, happens in another part of the brain, and basically this process kicks in when X process fails. So, Eric walks over to the door, he knows it's a door, and he knows if he pushes the metal bar, it will open. And he tries to push the metal bar, and it doesn't open. So, now my C system process kicks in. First of all, it helps me recognize that there's an issue with my X system process. It tells me that I just can't keep banging on the door and it will open at some point. It tells me that there's something wrong, that I either have to twist that bar or do something to manipulate the bar to make this thing open. It allows me to look at the situation and to try to figure out what I should do. Should I twist up, should I twist down, something like that. This is the C system process.

Now the neat thing about X system processes is that they feel so good to us. We can do them at the same time, we can do them simultaneously. We can chat with someone, which you know is an advanced skill, but it's also kind of replicating. We can talk about the weather. This doesn't require a lot of thought. It's the repetition of a conversation we've already had. We can talk to someone and chew gum at the time, or talk to someone and step off a curb at the same time. We can do these things simultaneously.

C system does not work that way. This is an example of doing a math problem. Most people cannot simultaneously solve a math problem with the right-hand and type an e-mail with the left hand, let's say. They are interfering; the C system processes interfere with each other, and they tend to work best with asymmetric problems. These are problems that we've never seen before and that we have to figure it out.

The fact is that we are social animals, and a few hundred thousand years of evolution and social interaction have really made it such that the X system processes feel much, much more comfortable to us. These processes actually helped us survive as a species. Imagine two guys are walking toward the watering hole, they pass a cave, a saber-toothed tiger comes out of the cave and eats one guy. From that point on, the surviving guy is understandably nervous about a combination including watering holes and caves. Probably, that's a reasonable suspicion to have.

It's amazing. Everybody knows there's a very advanced robot that's up on Mars right now doing scientific experiments. I just heard the designer of that robot say something interesting; he said, it takes that robot one full day to do what you or I could do in less than 30 seconds. And the reason for that is that we as humans understand symmetric situations so well, and can recognize familiar objects so well, that we don't have to calculate everything. We don't have to figure everything out; whereas a robot really does have to figure everything out.

Our brain is capable of solving complex problems, but it doesn't feel as good to us. Just like a minute ago, Linda, we really felt should be involved in the feminist movement. It just felt right. Well, this is the thing, we can solve complex problems, but it doesn't feel as good for us to do that. It requires effort. It requires sometimes planning if it's a very complex thing.

We also tend to confuse data and information. There is a brilliant study that was done amongst doctors. They gave a group of doctors a limited number of symptoms of a patient, a very limited number--let's say, four of five symptoms. And they said, all right, on the basis of this symptomatic list, tell me what's wrong with the patient. And then they gave another group of doctors a very long list, with let's say 30 or 35 symptoms or data points.

Now, the doctors that received more data were very confident that they understood what the disease was. However, the doctors who received only a little data were actually more accurate in their diagnosis. Isn't that interesting? This is analogous to us in the finance world, saying, ... I should run those quarter-over-quarter numbers, and see how that's been progressing over time. Maybe I should see what the status of that contract in Bangladesh is, or something like that. It turns out that we feel more comfortable if we have more information, but we don't make better decisions when we have more information.

So, does everyone feel that they understand themselves a little bit better now?

So now, we know the enemy, we know ourselves, now it's time to figure out how to win 100 battles. So, this phrase, "time horizon arbitrage," I think this may have been coined by my colleague, Phil Guziec. We're going to talk about this a little bit, and we're going to split apart this phrase, "time horizon arbitrage."

Let's first look at the arbitrage part. Everyone knows what arbitrage means? You make a riskless profit by somehow trading a small difference in price or, you know, a small informational difference. So you've got gold in London that's trading for a little bit more than it's trading for in New York, and you can buy the gold in New York and sell it in London and make a risk-free profit, let's say.

So any arbitrage strategy must be based on a C-system process. You have to look at something and analyze the data and make a decision about that. That is fundamentally a C-system process. It has to be rational, systematic, and testable. So, in our time horizon arbitrage strategy, we need something that is rational, systematic, and testable.

So the point that we've come to that I think is really kind of revolutionary in terms of investments is that investment decisions have to be based on the idea of some intrinsic value. So, we live in Chicago, and let's say we want to start a taxicab service here in Chicago giving just pickup rides. So, we know that we need to buy a car for this. We need a fairly large car that has good trunk space. It has to be fairly attractive, so people will want to ride in it. So, how many people would want to spend $200,000 on a Bentley to run this taxi service?

It makes sense, right? It's a big car. It has a nice trunk, and it's attractive. It doesn't fit the bill simply because you know you're not going to make enough money in fares and tips to pay for your $200,000 car. It's something that seems so sensible when we're talking about starting a taxi service; however, it completely goes out the window when we start thinking about a company.

So somewhere, a company must generate wealth or have the prospect for generating wealth in the future. It's irrational to pay more for that wealth-generation capacity than the company will actually generate for us in wealth.

Academic research supports this approach. It supports the approach that buying overvalued assets does not lead to investment success. The one thing that we should say is that, it is based on sound theoretical principles, but it is subject to analyst bias, and analysts are human beings, and we have all of the biases that we've just talked about. We hear a good story, and we love the company. We want it to succeed. So, obviously, it's not strictly arbitrage, because the profit is not riskless. But let's say it's not a bad approximation.

Okay, you burned this image into your mind just a few minutes ago. So, let's take another look at it. Let's take a look at the time horizon arbitrage sweet spot. So, we've got the hedge funds and the investment banks. These are the people that I lovingly describe as monkeys on crack, and they are trading over the next three months, and they are worried about whether a company is going to make $0.26 or $0.27 in the next quarterly earnings. They are completely focused on their bonus for the next year, or for a hedge fund, that they perform well enough over the quarter, so that the hedge fund of funds doesn't yank their money.

Way, way over there we've got endowments and insurance and pensions that have a time horizon that's really very long, and they're playing mainly in big, large-cap stocks. Then large private investors, they usually take something a little shorter in terms of time horizon. They tend to look at that middle to large-cap region.

So, the idea behind time horizon arbitrage is to fit where people are not, and especially where the monkeys on crack are not. These are taking a look at what will happen over one business cycle. So, yes, conditions now are better than they ever have been before. Is it logical or rational to extrapolate that because the conditions are good right now that they will continue to be good forever? Should you extrapolate your valuation based on the continuation of perfection into the future?

Or right now, we're hitting a global bottom, and it's never been worse before. A building will never get build again; a car will never be build again. We'll never see the light of day. We'll be squatting in the dirt, eating food with our hands pretty soon. Should we value companies extrapolating on this kind of worst-case, bottom-of-the-barrel kind of scenario? Obviously not.

Let's take over a whole business cycle where should we be? If things basically act as if they have in the past, what should this company be valued at?

So, obviously if you're trying to make investments based on this idea of time-horizon arbitrage, you have to have a very clear idea of what the value of a company is, and to take a look at that value of a company over time, over multiple business cycles, going on into the future. You have to separate data from information--really think about what is important, what is driving the business, and understand what can go wrong with that business.

So, this is very hard for smaller companies like Crocs a few years ago, where it's growing very quickly. Well, I don't know how Crocs will act over the next business cycle. Well, you do know that there are only 7 billion people on earth and that those 7 billion people only have 2 feet apiece, and so somewhere there's going to be an upper limit to the number of Crocs that can be sold to the global population. So this is the kind of base level setting that is important in this kind of a strategy.

I can't say that it's easy. Of course, we've already seen the behavioral biases that we as humans have that we anchor on things, that we have certain expectations. We have a hard time imagining something that is radically different from what we see today. And sometimes you have to do something that's very hard. That is, at the bottom of the downturn you have to say, "Things are not going to go terribly forever." Or at the top of the cycle you can say, "You know, I don't think the margins are going to hold up forever."

Here's my favorite X-System Argument in favor of time horizon arbitrage. Everybody can get behind it. Today is a hot day, unseasonably warm, but if it was an average-day temperature today, we'd have no problem figuring out whether we should bet on the high temperature of tomorrow versus the high temperature of 60 days from now. Is it going to be hotter in June or August?

So since my main job deals with options, somehow I have to think about how to tie this time horizon arbitrage back to investing with options. The problem is that options tend to have very short tenures, or most option activity is in the shortest tenor options--in other words, the options that are expiring within one, three, or six months from today. There are something called LEAPS. These are Long-Term Equity Appreciation Securities, which are options that expire as much as three years in the future. So obviously you can kind of play this time horizon arbitrage more effectively with these LEAPS.

However, you can indeed actually play a time horizon arbitrage strategy even with shorter-term instruments. For instance, if you sell a covered call. Basically with a covered call, what you're doing is, you are saying, I promise to keep holding this stock if it goes down in value. And in return for making that promise, you receive some premium, receive some income. And so, if you're happy that the stock won't reasonably stay down forever, you don't mind taking that bet. You don't mind saying, look I'll suffer the downside consequences, if there are any. Just give me some money in exchange for that.

So for a short-term investor that's a very scary thing: "Wait--you mean you're asking me to be exposed to the downside of the stock, maybe the downside of a stock that has just fallen by 10% or 20%, and everybody is saying it's a zero and it's a terrible bargain." So, for a short-term investor that's a very scary thing, but for somebody who is taking a look at a longer time horizon, it's not a scary thing at all, if you have an idea of the value that that company can create.

So, another thing--I read a lot of blogs and competing sites talking about different option strategies to use, and almost all of them are very complex, and almost always they have wonderful, colorful names like iron condor and butterfly and risk-backed spread and things like that. And what I've found is that more often than not, these very complex strategies do one thing very well, and one thing only--that is, put your options broker's children through college.

So, if you want to spend a lot on fees, then these complex strategies are a really good way to go. If you want to instead accrue wealth for your own children, so they can go to college, probably a simpler strategy is best, and certainly this is what we try to emphasize on the OptionInvestor newsletter.

Then the other thing is education. Education has two parts: Understanding first of all about firm value, and about intrinsic value for companies. The other part is understanding simply how options work. And this is one of the things that I'm very proud of and that I think that we do very well is providing some really complete, but also simple and non-jargon educational articles. One of the examples is this Option Recipe Book that we've put together. I believe that probably there are only a few different option strategies that you really need to understand well to invest successfully in options, and that once you understand these well, options become a very useful tool in a financial toolbox. They're peerlessly flexible tools. They can allow you to increase the growth in your portfolio, to increase the income that your portfolio is generating, and also to protect you from downside risk.

I know that options in a lot of people's minds are very complex, but indeed once you learn a few kind of simple combinations, you really end up kind of being able to profit a great deal.

So, thanks very much for coming today. I appreciate your attention, and I appreciate the laughter and the funny parts as well. Thanks.