A Road Map to Smart Money

Burton Malkiel's review of Michael Mauboussin's book today in the Wall Street Journal (page D12) is bang on - a road map to smart money, indeed!!

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A Road Map to Smart Money
By BURTON G. MALKIEL
June 14, 2006; Page D12

In a world in which today's investment books provide magic formulas for success or simple nostrums ("buy best in breed"), Michael Mauboussin's "More Than You Know" is a refreshingly intelligent antidote. This collection of essays, written when the author was the chief U.S. investment strategist at Crédit Suisse (he is currently chief investment strategist at Legg Mason), portrays the stock market as a complex adaptive system that does not lend itself to easy solutions or simple rules.

The thesis of the book is that an understanding of many disciplines -- including physics, psychology, biology and behavioral economics -- can shed light on the movement of stock prices and perhaps even protect investors from systematic error. The goal is to make the reader a better investor -- and, even more broadly, a better thinker and decision-maker.
[More Than You Know]
How to invest? Consider fruit flies, Babe Ruth, Tupperware and the race track.

Mr. Mauboussin is especially good at explaining difficult concepts and showing the links between various fields of activity and the practical world of investing. His explanation of the statistical logic of "expected value" is a case in point. To describe the distinction between the frequency of correct decisions (am I correct more than 50% of the time?) and the magnitude of the payoffs when you have made a correct decision, he makes analogies to baseball and race-track betting. "Ruth struck out a lot," he notes, "but he was one of baseball's greatest hitters." At the race track, he advises not to pick the horse with the greatest probability of winning but rather the horse offering odds that exceed its probability of winning. In the stock market, he advises investors not simply to buy the stocks promising the greatest growth (of cash flow) but rather to compare defensible growth estimates with the growth implicit in the valuation of the shares and then buy those stocks where future growth is not yet incorporated into the stock price.

Delightful examples follow from a variety of disciplines. The short period over which the average company can sustain a competitive advantage is likened to the lifespan of a fruit fly. The fatal risks of imitation by money managers are illustrated by ants who tend to follow one another in an endless circle, marching on and on until death. Mr. Mauboussin explains how Tupperware parties, where people buy lots more stuff than they need, provide important lessons for stock-market investors; how Tiger Woods's decision to change his golf swing even when he was winning reflects the "fitness landscapes" concept in evolutionary biology; and why gambling legend Puggy Pearson can help you be a better investor ("Ain't only three things to gambling: Knowin' the 60-40 end of a proposition, money management, and knowin' yourself").

"Psychology," Mr. Mauboussin writes, "may be the most underappreciated, undertaught and undercontemplated facet of investing." But he also recognizes that the misuse of behavioral finance -- investing based on predicting herd behavior -- "can lead to bad thinking." While many individuals in the stock market may be irrational, the market itself can be remarkably efficient. Certainly markets are prone to periods of excess, but they are the exception, not the rule.

MORE THAN YOU KNOW
By Michael J. Mauboussin
(Columbia University Press, 268 pages, $27.95)

Most of the time there is a wisdom in collective decision making. Only rarely does the crowd go mad in herds. The stock market, he says, is very adept in its "information-aggregation ability." Recognizing how hard it is for individuals to beat the market, Mr. Mauboussin observes that most money managers are turning over their portfolios (switching from stock to stock) at much too high a rate, thereby generating transaction costs and market-impact costs, as well as unnecessary tax burdens. Mr. Mauboussin emphasizes "the value of inactivity," showing that, even before considering taxes, low-turnover mutual funds have outperformed high-turnover funds.

I wish that Mr. Mauboussin had added the evidence that mutual funds with lower expense ratios outperform those with higher expenses. The equity mutual fund is an investment product where you get what you don't pay for. Higher fees do not generate better investment performance. Every extra dollar of management fees is a dollar less in your pocket. If we combine this lesson with Mr. Mauboussin's correct advice to buy low-turnover funds, an even better rule could have been provided for investors. The surest route to top-quartile performance is to buy funds with bottom-quartile turnover and expense ratios.

While there is some disjointedness and overlap in "More Than You Know," Mr. Mauboussin's essays are always highly readable. The book engagingly shows how a multidisciplinary perspective can deepen your sense of how financial markets work. While Mr. Mauboussin's advice is unlikely to make you rich, it could very well help you avoid some common investment errors.

Mr. Malkiel is the author of "A Random Walk Down Wall Street" (eighth edition, Norton 2004) and a professor of economics at Princeton University.