By A. Michael Lipper, CFA

Investment professionals and seasoned investors prize numbers that include repetitive patterns. With these abstractions of reality we can build nice neat statistical formulas that give us a good chance to be correct most of the time. The problem with that belief is the recognition that we won’t be right all of the time and some of the time, when we are wrong, the results are costly. Probably the best-known user of numbers was the physicist Albert Einstein, who was lured away from Caltech to Princeton by more money (numbers again). According to John Mauldin’s latest letter, the Professor had on his desk a sign which read, “Not everything can be measured and not everything which counts can be measured.” Clearly he was recognizing that the “unknown unknowns,” as Donald Rumsfeld has said, make us understand that we can not have complete confidence about both the understanding of the current situation and our ability to predict the future.

Behavior

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Many learned institutions around the world, including Caltech, have been studying how various elements in the brain’s circuitry light up repetitively as reactions to (or possibly causes of) specific behavior patterns. Of the work that I have seen, the connections between the specific brain waves and human acts are pretty simple and rely on learned memories of past pleasures or pains; for example, digesting food when hungry. So far I have not seen how our minds react to indirect stimuli. This is important because we live in a dynamic world where threats of bubbles and lost opportunities are present at an accelerating rate.

Opportunities

My study of history indicates not only that every single day some people are making money, but also that each day someone begins the climb to real wealth. Often those periods when great fortunes were ignited are described by the headlines of the day as “troubled.” Many investors, some seasoned and some not, are perturbed by the current level of real unemployment or underemployment throughout the age ranges, but particularly by the level for the youth — with or without college education. They are concerned by the political uncertainties in most democracies. The low level of interest rates manipulated by the major central banks is leading many into uncomfortable, and in some cases unusual, investments. In other words, many investors lack confidence and are unhappy. On the other hand, most economic and financial conditions as currently reported are not getting worse. The relatively low level of financial and investment activity is reassuring to some who are current market participants, as there are fewer opportunities for global transaction prices to go crazy, with the exception of extreme high-end real estate.

Perhaps in the real world, the one beyond the financial and political communities, people are coping. They are getting on with their lives and new hard-worked fortunes are beginning. What our academic friends have not yet captured is the ability of humans to cope with conditions for which they have no historical preparations. Think in terms of the recoveries of people in London during and after the bombings in WWII, in New York City after 9/11, in Japan after the Fukushima disaster, and in Boston after the explosions at the Marathon. Humans can eventually figure out how to survive and then prosper by using their developed problem-solving abilities that have no direct historical parallel. I believe we are in such a period now. Coping is working slowly and we are making some progress. We have a framed motto in our home from the US Marine Corps which intones, “Adapt, Improvise, and Overcome.” People all over the world are doing just that. This is not to say that everything is wonderful for all or that in the future we won’t suffer from human-induced bubbles.

Bubbles

Many keen observers of market prices have written about bubbles for hundreds of years. The most famous in the English language was Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds.” Other insightful authors were Charles Kindleberger and Hyman Minsky. An effective scribe, albeit not at the same level of the others, is John Mauldin, who is promoting his latest book through his weekly letter, quoting others who have written well on bubbles.

Most of the time, financial prices act in a rational fashion, often extrapolating near-term trends into the near future. Major price swings are largely absent and can be easily explained. In other words, most investments are dull, which is the best possible operating condition for disciplined traders. What the media and the amateur investors focus on, however, are bubbles, which distort for a period of time the normal price trajectories. I have not seen a good definition of a bubble so let me suggest one:

An exponential price increase (multiple doubles) in a relatively compressed period of time, normally 250 or fewer trading days, followed by a similarly drastic price drop in a similar (or more frequently, shorter) period of time.

Unless one is in control of one’s investment emotions, these not-infrequent disruptions can destroy a sound and careful investment strategy.

What is particularly disturbing about bubbles is that they start out as the recognition of some important price trend outside the normal trading markets for most investors. While the mathematical description of bubbles is remarkably consistent, the external factors are different. One explanation is the so-called Kindleberger-Minsky Perspective, which happens in five stages. The first is heralded change to the perceived order of things; for example, the widespread advent of electricity, radio, nuclear power, Internet, and new debt instruments. In the second phase, early adapters enjoy a boom. By the time of the third stage almost everyone has joined in the euphoria.

I remember the bubble in transistors, the forerunner of semiconductors. We were told to think about how big the market would be for transistor radios when they penetrated each village in India and how much better the world would be. This in turn led to the fourth stage in the crisis. What happened was that over-capacity and under-financed marginal companies bombed the prices for transistors. The final stage of the cycle is one of revulsion. I remember one large mutual fund in the 1960s that was heralded for having little to no investments in electronics. It was the equivalent of having a closet full of Nehru jackets.

I do not know when and from what sector a bubble will appear. Others have identified bubbles in 1929, 1962, 1987, 1998, 2000 and 2008. I could add some others that I have lived through. The main point is that we could be due for one, and it will be called an upside breakout to recognize how productive the world will be in the future. What has me particularly concerned is that various studies at Caltech and elsewhere have found that many participants in a simulated bubble knew it was risky, but were playing the so-called “bigger fool theory” — knowing full well that were paying too much but believing that they could sell at a bigger price. When the eventual decline is underway the most likely panickers will be the bigger fools turning on themselves.

Statistical hurdles

In trying to convince investors of the soundness of any manager or investment thesis, back-tested results are brought out. Notice none are shown that put the proposed concept at a disadvantage. While I am skeptical about all back-testing, I am particularly cynical of ideas that do not show the purported annual performance since 1990. Better yet would be quarterly performance since 1985. The comparisons should be against live, expense-paying competitors, not a publisher’s collection with its own biases.

Investment applications

Far too many investors, and some managers, are using index funds, ETFs, and closet indexers to meet the investment needs of their institutional and individual clients. These are closed-minded systems that only change their holdings when required to by outside forces that have nothing to do with sound investment judgment. One of my real concerns is that in the rapid acceleration phase of a bubble (e.g., the run-up of Apple’s price to $705 in NASDAQ), index funds create all kinds of risks. In Apple Inc. (NASDAQ:AAPL) ‘s case, it was just the parabolic performance impact of one stock; imagine the long term impact of a bubble on the whole index. This may well explain why the NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) is still well below the peak it reached during the Internet bubble of the 1990s even though many of the companies within the index have prospered.

Professor Einstein had it right when he focused on what we can measure and what we can’t.

What are you not measuring that you should?

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This was previously published on Inside Investing at the CFA Institute.

Copyright © 2008–2013 A. Michael Lipper, CFA

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A. Michael Lipper is a CFA charterholder and the president of Lipper Advisory Services, Inc., a firm providing money management services for wealthy families, retirement plans and charitable organizations. A former president of the New York Society of Security Analysts, Mike Lipper created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds. After selling his company to Reuters in 1998, Mike has focused his energies on managing the investments of his clients and his family. His first book, MONEY WISE: How to Create, Grow and Preserve Your Wealth was published by St. Martin’s Press. Mike’s unique perspectives on world markets and their implications have been posted weekly at Mike Lipper’s Blog since August, 2008.

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