Sunday, December 23, 2012

Ben Graham: Relative Utility Investor

One of my themes in The Missing Risk Premium is that people i people are benchmarking--aka relative utility investors--then they only deviate from the benchmark of what everyone else is doing  when they feel they have an edge. There's no other reason to do so. As many people falsely believe they have an edge in highly risky (antifragile?) stocks, this causes these securities to have lower-than-average returns within bonds, stocks, options, horses, and lotteries.

It's important to recognize this is the reason people take concentrated bets. The Wall Street Journal has an article on an old colleague of classic value investor Benjamin Graham, and notes the 107 year old's guiding principle:
His abiding goal, he told me, is "to know much more about the stock I'm buying than the man who's selling does."
That's a good rule, often noted by Graham. It's obviously impossible, in aggregate, but I think it's not only descriptive, but good normative advice. If you know that's the game you are playing, it should create greater caution, more sober risk-taking. The alternative is that you can take big risks and these generate return premiums via their risk premium, but alas the risk premium is usually negative, so that theory seems falsified via conventional empiricism.


Ben said...

It's "obviously impossible in aggregate" as you say, also it is obviously not automatable. There will always be a "value premium" because assessing value is hard work. Economics suggests that the value premium will about what a person with similar talents could earn doing another job.

The risk premium doesn't exist, because if it did you could create a diversified investment with low risk but still earning the risk premium. That's more or less what happened in the 90's with hedge funds (it's in the name), and pretty soon after, the premium hedge funds earned disappeared, having been bid away. In turn that opportunity was created by a technological shock in the form of cheap computers with which it was possible to put together complicated portfolios and assess the risk corrolations within them.

(That's my theory anyway, though in fairness that doesn't explain a negative risk premium.)

Daydreamer daytraders looking for the philosopher's stone of a trading strategy which makes money without work will always be the fool at the poker table.

bjk said...

Graham had a basket approach, buy 50 below NAV stocks (or whatever value metric you like) and sleep well at night. He wasn't diving deep to know those stocks better than anybody else, I would bet Kahn and Walter Schloss et al. are the same way. Buffett was a slightly different bird, but in general I find the value investors ignore opportunity cost ie Bill Ackman spending six months investigating Herbalife is missing out on significant opportunities.