Monday, December 24, 2007

A Few Great Investing Books of 2005 - 2007

The last two years have been great for readers of financial literature. I've been thinking about doing a list of my personal favorites for a while. Today I completed Alan Greenspan's epic "The Age of Turbulence," which is a genuine classic. It tops my list:

1. "The Age of Turbulence" - Alan Greenspan. The best and classiest memoir I've ever read. It cements Greenspan in the Pantheon of last century's great leaders, and establishes a lofty benchmark to which future memoirists will aspire. I know many people feel frustrated by his hedges and equivocations when giving testimony in front of Congress, and frankly I wish he had asserted his opinions more strongly while leading the Fed. In any case, he is a survivor, and he lays out his meticulously reasoned economic judgment and political analysis over the past 40+ years.

2. "More Than You Know" - Michael Mauboussin. An innovative multidiciplinary approach to understanding financial markets. It is fantastic, and a revised version was just released. Mauboussin ecclecticism is sorely needed in financial theory, and Mauboussin delivers exquisitely formulated multi-dimensional analyses. The analogies he brings from other areas of research are truly eye-opening when applied to explaining paradoxes in the financial markets.

3. "Inside the House of Money" - Steven Drobny. An excellent collection of revealing interviews with top global macro money managers, conducted in 2005. It intelligently delves into the thought processes and psychologies of these high achievers, which sets it apart from more anecdotal collections.

4. "The Little Book That Beats the Market" - Joel Greenblatt. The best book I've read on the fundamentals of successful long term stock-picking. It covers the basics of business and stock valuation in an entertaining and engaging fashion.

5. "Fortune's Formula" - William Poundstone. Entertaining and very useful summary of the foundations of quantitative analysis. It describes the evolution and utility of the Kelly criterion, arithmetic vs geometric means in portfolio design, and the impact of return volatility in a fun-to-read and narrative style.

I'm often asked which books are ideal for getting acquainted with behavioral finance and investment psychology. I'll answer that question in another post.

Happy Holidays!


Thursday, December 13, 2007

For Smooth Sailing, Winch up Your Financial Anchors

What's your anchor? If you don't know, it could be costing you.

There were some fascinating (but expected) results during a training program Frank and I ran for financial professionals this week. We asked one-half of attendees whether the Dow Index was likely to close above or below 18,500 in 12 months. The other half we asked whether the Dow would close above or below 10,250 in 12 months. After this first question, we asked each group to estimate where they thought the Dow would actually close in 12 months.

This is a classic experiment in which the irrelevant number mentioned in the first question profoundly affects the predictions made in the next one. It's called "anchoring" because people anchor their expectations to a recently seen, but irrelevant, number. In this case we had a positive anchor (18,500) and a negative one (10,250).

Amazingly, the average prediction for the high-anchor group was 15,644.
With the low anchor it was 13,792

The low-anchor group predicted a Dow gain of 2% over the next 12 months, while the high-anchor group predicted a 16% return. That's a 14% difference in range!

We get a spread about this wide whenever we do this experiment, and virtually every audience is shocked to see the size of the difference.

Anchoring affects analysts (who anchor on the most recent earnings estimates of other analysts), portfolio managers (who anchor on analysts' expectations), and individual investors (who anchor on IPO and recent or 52-week high and low prices).

Many investors anchored on an expectation of a 0.50% Fed rate cut this week. Ooops.

When expectations are anchored, then they can easily be disappointed, leading to emotional reactions that further impair judgment. It's a slippery slope.

Always good to be sure where you're standing (and what your anchor is).

Just some thoughts for improving self-understanding.

Happy Investing!