Relative Results and High School Classmates

On the last day of the season, September 28, 2011, the Boston Red Sox blew a lead in the bottom of the 9th against the Baltimore Orioles coupled (mere minutes later) with an extra inning come from behind Tampa Bay Rays victory, which made the Rays the American League Wild Card winners, eliminating Boston from playoff contention.*

Perhaps, the Red Sox were distracted by another team’s potential loss (which would have clinched the Red Sox’s playoff spot) such that they did not focus on the game at hand, leading to a come from behind win for the Orioles in the ninth inning. Perhaps not.

Investment managers are judged by a relative result, usually the S&P, Dow or Russell 2000–or some sort of index.  These relative measures are supposed to provide useful information in terms of whether one should pay a manager to beat a passively managed index fund.  Managers use such benchmarks not because they invest in the same securities, but because those investment options are the alternatives.

However, when the standard by which you or others judge you after the fact affects your behavior before the fact, your investing principles have been compromised.  I believe these effects are difficult to see and hard to judge, but they are there nevertheless. This is a tough problem and I am not proposing any sort of solution.  The intermediate solution is to understand that there is a problem.

One approach that has proved personally helpful is a healthy dose of contempt for the theory of a passively managed index. I will propose what may be a straw-man argument, but I have seen the Wizard of Oz and sometimes straw men can save the day.

I graduated from a class of about 400 people in my high school. Most of these people had grown up in the school system, so I knew a large majority of them fairly well by my senior year. My thought experiment has always been as follows: If I were given a pool of money to invest in the future earnings of my high school classmates, would I a) invest a proportionate sum in each of the 400 students, hoping that the winners would offset the losers and provide a satisfactory return or b) spend a bit of time thinking about the likely earning potential of my classmates given my knowledge and shared experiences with them over the past 10 years?

I could not state specifically which of my classmates would “succeed” or “fail,” but I would feel a lot safer with my future investment results if I chose only those who I thought had a high probability of success, say 10-20 students. There would be about 100 that I would cross of the list immediately and another 200 or so that could go either way, or probably just be about average. However, my experience was that there were a handful of students where the odds were fairly clear that this group would earn significantly more income in the future.

Taking the time to get to know the companies on the public markets seems to me a high probability event when compared with blindly investing in the available 500 companies listed in the index.

I have always been concerned about being the 6 ft. tall man that drowned in a river that averaged 5 ft. in depth, thus I chose to avoid situations where averages and generalities may prove fatal…

 

 

*This factoid is taken almost word for word from Wikipedia.  (Not the official blue book citation, for the lawyers in the audience).  In case I ever run for political office, I try to at least footnote my wikipedia sources.

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