Morningstar Magazine - June/July 2018 - 8

Dispatches

Contrarian Investing
Theories, crowds,
bubbles, and bees.

Phillips Curve
10

The Rise of Non-Investment Advisors

13

Why Buy Annuities?

16

Invest in HAL?

19

Policy
The Future of Clean Shares

LETTER FROM THE BOARD

Daniel Needham

Ivory Towers

The Old Squirrel

Behavioral Insights
23

Do Investors Really Pay Attention to Fees?

27

Americas
Greater Europe
Australia & New Zealand
Asia

Global Briefs
38
46
46

diversity into clear expositions for investors.1 His
work links a familiar concept relating to the
effectiveness of group decision-making by James
Surowiecki (The Wisdom of Crowds) with the
insights on the power of diversity of Scott Page
(The Difference). The key takeaway: Groups perform
better than the average individual would alone.
As Page defines it, "the wisdom of a crowd is
equal parts ability and diversity" and "the crowd
predicts better than the people in it." Markets are
an example of the wisdom of crowds.

"The central principle of investment is to go contrary
to the general opinion, on the grounds that if
everyone is agreed about its merit, the investment
is inevitably too dear and therefore unattractive."
John Maynard Keynes, Letter to Jasper Ridley, 1944

Contrarian investors are most active-or stand
apart from the crowd the most-when we believe
markets to be the least efficient. Like Warren
Buffett, I believe markets are frequently efficient,
rather than always efficient, which means that
it's possible for active managers to outperform,
albeit difficult. The key is to identify environments
where market efficiency drops-that is, when
investors are behaving irrationally. As valuationdriven investors, we base that identification
process on fundamentals and discipline.
Valuation always matters, but certain environments offer riper opportunities, especially with
multi-asset investing. Contrarianism helps us
define when markets may be less efficient, which
should help us be ready to act on our fundamental
convictions and be on the right side of the trade.
Diversity in Markets

Michael Mauboussin synthesized research on
complex adaptive systems, market efficiency, and

In well-functioning markets, investors behave and
think independently. "Well-functioning" means the
conditions exist for the wisdom of crowds: diversity
of decision-makers (many investors using different
approaches, acting independently); aggregation of
the decisions (exchanges aggregate investor views
into prices); and incentives for decision-makers
(rewards for generating excess returns). Important
elements of diversity are independence and
heterogeneity. These requirements are less
onerous than those of traditional finance, as they
don't need rational investors to set prices
provided they are independent, and there's no
assumption of limitless arbitrage. The opposite of
independence is dependence and homogeneity
of investors. This is central to our understanding
of contrarian opportunities and market pricing, and
an important element of herding.
The Wisdom of Bees

"Herding" means an alignment of thoughts or
behaviors of individuals in a group.2 Animals and
insects provide illustrations. For example, as
Thomas Seeley outlines in Honeybee Democracy,
the collective behavior of honeybees is more
complex than the behavior of individual bees.
When a bee colony outgrows its hive, the
queen and a swarm move to a nearby location,
normally a tree, to begin the search for a new
home. Hundreds of scout bees fan out over the
area and return to report to the swarm by dancing.
Attributes of the dance-primarily the number of

1 See these works from Mauboussin: 2007. "The Wisdom and Whims of the Collective." CFA Institute Conference Proceedings
Quarterly, Vol. 24, No. 4 (December); 2007. "Explaining the Wisdom of Crowds," Legg Mason white paper, March; (with Dan
Callahan) 2015. "Animating Mr. Market," Credit Suisse Global Financial Strategies white paper, February.
2 Kameda, T., Inukai, K., Wisdom, T., et al. 2015. "The Concept of Herd Behaviour: Its Psychological and Neural Underpinnings."
In Contract Governance: Dimensions in Law and Interdisciplinary Research, 1st ed. Edited by Stefan Grundmann, Florian
Moslein, & Karl Riesenhuber (Oxford, U.K.: Oxford University Press), Chap. 2.

8

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