Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management
Introductory Thoughts
September 25, 2008
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Three Themes and What They Mean
1. The role of time
2. The distribution of outcomes
3. Critical points
How do these fit with value investing?
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The Role of Time
Time horizon is crucial
Time
Horizon
Tool
Short term
Long term
Volatility
Margin of safety (price versus value)
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Source: LMCM analysis.
The Role of Time
S&P 500 Returns
1-Yr
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
5-Yrs
10-Yrs
15-Yrs
20-Yrs
25-Yrs
Annual
Return
Note: Data from 1926-2007.
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The Role of Time
What’s the worry?
Hirota and Sunder model on market behavior
Some long-term investors assure price and value converge
Only short-term traders lead to significant price-to-value gaps
Source: Shinichi Hirota and Shyam Sunder, “Price Bubbles Sans Dividend Anchors: Evidence from Laboratory Stock
Markets,” Yale Working Paper, November 2006.
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Distribution of Outcomes
Continuum of distributions
A common error: using the wrong model
Normal
distribution
Easy to model
Gray
Swans
Black
Swans
Hard to model
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-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
Percent Change (Daily)
Source: LMCM analysis.
1/1/1978 – 9/19/08
Days of >3 standard deviation price changes
Distribution of Outcomes
Volatility clusters
Time
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Focus on consequences
Problem of induction
Pascal’s wager
Distribution of Outcomes
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Where does volatility come from?
Endogenous (within system)
Exogenous
(outside system)
Critical Points
Over 75 percent of big moves appear to be endogenous
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Crowds are smart when you have:
Diversity
Aggregation
Incentives
Critical Points
We periodically get massive
diversity breakdowns; non-linear
effect on system
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Critical Points
Small incremental changes → large scale outcomes
No one can effectively manage a compl