Category Archives: Finance

Mental Model: The Profitability Factor

In 2012 Robert Novy-Marx wrote the paper The Other Side of Value:The Gross Profitability Premium. You could say that it is an attempt to test the hypothesis of Charles Munger and Warren Buffett that it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Novy-Marx measures profitability by using a ratio of gross profit to assets. Efficiency ratios such as the Du Pont analysis (asset turnover x profit) have been used for a long time in finance and accounting, but the unconventionality of his approach is by only using the cost of goods sold and disregarding other costs.

Looking at NYSE firms between 1963 and 2010 and international firms between 1990 and 2009 (ex-financials), Novy-Marx discovered that a company’s gross profitability did as good a job at predicting its future returns as conventional value metrics like book-to-market. More profitable companies today tend to be more profitable companies tomorrow.  Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain – diamonds in the rough.

– The Mysterious Factor ‘P’: Charlie Munger, Robert Novy-Marx And The Profitability Factor from Forbes (June, 2013)

 

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Mental Model: Empirical Finance

A mental model is an explanation of a thought process about how something works in the real world. Mental models help shape our behaviour and define our approach to solving problems (akin to a personal algorithm) and carrying out tasks. Mental models have been studied by cognitive scientists as part of efforts to understand how humans know, perceive, make decisions, and construct behavior in a variety of environments. Charles Munger provides a concept of “Elementary, Worldly Wisdom” which consists of a set of mental models framed as a solving problems of business, finance and investing. According to Munger, only 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person.

Articles on Emprical Finance as a Mental Model for Investing

Taxes are more important than alpha” on EmpericalFinanceBlog.com

Sources

Empirical Finance Blog

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Mental Model: Behavioral Economics

A mental model is an explanation of a thought process about how something works in the real world. Mental models help shape our behaviour and define our approach to solving problems (akin to a personal algorithm) and carrying out tasks. Mental models have been studied by cognitive scientists as part of efforts to understand how humans know, perceive, make decisions, and construct behavior in a variety of environments. Charles Munger provides a concept of “Elementary, Worldly Wisdom” which consists of a set of mental models framed as a solving problems of business, finance and investing. According to Munger, only 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person.

Common Biases and anomalies

1. The phenomenon called survivorship bias

“Suppose we invest $250 in each of four stocks. The first stock earns 50 percent, the second stock earns 20 percent, the third stock earns 10 percent, and the fourth stock goes bankrupt mid-year. We end the year with $950 ($375 + $300 + $275 + $0), or a loss of 5 percent on our $1,000 investment. Survivorship bias occurs when one calculates the returns on this group of investments using only the survivors at the end of the year, which in this case are the first three stocks. The survivors returned over 26 percent, much more impressive than a five percent loss. Survivorship bias is a virus that can infect indexes and the composition of mutual fund peer groups, but not just that.”
– Source: plansponsor.com

2. The-end-of-the-day-effect

It has been observed that racetrack bettors tend to shift their bets to riskier prospects as “these bettors really prefer ongshots because a small longshot bet can gererate a large enough profit to cover their earlier losses, enabling them to break even”. What the “the-end-of-the-day-effect” (tells us is that people use reference points in decisions that they make under uncertainty which goes against the expected utility theory (that assumes that people make rational choices).

Articles on Behavioral Economics as a Mental Model for Investing

Behavioral Economics Nuggets on Sportgamma

Prospect Theory: An Analysis of Decision under Risk” by Daniel Kahneman and Amos Tversky, Econometrica, Vol. 47, No. 2. (Mar., 1979), pp. 263-292.

Hidden Flaws in Strategy” by Charles Roxburgh, The McKinsey Quarterly, 2003, number 2

Consumer behavioural biases in competition: A survey” by Steffen Huck and Jidong Zhou (2011) Munich Personal RePEc Archive

Prospect theory and Asset Prices” by Nicholas Barberis and Ming Huang (2001)

Choice Architecture” by Richard Thaler, Cass R. Sustein and John P. Balz (2010)

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