Dylan Grice wrote a very comprehensive article @ Investment Insights on a Top Down vs Bottom up portfolio manager and the risk involve in both. Its rather lengthy as well.
A few interesting thing caught my attention.
The classic study on hindsight bias was done by Fischhoff and Beyth5 who asked their students to estimate probabilities for possible outcomes during Nixon’s visit to China in 1972 before it occurred (for example, “what is the probability that the USA will establish a permanent diplomatic mission in Peking, but not grant diplomatic recognition”). What the subjects didn’t know was that they would be later asked to recall those probabilities. But when they did, between two weeks and six months after the visit, they recalled that their estimate of events that did happen was much higher than their actual estimate had been, and likewise that their estimate of events that had not transpired had been much lower.
This hindsight bias helps explain our inability to see outliers. If you were perfectly rational in forecasting returns, an unexpectedly positive or negative number would widen your volatility estimate. But if you “knew it all along” you wouldn’t accept that the return was unexpected. Your estimate of potential price volatility would be unchanged and you’d continue to disregard the possible outlier events as too unlikely because your forecast range would remain too narrow. This was actually evident when I put the data together for the QQ charts above. The standard deviation of the actual exchange rate changes was 5.7%; that for the forecasts was only 1.8%.
Of Berkshire’s management of insurance risks:
At this year’s Berkshire Hathaway conference, Charlie Munger said that while most people and firms do whatever they can to avoid large losses, Berkshire Hathaway is designed to take them. “That’s our edge”, he said. When asked about his successor at the helm of Berkshire, Buffett said that the most important thing his successor at Berkshire must be able to do is “to think about things which haven’t happened before.” Most insurance companies lose money on their underwriting operations but make money on the float. Berkshire Hathaway makes profits on both. They haven’t been able to do this because they’ve been better at predicting the future than the competition – they openly admit to not even trying – but because their whole approach is grounded in a) the understanding that “outlier” events happen every few years, and b) being patient enough to hold capital in preparation for deployment when such “outliers” inevitably arise.
That sorta means that that they understand that after a few years you are presented with great buying opportunities and are willing to sit on the sidelines when prices do not get there
2 Strategies for an insurance based approach to portfolio management:
The first and most simple is the avoidance of the purchase of overvalued assets. Ensuring an adequate margin of safety against the unknown and unknowable future – rather than trying to predict it – is the central philosophy behind Ben Graham’s concept of value investing and one of the simplest differences between investment and speculation. It’s as important today as it has always been and is why a careful and prudent analysis of valuation is so important. This is why I spend what some might think is an unusual amount of time on equity valuation for a macro strategist
The second approach is to focus on the “grey swans” – the tail risks which are predictable – by devoting time to thinking about them and to finding effective and efficient protective insurance should they happen. Most of the research Albert and I write aims in this direction. It is for most of us, I believe, a more fruitful use of macro research than trying to predict various markets’ short-term moves. There is a very big difference. Some have interpreted my work on government solvency as a reason to short government bonds, and JGBs in particular. I’ve actually never suggested doing this. To get it right you have to get your timing right, and ? well ? see the above on how confident most of us (myself included) should be about that.
In essence, as an active portfolio manager you have an idea where the market is going or you might be riding on a trend, but at the end of the day, your purchase price is important and after experiences of 2 bear market in less than 10 years, you might want to start thinking about outlier events and protecting your portfolio against that.