Monday, October 30, 2006

Bill Miller's 3Q 2006 Commentary

Bill Miller's latest commentary came out last week, peppered with the usual references to philosophers from the 19th century and, of course, references to our friends WEB and Charlie Munger.

Fun on price and value:
Since more things can happen than will happen, if we can identify where our expectations differ materially from those embedded in market prices, we can construct portfolios that we believe will earn higher risk-adjusted rates of return over time than could be earned by a passive investment program.

This involves always keeping in mind a basic business principle: only compete where you have a competitive advantage. Warren Buffett refers to staying within your circle of competence.
And on the ways to make money in the markets, with a bonus shout-out to behavioral finance:
In markets, competitive advantages are three: informational, analytical, or behavioral. Informational advantage is when you know something material that someone else doesn't. It is the easiest to exploit and the hardest to find ... Analytical advantages come from taking publicly available information and processing or weighting it differently from the others ...

Behavioral advantages are the most interesting because they are the most durable. The field of behavioral finance is still in its infancy yet has already yielded results that can be incorporated profitably into a sound investment process. The best part is that such results are likely to be systematically exploitable and not able to be arbitraged away as they become more widely known. That is because they represent broad findings about how large groups of people are likely to behave under well-defined circumstances. Until large numbers of people are able to alter their psychology (don't hold your breath), there is money to be made from prospect theory, support theory, cognitive psychology, and neuroscience.
Miller's key point: ask yourself why you think the way you do. Question your assumptions, but also your own mindset and temperament. Examine the glasses through which you see the world - you might be surprised that the glasses, not the world, are what's affecting the view.

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