July 2, 2018
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
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“He who knows best knows how little he knows.” – Thomas Jefferson
For loyal Phoenix Suns basketball fans, 2018 brought two historic events: the 50th anniversary of the franchise, and the first time in franchise history the team had the number one pick in the NBA draft. For those who don’t know how the NBA draft works, picks are assigned via lottery, with a team’s record from the previous season determining how many lotto balls go in the hopper on their behalf. The worse record a team had, the more lottery balls it receives, and therefore the higher the probability it has of a better pick. For Suns fans, landing the number one pick was somewhat bittersweet, as it meant the team lost more games than any other team this past season.
However, Suns fans aren’t dismayed. While the 50th anniversary season was disappointing, on June 21st they selected Deandre Ayton with the first pick of the draft, a player many fans believe is the key to turning the team around. Granted, Ayton had a strong season at the University of Arizona, winning numerous awards as a freshman including First Team All-American. Unfortunately, neither college awards nor draft positions are guarantees of franchise-changing players. Of the 55 number one draft picks from 1947-2002 (many players drafted after 2002 are still playing), only 17 have been elected to the Hall of Fame. Perhaps even more concerning, 20 of those same 55 players were never selected to the All-Star Game or All-NBA Team.
By comparison, in 1996 the NBA announced a list of the 50 greatest players of all time, to commemorate the 50th anniversary of the league. Of those 50 players, only ten were number one draft picks, and six weren’t even picked in the first round. Granted some drafts were loaded with great players, like 1984, where Hakeem Olajuwon was chosen with the number one pick, Michael Jordan with the number three pick, and Charles Barkley with the number five pick, all members of the 50 greatest players. However, in between were Sam Bowie at number two and Sam Perkins at number four. Both enjoyed solid NBA careers, but neither were franchise altering players.
The lesson to be learned from the NBA draft is that it is extremely difficult to predict future success based on limited, short-term information (typically less than three years of college basketball statistics). This is true in every sport’s draft, and in investing as well. While fans and sports media spend hundreds of hours analyzing draft picks, speculating about trades, and attempting to predict long-term impact, investors and financial media obsess over quarterly earnings and news headlines, hoping to discern the future profitability of a company with a morsel of new information.
Recently Jamie Dimon, the CEO of JP Morgan Chase, and Warren Buffett, the chairman of Berkshire Hathaway, made headlines when they wrote an op-ed in the Wall Street Journal suggesting that companies should stop providing quarterly earnings guidance. They argue that it encourages a focus on short-term profits at the expense of the long-term growth and strength of the company. In some cases, companies have been known to set guidance artificially lower, making it easier to beat expectations the following quarter and report stronger-than-expected results.
Supporters of quarterly earnings guidance suggest it improves communications with investors, reduces volatility, and increases overall stock value. However, a study by McKinsey & Co. in 2006 found that guidance didn’t affect valuation or reduce volatility. Instead it increased trading volumes, and took up valuable time from management, forcing them to focus too much on the short term.
As human beings, we have a natural tendency to access more information if it is available. We’re almost insatiable. Many of us can look back over the last several decades and recognize the explosion in the availability of information. We have a twenty-four-hour news cycle populated by dozens of news outlets, not to mention the amount of information available on our cell phones at any time. The amount and availability of information continue to grow because we keep consuming it, despite the data that shows we’re not really better off for it.
As Mr. Dimon and Mr. Buffett suggest, we should pay less attention to short-term information. To do so will feel completely unnatural, but it will make us better investors. As a simple example, consider the performance of the S&P 500 over various time periods:
If investors look at the S&P 500 every day, they will see positive returns a little more than half the time. The less frequently they look, the more often they see positive returns. Let us consider Mr. Dimon’s and Mr. Buffett’s position in light of this information. They’re encouraging corporate CEOs to provide guidance less frequently, which will cause them to manage more to the long term than the short term. In addition, it will hopefully decrease the amount of emphasis placed on quarterly numbers and encourage investors to think longer term.
When investors consider their own portfolios, they don’t have to manage to outside shareholder expectations, but they do have to manage to their own. If investors look at their performance and portfolios every day, there’s a natural inclination to do something with that information. If it’s positive, it reinforces previous decisions. If it’s negative, it may prompt a change to try and make things better. When investors look at their portfolios every day, they are almost forced to deal with that prompt to make a change every other day. If investors look at their portfolios every week, not only will they feel good more often, but they’ll feel like they have to make a change less often. The pattern continues the less frequently one “observes” performance. Can you imagine looking at your portfolio only once per year? If you were invested only in stocks, you’d feel good nearly eight out of ten years. The probability of success is even higher with a diversified portfolio.
Suns fans can be excited about a number one draft pick, but no one will know how good Deandre Ayton will be, or what he will mean to the Suns, for many years. In the same way, investors can pay attention as often as they want, but the value of short-term information is very little. As the quote at the beginning of this article from Thomas Jefferson implies, the wisest people accept how little they know. Perhaps this is why one of the most well-known quotes about forecasting the market comes from John D. Rockefeller in the early 1900s. When asked what he thought the market was going to do, he responded, “It will fluctuate.”