Guest Post: Kevin Lane on the Danger of Seduction

This guest post from my colleague Kevin Lane, principal and portfolio manager at my firm Fusion Analytics, makes a nice bookend to the Tyler Cowen speech about the danger of stories in life and finance.   Kevin’s built the quantitative FusionIQ engine out of a desire to reduce the seduction of sexy stories from his investing process.  Whereas many investment managers fall in love with the narrative first and then search for the numbers that back up what they already think, a true quant goes in the opposite direction, allowing the data to dictate what’s really going on.

I think you’ll enjoy Kevin’s take on this concept. – Josh

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As I wrote the recent story on U.S. Airways ($LCC), I couldn’t help but think of how good the story sounded, particularly as a supporting thesis to the improving technical picture.  Aggressively falling fuel prices not yet factored into earnings, demand for seats still remains strong, and from a sentiment perspective the airlines are extremely under-loved. It all sounds so plausible, so logical, seemingly without flaw, and that my friends is the seduction of the stock story !   Seduction can make us blind, particularly to risk, because the power of the seduction (ie: the stock story) is so strong.

It reminds me of 1997 movie the Devil’s Advocate starring Keanu Reeves, Al Pacino and Charlize Theron.  In the movie Reeves stars as a defense attorney in Gainseville, Florida who has never lost a case. He defends a school teacher, Mr. Gettys, against a charge of child molestation. During the trial, Reeve’s character realizes that his client is guilty, and a reporter tells him that a guilty verdict is all but inevitable. However, through a harsh cross examination Reeves destroys the credibility of the victim and secures another yet another not guilty verdict.  As he celebrates, Reeves is approached by a representative of the New York Law firm Milton, Chadwick & Waters, who offers him a large sum of money to help the firm with a jury selection. After Reeve’s jury delivers a not guilty verdict, John Milton, played by Al Pacino, offers Reeve’s character a large salary, and a swanky New York apartment overlooking Central Park, if he joins the firm. Despite warnings from his Evangelical Chistian mother, Alice, about the sinful and seductive big city life, he accepts the job and moves to New York City with his wife Mary Ann, played by Charlize Theron.

Once in New York the seduction continues as Pacino’s character wines and dines Reeves, tempts him with money and easy woman, to the point where Reeve’s loses himself in the seduction.  In the process he loses his moral compass and ability to be objective.  We draw this analogy as the same thing happens everyday in the world of investing.  A story sounds wonderful, an investor pours money into it, and when the stock goes south, the seduction of the story keeps the investor from being able to make a logical decision. While it is good to be as informed as we can about what we invest in, again, there is a very fine line between knowing the story, yet not letting the story blind you should the stock is not trade as the story suggests, hence the power of the seduction.

This is why we love the quantitative methodolgy and looking at unbiased data, as it allows us to balance the story’s potential with the reality of how the underlying stock is trading.  We have seen too many great story stocks drop 40 or 50% in our day, while the underlying and seductive story seemingly never changed.  So while the potential for U.S. Airways is there and the supportive story sounds good, we always know a story is only as good as the way the stock trades. Hence, why its’ a good idea to always have an exit strategy in place before entering a position, for not only the upside, but also for the downside, before love affair begins!  IQ’s unbiased numerical ranks and BUY and SELL signals certainly aide this process.

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Thanks, Kevin!

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