What is the future of search?

Here is a link to an interesting story by Dean Takahashi of the San Jose Mercury discussing an internet start-up called Mahalo (named for the Hawaiian word meaning "Thank You").

The article reports that "Mahalo is a search engine that is powered by human judgment, known in Web 2.0 circles as 'curation.' Curation uses human expertise to weed out all the stuff that you obviously don't want when you're searching."

The Mahalo site itself states, "With traditional search engines you need to figure out the right search term and find relevant results within an unorganized list that often contains irrelevant results, spam, and some mediocre sites" and "Search results for certain categories such as products, travel, cars, and health, are cluttered with people selling things, making it difficult to find great information on those topics."

Regardless of the actual usefulness or success of this particular Mahalo site and their approach (which they claim is "the world's first human-powered search engine"), the issue should raise important questions if you are thinking like a portfolio manager. What other ways will we "search" (navigate the vast and growing amount of information available on the internet) in the future?

Right now, Google is the acknowledged champion of search. Their share of search is more than twice that of their next competitor (Yahoo!). According to NetRatings, Google share of all search in the US is just over 50%, with Yahoo! second at about 20% and MSN third at less than 15%. Globally, Google represents an even greater percentage of search, at nearly 70%.

However, the search engines mentioned above yield results based on algorithms such as Google's PageRank, which ranks search results based on the web of links to and from different pages. While this method has its strengths, it certainly has disadvantages as well. You may value the input and opinions of certain circles of friends or experts on one subject or another greater than you value the rankings generated by measuring the links on the web.

There are a variety of things that you search for that could be improved with forms of search that include conscious human input, including the input of the various circles of people with whom you associate (your friends from business school for some information, the other parents of children at your kids' school for other information, fans of the Boston Celtics for other information, and so on). Mahalo may well be just the first in a shift in the way that the information on the web is found and navigated. While the existing method will probably continue to have usefulness, in five years it may be just one of many players in the cast of internet facilitators, and a small one at that .

* The principals of Taylor Frigon Capital Management do not own securities issued by Google (GOOG) or Yahoo! (YHOO).


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For future posts dealing with this subject, see also:

• "A paradigm shift in the way you get information" 02/11/2008.
  

• "Will 'friend-casting' be as big as search for discovering information?" 02/16/2010.

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Deworsification

In yesterday's post, we discussed some of the drawbacks caused by portfolio size. As "mass-managed money" pools grow larger, they are forced to own more and more portfolio holdings and those holdings typically need to be in larger and larger companies as well.

Some of the largest mutual funds have well over two hundred names -- one fund mentioned as an example had 286. A common question you might have is, "But doesn't that at least give you diversification?"

Diversification is an important concept in investment management. However, the marketing machine of Wall Street has taken an important investment concept and used it, in some cases, to convince people that they need to own more different products, and therby more holdings, than they actually need.

As the graph above illustrates, diversification does reduce the volatility of a portfolio. However, the reduction in volatility is great when you take a one-stock portfolio and make it a two-stock portfolio. There is another large reduction in volatility when you make the two-stock portfolio a three-stock portfolio, but the reduction is slightly less than it was when you went from a one-stock portfolio to a two-stock portfolio. Each additional stock reduces volatility a little less than the last one did. After ten stocks, the reduction in volatility begins to slow dramatically with each additional holding, and after twenty-five stocks the reduction in volatility is very slight, becoming asymptotic after thirty or so holdings. This property of portfolio volatility is well-researched and has been published in many different places for over forty years.

In other words, mass-managed portfolios do not own 286 stocks for diversification purposes. The reason most investors (even wealthy investors) do not know about this principle is probably because there is a vested interest in the investment industry in having people buy numerous products. If people realized that the capital they allocate to the financial markets could be properly invested in a relatively small number of individual stocks and bonds (likely no more than fifty companies), it would seriously threaten the business models of those who make a living selling investors slices of everything under the sun (each slice containing hundreds of individual stocks or bonds, in some cases).

There are many costs associated with owning many more investment vehicles than you need. There are obviously transaction costs and management costs involved, but just as important are the potential opportunity costs. It is true that some businesses are better than others. The more companies you buy, the more chance you have of buying into average or below-average companies. This problem could be called "de-worsification" and it is a serious problem for many investors (although not necessarily a problem at all for Wall Street).

For later blog posts dealing with this same subject, see also:

• "Build your house of bricks" 02/25/2008.

• "Some drawbacks of mutual funds" 05/20/2008.

• "Invest like Mr. Howell" 05/18/2009.

• "A conversation with Gerry Frigon" 08/10/2009.

• "The hard-money real-estate sinkhole" 09/17/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "The dance of the hippos" 08/10/2010.

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The further you are from owning individual companies . . .

The further you are from owning individual companies, the more your investment management tends to be rooted in the performance of markets (or sectors of the market) rather than rooted in the performance of businesses.

In a mutual fund, you don't actually own the stocks of businesses. The mutual fund owns -- in a giant pool -- those stocks in the businesses, and you own shares in the pool. One important thing to realize about these pools is that, as they grow very large, they are forced to buy more and more companies in order to find a home for all the dollars in the pool.

Look at the list of the top twenty mutual funds by holding, as listed in Wikipedia (but available elsewhere as well). If you are a money manager with a pool of $94 billion under management, you cannot own just forty or fifty companies. You could not even own just ninety-four companies. You are forced, by sheer size to own hundreds of companies -- not because you particularly want to own hundreds of companies for investment reasons, but because you must find a place to spread all those assets. The top fund on the list above, for example, owned 286 companies in its portfolio when it last disclosed its holdings at the end of the third quarter of 2007. In fact, you will be forced not only to own a large number of companies, but you will be forced to find relatively large companies (companies with a large market cap) to own. You won't be owning many companies with market caps under a billion dollars, because you will almost buy those companies outright if you put even a small percentage (less than one percent of your assets) into the shares of those companies.

This means that as these pools get larger, these companies own more and more of the same names in the S&P 500 (some may own more than half of the "entire market" if the S&P 500 is taken as a proxy for "the market"). It also means that they own many of the same companies as one another! There are only about 290 companies in the U.S. with market caps of $10 billion dollars or more (these numbers fluctuate slightly every day as stock prices rise and fall). There are only about 23 companies in the U.S. with market caps of $100 billion or more.

As mutual funds own more of the same companies as one another, and as the overall market, they cannot differentiate themselves by owning different businesses. It is hard for them to be able to say, "You invest in Apple, and I will invest in Google, and we'll see who chose a better company after five years." Chances are, they both will own Apple and Google and a whole lot of other large companies as well. So, investors who build their investment foundation upon mutual funds are resting upon a foundation not of business selection, but of market movement. The mutual fund may move from one sector to another sector during the year (as the manager predicts better or worse performance for this or that sector during the next few months), but this is more a system of predicting markets (or slices of markets) than of analyzing companies (for a discussion of the fact that index funds by definition are built on a foundation of markets rather than companies, see our commentary entitled "The Emperor's New Index Fund").

The growing size of the pools inside individual mutual funds can also lead towards increased portfolio turnover in some (although not all) mutual funds. Because they own a huge number of identical companies as those held by everyone else (not because they want to, but because of the forces described above), they cannot differentiate themselves by owning different companies. Instead, in a very competitive marketplace, they can differentiate themselves by owning the same company but for a different quarter than their competition owned it.

In other words, they realize that they own Apple and their competition owns Apple, but they will differentiate themselves by owning it for a better quarter or two than their competition owned it -- creating higher turnover in some cases, as well as creating a tendency to focus on short-term events rather than on the long-term business outlook for a company over a period of many years. In short, investors should be aware of the fact that the further they are from owning companies directly, the more likely it is that their investment philosophy tends to be rooted in market-timing activities rather than in lining their fortunes up with the long-term performance of exceptional companies.

And, as we explained in this previous posting, most of the big fortunes in this country (over the past twenty years as well as over the past one hundred years) have been made by lining up with successful companies for a period of several years.

For later posts dealing with this same subject, see also:

• "Invest like Mr. Howell" 05/18/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

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Don't isolate your forces

Deploying your capital has some parallels to deploying forces on the battlefield.

In both cases, for instance, you don't have unlimited resources to accomplish everything you want to do. You can't put troops on every single hill -- you have to weigh the costs and the risks and decide where you are going to deploy your forces. Furthermore, you are making these decisions in a very fluid environment (constantly changing) and you never have perfect certainty. In military operations, you have to make decisions that have real consequences and you have to make those decisions in conditions of some uncertainty.

Similarly, in financial operations you are also making decisions in a fluid environment that changes constantly. You must make decisions that have real costs and consequences. And you must make those decisions in conditions of uncertainty as well (at any given time, some people are bullish and some bearish about the same issues, some people think jobs growth will be X and others feel it will be Y, some think the Fed will do A and others are certain it will do B).

Just like in military operations, you don't have unlimited troops to spread around everywhere that you want to put them. If you sign up for Long-Term Care Insurance, for instance, then you are committing resources (capital) on an ongoing basis, typically for many years, and that capital cannot be used towards buying a piece of real estate or investing in a promising company, for instance.

One very important principle of military operations is that you don't want to isolate your forces -- you want them to be "mutually supporting." In the map above, if you are in command of three platoons or three companies or three battalions, you don't want to send one force way off to the left "just in case" the enemy comes that way and then find that the enemy comes from the right and your unit is too far away to come back and support the unit on the right that is under attack. Far better, given the fluid conditions of uncertainty described above, is to be able to shift your forces to the place they are needed and to keep them in positions that can mutually support one another.

This same principle holds true with your capital. You want your capital to work in a "mutually supportive" manner. You don't want to isolate your resources by sending capital off in one direction "just in case" and then find out that you needed it somewhere completely different. However, most people tend to do just that (largely because the players in the financial world want you to "silo" your assets in their domain -- your financial market assets are usually not well coordinated with your real estate assets, and your insurance instruments are in a completely different "silo" and not integrated with either of the others).

Thinking in these terms about the way you are deploying capital is a good way to approach the financial battlefield. Look for ways in which you are "siloing" or isolating your forces and potentially causing attrition that you could avoid.

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Stick that in your pipe and smoke it

Here is a link to a video presentation of a talk given by Professor Noah Robinson of the Oregon Institute of Science and Medicine at the annual Gilder Telecosm event in October, 2007.

Of course, a fairly large segment of the population does not permit any discussion of this side of the global warming argument to be so much as whispered. Simply uttering such views makes one a target for abuse, ridicule, and personal attack.

The presentation by Dr. Robinson contains evidence about the retreat of glaciers and the increase in CO2 that should be considered by any thoughtful participants in the "global warming" and "climate change" discussion. The data presented cast serious doubt on the connection between human hydrocarbon use (first coal, then coal plus oil, and ultimately coal plus oil plus natural gas) and temperature change and ice melt. Data on glacier retreat show that the retreat began long before significant human hydrocarbon use and that the pace of the retreat has not increased along with the increase in hydrocarbon use.

This issue is one with serious economic consequences, as the calls for international reduction of carbon use grow louder and louder. The same voices denouncing anyone presenting evidence like that shown in this film are often the voices calling for greater government regulation of business through carbon taxation, "cap and trade" regulations, bans on incandescent light bulbs, taxpayer funding for the weatherization of homes, and so on. Over the next several days, you will be hearing about the international gathering in Bali where participants will be discussing these and other government measures.

Influential media outlets such as the New York Times are carrying prominent stories such as those featured on this page, all of which are from the perspective that the connection between human carbon use and climate change is settled science and that "federal regulation of greenhouse gases" is the logical way forward. A prominent story in today's edition of the Times features the title "A Future Without Skis: Alpine resorts are trying to stay ahead of global warming." A New York Times blog entitled "Dot Earth" features an entry today entitled "A Few (Hundred) Things the Next President Can Do to Limit Warming."

National Public Radio, which is primarily funded by taxes, features a similar collection of "Climate Change" stories to those found in the Times. One story from today's Morning Edition features the human-interest angle of a family in Iceland which has been trekking out to the glaciers every year, only to find that they (the glaciers, that is) are shrinking.

"The trip is no longer just about adventure and companionship," says the story's author. "This group has become unintended witnesses to climate change. Leifsdottir says the last 10 years have been much warmer. But global warming isn't good for the world, she says."

Other links on the page take you to "Top Ten Tips for Fighting Global Warming" which urge you to forgo red meat, dry your clothes on a line instead of in a dryer, and "leave the car at home and take public transportation to work," among other suggestions. Calls for "federal regulation of greenhouse gases" mentioned on the Times website are merely calls to make "suggestions" become mandatory for all, and to enforce similarly-minded restrictions on businesses as well.

There are real economic consequences to suggestions like these. Before we return to levels of government regulation of business last seen in the 1970s, we should at least be unafraid to examine compelling evidence showing that such regulation may have no impact on climate change at all. (Even if carbon reduction would be effectual, it does not necessarily follow that governmentally-mandated carbon reduction is the best course of action, but that is a subject for another day).

For more recent posts dealing with this same issue, see also:

• "'Earth Day' investment lessons" April 22, 2009.
  

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