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The Plight of the Ordinary Investor

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By EverydayInvestor
March 31, 2009

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The Greatest Series of Investing Blog Posts in the History of the World: Part 1.1, An Introduction to Evidence-Based Investing

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The Plight of the Ordinary Investor

A few finance professors measured the performance of all investors in Taiwan over a period of years by looking at the data direct from the exchange. They found that individual investors and traders underperformed the Taiwanese stock market by an average of 3.8 percentage points per year. Institutions outperformed by an average of 1.5 percentage points. While comprehensive data such as these are not available in the United States, smaller surveys have consistently shown that individual investors underperform the broad market, whether they buy individual stocks or mutual funds or hedge funds. Individual investors are often like kids suffering from shiny ball syndrome: whatever stock is hot or in the news catches their attention and they buy it; they trade too much generating lots of commissions, sub-par returns, and big tax bills. Such ‘investing' is the opposite of rational investing.

This article will show you the way to avoid becoming just another losing individual investor (not that only individual investors do poorly-Alfred Cowles' pioneering research 70 years ago showed that both stock newsletters' and insurance companies' stocks picks underperformed the market as a whole). This is the definitive guide not about how to invest, but about how to learn to invest.

Certainty and Overconfidence

I recently asked readers of my blog on Motley Fool CAPS whether they were good or bad drivers. Driving skill should be only loosely correlated with interest in investing (the very young are horrid drivers and are unlikely to be avid investors, while the very old are poor drivers and are unlikely to be reading blogs), so while this is not a representative sample I had no doubt that my little poll would replicate more scientific polls. What I found was unsurprising to me: out of 159 responses, 46% rated themselves as "above average drivers", 44% rated themselves as "average drivers", and only 10% rated themselves as "below average drivers." In driving as well as in other endeavors, people believe that they are smarter, more attractive, and better than they are in reality. I decided to replicate this study by asking my blog readers about their attractiveness: while 39% of 102 respondents thought they were in the most attractive third of the population, only 22% said they were in the least attractive third of the population. What is amazing is that people can be overconfident about anything: in a third poll I asked the simple and nonsensical question "Quack?" to which 58% of 66 respondents replied "Quack!!!!!!!!!!!" while only 42% responded "Quack?".

Most people are overconfident most of the time (this is sometimes known as the Lake Wobegon Effect). This has advantages. Those who are not overconfident never dare to dream and to try to do unlikely things. Thus they never accomplish as much as the overconfident do. To misquote George Bernard Shaw, "The diffident man adapts himself to the world: the overconfident one persists in trying to adapt the world to himself. Therefore all progress depends on the overconfident man." If people were not overconfident they would apply to far fewer jobs, they would have fewer dates, there would be fewer world records and less greatness.

But in certain areas our human tendency toward overconfidence acts as a tether rather than as a pair of wings. One of these situations is investing. People are generally overconfident in their abilities as investors, just as they are in other aspects of their lives. Professor Terrence Odean has theorized that investors become overconfident because they attribute their successes to skill while forgetting about or attributing to bad luck their failures. One of the key findings in the psychological study of overconfidence is that the worst performers are the most overconfident; they have the worst ‘calibration', or understanding of their own skill. This mis-calibration prevents underperformers from correcting their errors. The first step in fixing a problem is to realize that a problem exists.

Improving Investment Performance First Requires Measuring It

How much do you weigh? While people may not like this question, most people can answer it accurately. Anyone who cares about their weight or fitness can probably recite a reasonably accurate history of how their weight has fluctuated over the last couple years. If you care about your health and fitness more than about your weight, you can probably recite other statistics, such as how quickly you can run a mile, how much you can bench-press, and what your resting heart rate is. This makes perfect sense: if an athlete did not measure her progress, how could she know if she were training correctly?

People purport to care about their investment returns. In reality, few really care. If they did care, they would put forth the effort to accurately track their investment performance. Back when I was a more normal investor, holding several mutual funds and maybe 15 stocks, I set forth to measure my investment performance. It took me about 20 hours to enter all my transactions into the free website Icarra.com. The result? I found that my grand efforts netted me maybe 2% better performance than the S&P 500 per year. That was not very much considering how much effort I was putting into managing my portfolio! I was also not confident that I could continue to outperform the market. Seeing my performance forced me to question whether I was putting too much effort into investing (about 20 hours per week or more following companies, reading books, and researching better ways to invest). That time was definitely hurting my performance in graduate school.

Just as an athlete would not fail to measure her performance, an investor must not fail to measure hers. Otherwise an investor will not know whether she is doing well or poorly. Icarra is free and easy to use. There are other ways to track performance, but most of them fail utterly. To accurately track performance you need to account for cash that is sitting in your brokerage account and you need to account for deposits and withdrawals from your brokerage account. Remember the Beardstown Ladies, an extremely profitable investment club from the mid-1990s? They "beat the market" and became famous. The only problem was that they failed to properly account for deposits they made to their brokerage account, such that they counted those deposits as profits. The Beardstown Ladies actually under-performed the S&P 500 by 1.9% per year from 1983 to 1997.

If you wish to see my performance, take a look at my long term longs portfolio on Icarra; the goal of this portfolio is just to offer market-like returns. See also my Roth Quant portfolio, which was traded using a quantitative trading strategy and is currently all in cash. On the other hand, I am a professional stock day-trader. I do not track these sorts of trades (90% of which are intra-day) online and I do not compare them to the market. There would be no reason for these trades to correlate with the stock market as I go both long and short; I track them in an Excel file and measure my success by total profit, profit margin, and other such metrics.

Once you start using Icarra (or a similar program / service), make sure you look at your Sharpe Ratio and Sortino Ratio (I prefer the Sortino). They are measurements of volatility-weighted performance relative to your benchmark (Icarra uses the T-bill return as the benchmark). Large positive numbers are good! Volatile portfolios are riskier than non-volatile portfolios, so these numbers give you a good idea of risk-adjusted portfolio performance.

I beseech thee now, go out and track thy performance!

The Data do not Lie, and if You Listen Closely You May Hear Their Glorious Song!

"How do I invest? How do I Trade?" These are questions I receive fairly often, as a fairly popular blogger (a couple hundred visitors per day at GoodeValue.com despite my infrequency of blogging) and a Top Fool on Motley Fool CAPS. The answer I give changes over time with my mood and as my opinions change. But the core of any good answer to that question is this: do what works. So be empirical! See what works in investing and then do it! Of course, such advice is almost too vague to be useful. But I find that most investors are not empirical at all. They use their gut, they go with hunches, they make decisions based only on a few pieces of evidence.

A simple empirical question, "what kinds of stocks outperform the market?" has a few different answers. Simply by asking the question we avoid the pitfalls of many investors who buy and sell randomly; as an example, my real estate agent bought shares in Arch Coal "because [he] saw so many trains going by, full of coal." One variation of this question is as follows: What has been the best-performing class of stocks over the last 85 years? The answer is small value stocks. By far the best performers are microcap value stocks. They are highly volatile, risky, and illiquid. (See the great data behind the linked academic articles at Prof. Ken French's website.) Of course, the articles I link are not the ‘truth'; it pays to check out contrary viewpoints and different data sets. For academic research on investing, search on SSRN; why not try searching a term such as ‘Motley Fool' to start?

My arguments in favor of empiricism do not come at the expense of theory; I believe that any investing or trading strategy should have good theoretical underpinnings as well. Hence, we must ask ourselves: Why do value stocks outperform? Ken French and Eugene Fama, authors of the above-linked articles, argue that they are riskier. Higher returns are compensation for higher risk. Others, such as Joseph Piotroski, argue that the value premium does not reflect risk but rather a market failure. I believe that consistently illogical human thinking results in value stocks being consistently priced too low. (I thus fall into the behavioral finance camp.)

Why Do Things Happen? The Importance of Theory

Every year I see articles in the Wall Street Journal and other reputable financial news rags about the Superbowl indicator of the stock market. Supposedly if an NFC team wins, the stock market will go up that year. If an AFC team wins, the stock market will go down. Of course, there is no reasonable way the Superbowl could affect the stock market. Thus any investor who follows this indicator would be doing something very stupid.

Not every stock market indicator is as foolish and as theoretically vacuous as the Superbowl indicator, though; not all dumb theories are as easy to debunk. Take some popular technical indicators such as Gann Angles and Elliott Wave Principle, both of which posit that stock market prices follow certain mathematical rules. Neither of these technical analysis theories have behind them a plausible theory of why they should work. The hypothesis that Elliott Waves follow fundamental mathematical relationships found in nature is a non-explanation. You can find lots of things in nature that obey interesting mathematical rules (like the Fibonacci series), but it is impossible to predict a priori what will or will not follow such a series. Thus saying that something follows some mathematical rule describes but does not explain it.

Any theory should be testable and thus falsifiable (it should make predictions that can be proven wrong), and to quote one technical analyst, "The Elliott Wave Principle, as popularly practiced, is not a legitimate theory, but a story, and a compelling one that is eloquently told by Robert Prechter. The account is especially persuasive because EWP has the seemingly remarkable ability to fit any segment of market history down to its most minute fluctuations. I contend this is made possible by the method's loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong." (quote from Wikipedia article linked above.)

A person can legitimately criticize the vacuous theory behind a strategy while believing the strategy still works. Such is the case with me and some basic technical analysis chart patterns like head and shoulders and cup and handle patterns. Whatever theory originally attempted to explain them matters little to me. My theory is that they work because they are very popular and people believe them. They become a sort of self-fulfilling prophecy. Professor Carol Osler's research has found that some basic chart patterns do work in foreign exchange markets. Conversely, one can find a theory behind a strategy to be plausible while finding that the strategy itself does not work. Such is the case with Dow Theory. Yet while the theory seems plausible (at least to me), a test of William Peter Hamilton's early 20th century stock market prognostications using the theory was mixed, with Dow Theory underperforming the stock market in real terms but outperforming on a volatility-adjusted basis (it had a higher Sharpe ratio).

One last note on theory: the Dogs of the Dow is one of the most over-hyped, over-used useless investing strategies, with little theory behind it. The Motley Fool used to have a couple portfolios based on the Dogs of the Dow and they had even less theory backing them up.

(This post is continued in the previous blog post, Part 1.2)