Hi Guys,
To paraphrase an unremembered source, “Just as there are no atheists in a foxhole, there are no contrarians in a market selling panic”. Many versions of this old saw have been circulated during the turmoil of our current marketplace. For example, from a June 8 ETF Guide column by Simon Maierhofer: “It is said that there are no atheists in foxholes. How about perma-bulls during a nasty correction.”
I recently noticed that an increasing number of Forum participants are asking for selling and buying advice, sometimes on the same day. They appreciate the risk of their decision and are seeking some confirmation comfort. But nobody knows the future so this is a fruitless exercise.
You might be confident what the stock market will do tomorrow. If you guesstimate an Up day, your chance of being correct is a little above 50 %. That’s the historical record, and you will be more lucky than skillful if your prediction is correct.
As the time horizon expands, your chances of making detailed, accurate forecasts erode. We seldom know what will happen a week from now; it is highly unlikely that we will project our situation with any precision next year. Uncertainties dominate the future.
The secret to successful forecasting is to forecast frequently. Random successes occur and are touted as proof of extraordinary prescience and/or skill. In reality, it is exactly what it is – blind luck.
Hell, even understanding the past is a seriously problematic task. We still debate the causes of the equity market blowup that was a forerunner to our Great Depression over 80 years ago. David Snowball states that 20,000 texts have explored the issues of Germany’s Weimar Republic with all kinds of plausible interpretations. Yet resolution of the causes still escapes us. Given these interactive, complexities, it is small wonder that an accurate forecast of the future marketplace eludes us.
“Despite the plausible ideas, the computer-tested systems, the economic wisdom, the refined techniques, the documented track record, and the common-sense approaches, the simple truth is that practically nothing in the economic or investment world works out as we were assured it would.”
That’s not me talking. These prophetic words were lifted from Harry Browne’s book “Why the Best-Laid Investment Plans Usually Go Wrong”. That fine book was written in 1987. That was a true observation back in the 1980s; it is even truer in the 2010s.
Each of us, for our own reasons, seek command and control. Behavioral studies repeatedly demonstrate our propensity towards overconfidence. The professional money manager needs this to bolster his client list and to preserve his professional reputation. Individual investor need this psychological lift to uphold his dignity and self-esteem. Nobody wants to claim the sobriquet of a market loser. So we each fudge the data and lie just a little.
But we can do much better once we recognize and acknowledge that there are precious few secrets behind the curtains along the Yellow Brick Road. Forecasting frequently fails, market beating strategies rarely deliver positive Alpha (excess returns), market advisors and wizards are prescient only 50 % of the time, demonstrating no superior cognitive skills, and private investors have been fractionally recovering merely 30 % of Index returns for decades. These are devastating and discouraging findings.
In an uncertain environment, we must learn to recognize and accept the fact that luck must be coupled with market knowledge (skill) to generate respectable returns.
Harry Browne catalogues many investment dogs that either do not hunt or hunt the wrong prey. Among the false investment tools that Browne highlights are: trusting forecasts, applying untested scientific theories, deploying unverified charting rules, being a constant contrarian by design, using inappropriate benchmarks, assuming superior knowledge, and a host of other erroneous concepts. Investing is not an easy task and demands discipline.
We have developed some loser’s characteristics over centuries of investing. Over the last few decades behavioral researchers have identified and classified a rather long list of our financial shortcomings and wealth destroying habits. We must overcome these to reach the investment winner’s circle.
One such habit is pattern seeking. We often identify patterns that are truly present, but we also see patterns that are illusionary products of our bold imagination.
Yet another habit is that we award intelligence points to ourselves when investment returns are positive; we blame others when our investments go south. I suspect some of us do not deem luck as a major component of our investment process because of our behavioral overconfidence bias.
Another common fallacy is the acceptance of charts as predictive tools. Charts and graphs are a great way to organize and summarize data. Charts document what we know. They represent history and knowledge. They have no forecasting capability except in the active minds of market technicians. A graph of the S&P 500 Index has about the same predictive power as the Periodic Table of the Elements. Using graphs to project the future in a nonlinear, complex world with untold feedback mechanisms is an exercise in futility. That’s not the way the world works.
Michael Maubaussian, research specialist at Legg Mason, believes that luck plays a major role in securing and holding market rewards. He recently appeared on Consuelo Mack’s WealthTrack show to share his views with us. I have provided a Link to a video record of his discussion.
http://blip.tv/WealthTrackSyndication/michael-mauboussin-5313504On a spectrum scale that ranges from pure luck to pure skill, Maubaussian suggests that almost all actors in the investment story are most properly located very near the luck end of the scale. He holds that view even for professional market experts.
In that instance, professionals do have skill because of their resources and time commitment; however all market pros share about the same skill level, and this tends to neutralize each other. Hence when they compete against one another, luck is the primary residual component.
Of course, that’s not the case when a professional competes against private investors. In that scenario, the financial player has a steep advantage over the time-limited and resource-limited amateur. It’s similar to when the Indianapolis Colts play against the New Orleans Saints or against Ridgemount High School. The results are predictable.
We can do much better with a few time-tested approaches.
Before we consider doing better, it is important to recognize the distinction between an investor and a speculator. For my purposes I’ve adopted a rather broad definition. A speculator is anyone who attempts to outperform market-like returns using whatever strategies, methods, or trading frequency he elects to pursue. An investor is anyone who is satisfied with collecting market rewards.
Speculation is not inherently bad. I do some. But since excess rewards are the goal, it is likely that both the short-term tactics and the long-term strategies incorporate some additional risk elements. Being an investor and being a speculator are not mutually exclusive. A portion of a portfolio could be well served using an investor-like approach, while the remainder of the portfolio could be committed to more speculative adventures.
The success formula for the investor segment of a portfolio is not a secret. The approach recommended by an impressive collection of market luminaries is simplicity itself: Invest in a global array of low cost, well diversified mutual funds or ETFs. The diversification includes geographic, foreign exchange, real estate, commodity, and precious metal holdings that complement the usual small and large stock funds, some inflation protected bond products, and several fixed income units. It need not be a complicated portfolio.
The long list of investment wizards who preach this gospel are almost endless. It is more difficult to prepare a similar list for active investors and speculators. That is a much shorter list.
As we celebrate our Independents Day, we must be constantly vigilant to protect our personal financial independence. To enhance the likelihood of this outcome, we must be highly skeptical of false financial prophets who claim to see the future clearly, and profess to possess investment secrets and insights that they do not. Even for those who enjoy momentary success, be alert that much of that success is transitory and that luck was a likely major contributor. Luck and good fortune are fleeting attributes that change instantaneously.
Happy Fourth everyone.
Comments
Good stuff MJG.