Investment-Related “Believable” Misinformation Makes Successful Investing Hard Work
This article is a continuation of the previous article. You should read the preliminary information provided in that article first.
Diversification protects against losses. Harry Markowitz won a Nobel Prize in 1990 for his ground-breaking research on diversification (modern portfolio theory) in 1952. The simple explanation of this theory is that by diversifying across a wide range of asset classes, one will not be devastated by a significant decline in any particular asset type. Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Typical investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that airline stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. He proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that individually have attractive risk-reward characteristics. In a nutshell, investors should select portfolios not individual securities. Here is what Peter Lynch, former successful manager of Fidelity’s Magellan mutual fund had to say, “Diversification is not a guarantee against losing money, it is just a guarantee that you won’t lose all your money at one time.”
Compounding is the eighth wonder of the world. Well, that is certainly true if all of the compounding was positive. Banks and savings institutions can certainly tout the magic, but in the stock market, there are many years when prices go down and those down years can destroy an investor’s wealth quickly. Negative compounding requires exceptional returns over the following years just to recover. Wall Street doesn’t like this kind of math. If you experience a decline of 33%, you must have a gain of 50% to recover. A loss of 50% requires a gain of 100%, a loss of 75% requires a gain of 300%. Don’t forget, those gains are just so you can break even. Breaking even is not exactly a sound investment strategy. You must have some means available to avoid the devastation of bear markets.
If you miss the 10 best days each year you will not perform as well as the market. This is certainly a true statement. It is commonly touted to further convince you that you must invest for the long term. Another statement that is also true is “if you miss the worst 10 days each year you will greatly outperform the market.” Studies have shown that missing the worst 10 days each year will offer exceptional returns, significantly better than the market, and much better than those generated by missing the 10 best days each year. For the period 1979 through 2004 (25 years), using the S&P 500, a buy and hold strategy yielded a return of +10% per year. If you had the misfortune of missing the best 10 days for each year, your annualized return would be -10%, significantly worse than buy and hold. Convincing, isn’t it? However, if you missed the 10 worst days of each year, your annualized return would be +38% per year. Of course, both of these scenarios are hypothetical, and neither are a realistic investing strategy, but the point is that missing the down days is much better than missing the up days.
Probability and risk are essentially the same thing. The dependence on statistics (probabilities) for investment forecasting is tantamount to stating that with one foot in the fire and the other in ice water, things feel about average. The investment world is full of “rules of thumb” and statistical evidence. Behavioral psychologists refer to this a heuristics. These statistical rules of thumb are widely covered in the media and by many analysts. Usually they are only used to add support to their current market hypothesis. Investor’s understanding of probabilities is usually not good. A simple example is that as a coin is tossed, if heads comes up more and more times in a row, most think the odds are better for the next flip to be tails. It is not, the odds are 50 / 50 and independent of the previous coin flips. A good friend likes to tell a story about offering someone a chance to win at a game by telling him he will guarantee his winning 5 times out of 6. Most eagerly accept such odds. That is, until you tell them that the game is Russian roulette. The focus then shifts to the risk of the loss, not the probability. Most investors forget to incorporate risk into their decision-making process when the truth is, managing and assessing risk is tantamount to investment success. As Thomas Gilovich says, “odds are you don’t know what the odds are.”
Chasing performance will work. Investors have a habit of jumping from one strategy / manager to another during times of diversity. This performance chasing can also be devastating to their investment health. There are a host of reasons a manager might outperform or under perform their benchmark, not the least of which is the benchmark itself. Many times, the benchmark is inadequate for the manager’s style. Past performance is not predictive, it is only a measure of how a manager achieved past success (or not). Success (or failure) can be attributed to style (growth, value, large cap, small cap, etc.), economic conditions, bull/bear markets, etc. Past performance is about hope, which is a comforting companion but a poor indicator of the future. One should adopt an investment philosophy that realizes the market has its good periods and its bad periods, and the philosophy adjusts to them as needed. A technical approach that follows the intermediate trends of the market with strong risk management offers a peace of mind dividend.
Each of these examples shows us where human frailty translated into investment errors. They also attempt to show how we humans tend to take perceived “common knowledge” for granted. If we so easily accept some things as true, then how much investment-related information do we treat the same way? Think about it.
Dance with the Trend,
Greg Morris
