“The fool doth think he is wise, but the wise man knows himself to be a fool.” ― William Shakespeare,
This week is Blogger Wisdom week on Abnormal Returns. As we have done in previous years we asked an esteemed group of independent finance bloggers a series of (hopefully) provocative questions. Answers are not edited and the author’s name, blog name and Twitter handles follow. We hope you enjoy these posts as much as we do putting them together.
Question: What do you know with a high degree of confidence about investing that does not require any statistical support? (Answers in no particular order.)
Leverage can be deadly. It doesn’t take a statistician to know that if you bet more than you have, you are dramatically increasing your risk. It’s great on the way up, though!
I know how little I know: I am aware of the limitations of what I truly know for sure; that I have no idea what the market will do next year or the year after; what sectors are going to outperform, what stocks will still be here in a decade or two; what the Fed will do, where the Dow will be, what GDP looks like. Once we acknowledge what we do and don’t know, it makes the task before us easier, as we are not relying on a false set of premises to build our investments and portfolios upon.
Performance distorts decision making. Almost always and almost everywhere. Very few investors, including professionals, can avoid the tug of historical numbers when making decisions. (Some are more swayed by long-term numbers and others by what’s happened recently.) The evidence backs up that belief, but you don’t need it to know it’s the way of the world; you can easily observe it.
We know that stocks represent shares in the ownership of businesses and bonds and loans are promises to pay. If we buy sound investments and hold them, we will make money in the long run at minimum (absent war on your home soil, famine, plague, socialism, etc.)
Top traders and investors work to find strategies that suit their personalities (so they can stick with it) and produce net profits over time. Then there is risk management, which keeps you in the game. Whether you are a chart-based swing trader or a long-term value investor, you must find some way to limit your losses or define your “margin of safety” in order to preserve your capital and secure your ability to take advantage of future opportunities. As the popular Market Wizards book series suggests, there are many paths to trading and investing success. While investing styles can vary wildly, a common thread among the top investors interviewed is a respect for the markets and a defined process for controlling risk.
No matter what anyone tells you, successful investing is hard. No stance in the financial markets is ever easy and no strategy will ever give you 100% confidence in your ability to achieve your financial goals. You can make things simpler or more complex but no matter what you do it’s going to be hard. There are far too many psychological landmines to allow this game to ever be easy.
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Tobias Carlisle, The Acquirer’s Multiple, @greenbackd, co-author of Concentrated Investing: Strategies of the World’s Greatest Concentrated Investors:
Value investing works. Buying something for less than it’s worth increases the value of the buyer’s holdings. I don’t need a backtest to know it makes sense.
Investors should minimize or optimize taxes and fees.
Return requires taking risk. Taking more risk, however, does not guarantee more return. Imprudent levels of risk can simply increase the risk of ruin.
The stock market goes up most of the time and every so often it goes down a lot and scares the hell out of a lot of people because it is somehow “different” than other past declines. The circumstances for the declines are different but not the market process for handling declines. It goes down a lot, people panic then it stops going down, often for no apparent reason and then it starts to go back up to a new high. The only variable is how long it will take to make that new high. An advisor or investor may or may not be able to add alpha along the way but the simple act of remembering there is nothing new about the market going down a lot along with maintaining a suitable asset allocation and adequate savings rate should be sufficient provided that panic is not succumbed to.
Thanks to investment costs, investors must collectively lag behind the market–and, thanks to skewness, the number who outperform will be far fewer than a normal distribution curve would suggest.
Hindsight is a hell of a drug.
Markets and economies move in cycles characterized by mean reversion.
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That most decisions get made with a high degree of confidence without having any statistical support.
The price of a stock is a result of its supply and demand.
Overweighting a position, no matter how good it looks, is almost always a bad idea. For every Warren Buffett that massively overweights a position like Coca-Cola that ends up doing well, there are many more Bill Ackmans that massively overweight a Valeant Pharmaceuticals and have it blow up in their face.
That relative values are confusing. That compounding is not intuitive. That many people are here for the game more than the outcome. That simple things are too easy for smart people to take seriously. That Michael Batnick is a good writer.
I know, with increasing certainty, that I know less than I think I do.
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The ongoing march of market efficiency will always be limited by the ability of human beings to behave rationally. Which means that even as most forms of available alpha seem to be shrinking, some level of sustainable alpha – “behavioral” alpha – will remain. In essence, we can think of market inefficiencies as providing two different types of alpha: informational alpha, available to use who can rationally access and use available information better than peers, but prone to being arbitraged away; and behavioral alpha, available to those who can behave better than peers, and capture the return opportunities created by the behavioral mistakes of others, and more likely to sustain (as long as our brains are wired the way they are). Of course, the caveat is that the behavioral biases that create behavioral alpha opportunities are the same biases that make it hard for any particular investor to capture behavioral alpha in the first place!
Wesley R. Gray, Ph.D., Alpha Architect, @alphaarchitect, co-author of Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System:
Better to be lucky than good.
Big corrections lead to great buying opportunities. Trends last a lot longer than most expect because different people buy for different reasons and at different stages of a trend. All trends need sceptics; otherwise, there won’t be anyone left to buy. Corrections are relatively rare, but they are fast and furious and most people don’t act the way they think they will act during them.
I know a lot less than I assume I do.
That investors love stories aligned with their prior views and will look for flaws with any new information that runs counter to these views.
As an investor and trader it’s clear that market participants will continue to act emotionally around money.Ego can be a much more powerful emotional force than fear or greed. People who are very well educated don’t like being wrong. They are not used to it. Designations and degrees are “perceived as success” around attaining knowledge, but that is not the same as being able to have tactical mastery. Having a big ego around intelligence can keep individuals tied to the whipping post for a lot longer than they have to be. Rule: Your first loss is your best loss. Get out. Learn from your mistakes. You can always get back in at a better time.
You have no control over the market. The implication is that you should spend way less time thinking about the market and worrying about short-term moves.
Everyone who expresses an opinion about it is in some way conflicted. It’s usually to do with our business model or some other financial incentive; it’s sometimes about personal or professional pride, or trying to justify silly things we’ve said or done in the past. Always ask, Who’s saying this and Why?
Whatever proposition you make or conclusion you reach can be supported by a carefully-selected chart, some ancient investing wisdom, or advice from a “billionaire fund manager or investor”.
Markets will take you to the point of emotional breakage. You will get out. Then it will go the way you wanted it to go.
Brett Steenbarger, TraderFeed, @steenbab, author of Trading Psychology 2.0: From Best Practices to Best Processes:
Diversification works. If you can harvest returns from relatively uncorrelated strategies with positive expected value, your return stream will be smoother and more reliable than if you go big on any particular strategy. The way to get big is to get broad. Investors have finite Sharpe ratios and those Sharpes have some degree of variability. Many of the psychological problems that occur among investors and traders are the result of amping up strategies and being unable to tolerate the drawdowns when those strategies hit expectable drawdowns.
Thanks to everyone for their time and effort. Don’t forget to check out Tuesday’s Blogger Wisdom question on what we would learn if we had 1000 years of good financial data.