The Biggest Investor Mistake

For most people, the information in today’s post is probably more important than any other single fact they can learn about investing.  Understanding and following this advice could make a million-dollar difference for a middle-class family thinking about college and retirement.

The problem is that the advice is extremely difficult to follow.  Since very few individuals will follow this advice, it is yet another source of market inefficiency.  It explains why Warren Buffett and other managers can maintain a positive expectancy in gains over the market.

Ready?  Here goes —

Don’t sell the bottom!

Don’t do it with stocks.  Don’t do it with mutual funds.

Let me explain the psychology first, and then show you some persuasive evidence of the effects.

They psychology comes from our desire to control, and the feeling that we can control our investments.  There is a strong marketing interest in persuading investors that they can and should make their own decisions.  It is profitable for brokerages, and they run many ads to that effect.

They show the "Power Guy" with his fancy trading tools telling a broker (as if he would really be talking to a broker in these days of online trading).  The Power Guy says "OK, I’ll buy a thousand shares, but if it goes down, I’m going to dump it!"  Firm, decisive, and wrong!  The market creates all sorts of movements in stocks.  If your fundamental reasons are intact, you should be prepared to buy more.  But it certainly sounds good.  The TV commercial plays upon our desire to show that we are in control, and that this sort of decisiveness makes sense.

Another commercial theme for Diamonds (the ETF that is a Dow 30 equivalent) highlighted a woman who did not have the time to study individual stocks, but who had a "feel for the market."  Just what people need — not!  Encouragement to try market timing based upon casual knowledge.  I wonder how much people have lost following that commercial.

And then there is the guy who spots a good investment because he is buying jeans for his daughter.  This is a perversion of some great advice from Peter Lynch.  It is fine to try to spot trends early. This provides a nice starting point, not the reason for an immediate investment.

The sad result is that individual investors make 1/3 to 1/2 of the market returns in every study I have seen on the subject.  Here is one such study, and there are many more.

Warren Buffett says the following:

"You can’t get rich with a weather vane."

"The market is there only as a reference point to see if anybody is offering to do anything foolish.  When we invest in stocks, we invest in businesses."

If you are not studying the individual companies, the financials, the trends, you are not analyzing the business.

In many stocks right now the market is offering an opportunity.  There is an extremely high level of concern, not about current conditions, but about an expectation that the Fed or oil prices or budget deficits, or something, will ruin the economy.  Before concluding that the market (which has predicted seven out of the last two recessions) has some great message, the investor should get some evidence.

The studies also show that the average investor applies the same criteria to investment managers, selling funds that did poorly recently to buy those that did well.  The investor is not making a careful decision because this strategy has been proven to work.  In fact, it has been proven to be a loser.  Investors behave this way because they want a simple rule, called a heuristic in behavioral finance, and this is the only information they have.  It gives the illusion of control, and costs them many thousands of dollars.

Warren Buffett on Market Efficiency

Warren Buffett is generally acknowledged as the world’s greatest investor.  He has gotten a lot of well-deserved publicity this week for his plan to give away most of his wealth.

Spending some time thinking about his success is a good exercise for anyone interested in markets or investing.  Janet Lowe’s book collecting useful wisdom is a good source.

Warren Buffett does not believe that markets are efficient.  If they were, he would have no advantage.  On the contrary, he feels that he gains an advantage from those who take the theory too seriously.

"I’d be a bum on the street with a tin cup if the markets were always efficient."

"Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards."

(Personally, I prefer to think of it as opponents who do not look at the cards!)

"It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn’t do any good to think."

Warren Buffett has spent a lifetime finding seriously mis-priced stocks to buy.  It is little wonder that he sees the market as inefficient.  Does that mean that Nobel prize-winning professor lose to the world’s greatest investor?

Markets are not (very) efficient

In my years as a college professor, I had more than a passing acquaintance with general investment theory.  I was interested in the subject, and did well with my personal account.  Despite this success, I believed that markets were efficient.  The Efficient Market Hypothesis had gained credence in academic circles, was taught in classrooms, and earned Nobel prizes for the theoreticians.  It made its way into popular literature.  The Wall Street Journal even started a feature comparing the stock picks of experts to the stock picks generated by throwing a dart at a page of stock prices.  The darts did pretty well.  John Bogle was a pioneer with this concept, introducing the first index fund on the S&P 500.  He wrote articles and spoke in front of influential audiences, pointing out the failings of fund managers, most of whom do not beat the market averages.  Thinking that you could beat the averages by picking "hot" fund managers was misleading.  There will always be managers that will do well and managers that will not, but it is a function of randomness.  An excellent book on this subject by Nassim Taleb explained this concept in more detail.  I purchased many copies of the book and sent them to my investors so that they could begin to understand how to distinguish expected performance from past results.  Any investor could profit by reading even a small part of Taleb’s book.  It is well worth the price.

I began work in the investment business providing models and research support for options traders, market makers in the Chicago Board Options Exchange, known in the market as the CBOE (see-bow).   I  began this work for professional traders, trading their own money (and often that of backers) for their own accounts because the traders had an edge.  They bought options on the bid and sold on the offer, conferring an inherent advantage.  The traders needed modeling support and fundamental analysis of the stocks.

As I did this work, I operated with the open mind of an academic researcher.  Gradually I became convinced that there were significant market inefficiencies.  This is extremely important.  The opportunity for the investor comes when others are making mistakes.  If markets are not really efficient, there is opportunity.  The problem comes in determining the sources of the inefficiency and knowing how and when to react.

This concept is crucial to investment management.  If markets are efficient, managers could not show excess returns.  I learned that individual investors made many mistakes, and that their personal accounts showed about half of the gains of the market averages.  They would indeed do better to buy an index fund.  I also learned that the recommendations of analysts at the major firms were a contra-indicator, even though followed by many institutional investors.  The premise was simple:  If the analysts were all in favor of a stock, their followers were already all-in.  The key was to find great stocks that were currently unloved by the analyst community and by individual investors.

I reached this conclusion long before the recent disparging of analyst research, assorted scandals, and the like.  My investors enjoyed great returns from following a contrarian strategy.  The gains did not always happen over night, but they came with time.

I intend to elaborate on this concept, the source of the inefficiencies, why they occur, and what opportunities results.  But first, I need to elaborate on the evidence that markets are not really efficient.  It is a difficult but important concept.