Tuesday, May 08, 2007

Fundamental Advice About Playing The Market

For reasons that entirely elude me, I am sometimes asked for advice about investing.* Generally, I dodge that bullet, and turn the conversation back so that the questioner ends up talking about themselves, which most people love to do.

Still, I have a few brief principles, some I've learned from my errors, and some that I've learned from the errors of others. If even one person who reads this acts like less of an idiot afterwards, then my good deed for the day is done.

  1. Some peope like to brag that they have a great appetite for risk. What they mean to say is that they “have a great appetite for returns” and those are not the same. The reason a Canada Savings Bond pays 2.8% interest is because it’s guaranteed. The reason 00 on the roulette wheel pays 35-1 is because you’ve only got a 2.8% chance of your bet paying off. If you had a $100K in your pocket, and you were standing in front of the roulette table, would you still have that avowed appetite for risk?

  2. I thought that internet bulletin boards devoted to weightlifting, bodybuilding, and other strength sports were full of kooks and oddballs, until I browsed a few "investing" web boards. I needed all of five minutes to recognize a surplus of noise, and an absence of information.

  3. “Investment Clubs” that meet in person are no better than investing boards on the internet. In fact they may be worse, because in person charm, guile, and persuasion can be more effective to fleece the unwary. Google for "High Yield Investment Programs" and "Prime Bank Instruments" and read about how those schemes always play out. Surprise surprise, there is always someone at these clubs promoting those schemes. There’s two type of people involved in “clubs” and internet stock boards: Eloi and Morlocks. I don’t think that I need to elaborate, do I?

  4. Anybody who tells you anything that sounds like an "inside scoop" is playing a deeper game than just acting out of an altruistic desire to help you make money. Many people seem to have trouble grasping that.
  5. Running money is like masturbating. It is a solitary, private activity. You don’t do it for the aclaimation of others, and how you do it is no one else’s concern. Anybody who insists on telling you at social functions how they do it is creepy and weird, and you should avoid them.
  6. Most people don’t understand the distinction between “investing” and “trading”
  7. I don’t have a lot of truck for financial advisors. You’re paying someone to do your thinking for you. If you own your own business, do you trust someone else to make your decisions for you there? It's your money, if you don't trust yourself to run it, you probably shouldn't trust anybody else either.

  8. Now consider that the majority of fund managers can’t consistently deliver a return above the market indexes. Why pay fees so some schlub can underperform, when you could buy Index ETFs that would keep up with the sectors you play, and park your liquid cash in a high-interest, low fee savings account like ING or Royal Bank offer, until you see something you like? Advice that you need to be “fully invested” and that “cash is trash” is advice given by advisers who want more of your money.
  9. Just like at the casino, the need for action, to make a trade, any trade, is a negative behavior. Only go “in” when all the signs point to "yes," not because you have the fever. This is probably a tall order for most people.

**The content contained in this blog represents the opinions of Mr. Distad. This commentary may contain forward looking statements and definetely contains sarcasm and rude sentiments. This commentary in no way constitutes a solicitation of business or investment advice. If you're looking for stock picks from me, look somewhere else. Really, what were you thinking? If you came here because you were trolling Google looking for someone to help you get rich in only twenty minutes a month, you need to seriously re-evaluate your worldview. This blog is intended solely for the entertainment of the reader, and the author, and not neccessarily in that order.

*I really, really hate that term and how it is used by people.

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Jason said...

Ah, I agree with you, for the most part.

Financial advisors cannot reliably add returns or beat the market without adding a commensurate amount of risk. Theory predicts it, and study after study after study confirms it.

The problem, though, is that while professional advisors underperform the market by roughly the amount of their costs (exactly as one would predict), they do outperform the average do-it-yourself schlub by quite a margin.

For example, run a google search on DALBAR's studies on the actual returns experienced by individual investors, once cash flows are taken into account. It's pathetic.

The best financial advisors can add value, in my opinion - just don't ask them to beat the market consistently.

Where can an experienced financial pro add value and earn his or her keep?

1. Risk management
2. Wealth protection
3. Behavioral counseling
4. Tax planning

For investments, I personally do almost everything in index funds with Vanguard.

I'm kicking around the idea of using a dividend-based index rather than a market-cap based index, though, because of the innate bias towards growth that traditional indexing has.

That seems to be what Benjamin Graham would advise for passive investors.

One idea: Divide your S&P index between a Growth index and a Value index fund. Vanguard offers both. Rebalance occasionally (say, every three years.)

Assuming that growth and value styles will eventually perform roughly evenly, this has the effect of using dollar-cost averaging to buy more shares of whatever style is out of favor, while you sell shares of whatever's been hot. The idea is to add a bit of value at the margins.

I don't do that, though, probably because I'm too damn lazy to check my balance every two years.

NoShow said...

[quote]Some peope like to brag that they have a great appetite for risk. What they mean to say is that they “have a great appetite for returns” and those are not the same.[/quote]

I find that the basis for comments like this, usually come from the saying "the greater the risk, the greater the reward" (or "in order to get more reward, you have to take on more risk" or various of).

Though many people misinterpret those sayings. "Risk" is "the possibility of suffering harm or loss; danger". I've seen newer finanical definition that alter that somewhat to something like; "The quantifiable likelihood of loss or less-than-expected returns". Regardless, it's about losses, not rewards.

Going back to the saying, one can see that reward is not a component of risk, loss is. So the great the risk, the great the loss. The way reward gets worked into it, is that the greater the risk, the greater the reward, required in order to indice one to take said risk. So one has to also evaulate the risk of the reward, in that how likely is the reward?

Let's us a restaurant as an example. Let's say that your borther-in-law the mechanic, decides he wants to open a restaurant. His cooking experience is burning the BBQ ribs at the summer picnic. And by some fluke, you get the opportunity to invest in Danny Meyer's next restaurant. Your BIL offers you 25% of all profits for your investment and Meyer offers you 8% for the same dollars invested. Now the "risk" here is going with your BIL, I lousy cook versus an established restauranteer. So if the greater risk, gives you the greater reward, you should invest in your BIL. Moving on to the reward factor; though your BIL is offering three times the percentage of what Meyer is offering, in all likelihood Meyer's 8% will exceed (in actual dollars) the 25% offered by your BIL.

But people get all fuzzy trying to do the analysis and usually don't do it and settle with applying sayings like "the greater the risk, the greater the reward".

Which must also explain the success of those Nigerian emails.

Lee_D said...

Jason, I don't disagree with your assertions. Like anything, there are good financial planners out there, although Sturgeon's Law could be modified to say that 98% of them are crap. And you are correct, the evidence bears out that individual stock pickers deliver, on average, sub-par returns. Bear in mind though that despite both the median and mean numbers, there are always individuals who do far better, as well as far, far worse.

Still, if someone is a clever monkey, sheds some negative behaviors, and is willing to steel themselves with great discipline and lots of hard work, they could earn above average returns. Certainly not in the "get rich quick" way that quacks and charlattans promote to sell books and newsletters.

Many people who climb the mountain will fail, but that's true of so-called professional traders. Brokerages chew up and spit out traders who zigged when they should have zagged every day. It's only survivor bias that puts the winners on a pedastal. Like Chinese or Bulgarian weightlifters, we only see the gold medalist on the podium, not the hundreds of wrecked lifters cut from the training program because they didn't measure up.

There's many factors beyond individual control that can't be helped, but the internal factors of discipline and good sense are worth training to improve upon.

And NoShow, you are absolutely right that risk and reward are completely uncoupled. It's fuzzy thinking to assume that they are. I have taken huge risks that have paid back peanuts. Certainly NOT commensurate with the chance I took.