Sunday, October 24, 2010

More on "The ABC of Stock Speculation" - part 1: investors' overall incredible underperformance

I've found more "quotable quotes" in that book than usual, and having it available as pure text in Google Books makes the temptation of sharing some of the quotes hard to resist (as copy and paste is SO easy;-)... the fact that it was written in 1902, when my beloved (and now long-deceased) grandparents were small kids, and yet so much of it feels as fresh and applicable today as ever ("timeless" comes to mind!-) tips the balance!-).

So, I'll irregularly do some posts based on quotes from Nelson's book -- selectively, of course, but I do think they'll be worthwhile. All the quotes in this and other posts of this ilk are from Google Books' scans, except for typo corrections I'm making along the way.
The maxim "buy cheap and sell dear" is as old as speculation itself, but it leaves unsolved the question of when a security of a commodity is cheap and when it is dear, and this is the vital point.
The elder Rothschilds are said to have acted on the principle that it was well to buy a property of known value when others wanted to sell and to sell when others wanted to buy. There is a great deal of sound wisdom in this. The public, as a whole, buys at the wrong time and sells at the wrong time.
Nelson then goes on to explain the reason for this as he sees it...:
The reason is that markets are made in part by manipulation and the public buys on manipulated advances and after they are well along. Hence it buys at the time when manipulators wish to sell and sells when manipulators wish to buy.
While I entirely agree with the core observation, I disagree with Nelson's explanation.
I know my son Lucio -- a financial economist, freelance trader, and poker champion -- would in fact agree with Nelson: Lucio handles the "family money" (I left it all in his care as I moved to the US 5.5 years ago, taking from it only a modest interest-free loan so I could get a car, plonk down a security deposit on a residental lease, &c, without needlessly incurring debt for the purpose, and repaid that loan entirely in about 18 months, i.e., as soon as my savings allowed me to) and he never has any substantial part of it in the stock market, exactly because he thinks that it's a shell game run by insiders for the insiders' own benefit (much like what Nelson depicts throughout most of his great book).
Now maybe that was true 120 years ago or so (I have no personal experience of those times to base an opinion on!-), but having been personally involved in the market -- as a businessman, a manager, an investor -- throughout my adult lifetime, I've seen the market's workings (to some limited extent) "from an inside viewpoint", and I'm convinced that, while there may be manipulation attempted (and sometimes successful), it's nowhere like a primary driver of the market's movements.
In addition, there's no need for such a hypothesis to explain the clearly-true fact that the many-headed, as a whole, "buy dear and sell cheap" -- human psychology on its own is plenty sufficient to account for this (and therefore, Occam's razor urges us not to introduce additional, unneeded hypotheses!-). Consider the measurement of returns over the last 20+ years published by Dalbar: summarizing, while the S&P500 was showing annualized returns of 8.2%, mutual funds investors got annualized 3.2% returns -- a shockingly large difference. Now maybe 1-2% of this can be accounted for by the fees, commissions (through over-trading, AKA churning) and other semi-hidden expenses routinely charged by most mutual funds, but where does the rest of the 5% underperformance come from?!
Easy: it comes from investors' psychology -- invariably, inevitably, doomedly chasing the "latest hottest trend" -- last year's highly performing fund, manager, industry, sector, whatever. Over and over again, investors en masse are systematically selling the "underperforming" fund (or security, or sector, &c) when it's cheap, in order to buy the "outperforming" one when it's dear -- that's known (by its heartiest supporters, no less!-) as "momentum investing" (or "trend following"), and that's the core reason why I named this blog "mutnemom"... because that (made-up) word is the reverse of "momentum" (and a great summary of my overall investing philosophy;-).
I believe human psychology hasn't changed at all deeply in the course of the last 100 years (or 1000, or 10000, for that matter, though social and cultural conditions do change -- on those, and even faster, timescales -- and do make a difference at some level), so the "chasing the latest hotness" mistake is plenty sufficient, IMNSHO, to account for Nelson's 1902 observation, no less than for investors' woeful underperformance of the markets in the 1989-2009 time span (plenty of other human-psychological issues, such as over-trading, panics, &c, help out -- but even if you rebalanced your portfolio just once a year, but every single time to the last year's "hottest stuff", I'm convinced that you'd manage to underperform the markets, if not by 5% yearly, surely at least by 3-4% in the long run.
BTW, once you contemplate the fact that investors as a whole heavily underperform the market, I hope it's clear that theoretical arguments about the impossibility to outperform the market can't hold: if you have a negative oracle (an oracle that invariably gives the wrong answer to every question), that's just as useful as a perfect oracle, once you know about it...: just do the reverse of whatever it's suggesting!-). Ben Stein and Phil DeMuth have written a good, if dry, book, "Yes, you can time the market!", showing extensively that getting into the market only when it's cheap compared to its own moving averages (and out again when it's dear) vastly outperforms "buy and hold" over the decades, for example. But, I guess, that's a subject for another post, as this one is plenty long enough already;-).

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