You. Investor. You’re a sucker
Posted on July 24, 2007 by Richard Beddard
Filed Under Investing |
My nomination for top blog posting on another blog this year is this one: You, investor, are a sucker. It sent me into a bout of introspection that all investors would benefit from, occasionally. Graeme Pietersz challenges active investors to justify themselves. Are you really beating the market? Or are you a vain time waster, better off doing something productive instead of running hamster-like round the spinning wheel of investment cycles, battering your head against the EMH (see below, if you’re not familiar with the Efficient Market Hypothesis).
I took Graeme’s questions out of his article and re-wrote them as a questionnaire. Then I filled in my answers. If you’re an active investor, I suggest you try it. If you emerge from the questionnaire confident:
- congratulations!
- email me ( richard.beddard(at)iii.co.uk ) your answers, or comment below, and I and other investors that read this blog will be forever grateful
You think you can out-perform the market do you?
Yup.
Aren’t you just wasting money funding the huge industry that sells suckers like you financial information and advice?
No. I get information from REFS (for UK stocks) and Value Line (for US stocks) in the library. I don’t take advice.
Can you tell me what market inefficiency your strategy is exploiting?
Yes. According to the Efficient Market Hypothesis*1, in an efficient market no investor has an advantage. Everything known about a share, say, is factored into its price and price movements are essentially random. No matter how much you study the company, if you beat the market it’s blind luck.
In reality I think markets bounce around levels they would if they were properly efficient, occasionally departing radically from them.
That’s because supply and demand determine share prices. In-turn economic reality and investor sentiment determine supply and demand. I try to buy shares when sentiment dominates the price and they are unreasonably cheap.
Can you produce any evidence at all that your strategy actually works?
Yes, but not conclusively. The evidence is in Graeme’s definition of market efficiency on his moneyterms.co.uk site, an investing super glossary:
The most glaring exceptions to efficient markets seem to occur during investment bubbles and collapses when prices reach levels that can not be explained by reasonable valuation methods.
Just as the stockmarket in general fell to inexplicable lows in early 2003, I work on the assumption that markets in individual companies and industries are prone to extremes of sentiment.
In March 2006 Plus.net, a broadband internet provider, entered an apparent death spiral as its share price plunged from over £4 a share to little more than £1 in August.
The company had no debt, so it wasn’t on the brink of bankruptcy, and you could buy it for a very low multiple of its earnings. There was nothing in its financial reports or updates to account for a 75% fire-sale, so there must have been another reason for the sell-off. In-fact there were two:
- BT was upgrading the broadband infrastructure companies like Plus.net use, which reduced the quality of its service and enraged customers.
- Carphone Warehouse, Orange, and BSkyB had all announced ‘free’ broadband internet bundled with their other services.
I reckoned the first problem was temporary and likely to affect other providers, and the second was the main cause of the crisis in confidence. Competition from the big boys had injected a near-fatal dose of uncertainty into investors’ minds.
Thinking the risks were low, I bought at £1.40 and £1.25. Plus.net was profitable and financially sound, and investors were assuming the very worst; that the ‘free’ broadband offers would sweep all before them. As a customer of Plus.net, I wasn’t inclined to subscribe to Sky TV and I thought many of Plus.net’s customers would hold fast.
Other investors thought Plus.net had a future too, and later in the year BT paid over £2 a share for the whole company. It was a quicker, but smaller return than I had hoped for.*2
Since interviewing Ken Fisher about his book, ‘The only Three Questions That Count’, which promotes a scientific approach to investing, I’ve recognised that my method is far from scientific. It’s founded on principles I learned from the books of gurus like Peter Lynch, and Benjamin Graham. I haven’t tested them myself, and they may not have stood the test of time.
But, since the peak of the bull market in early 2000 my portfolio returned 17% a year on average, a period over which the market returned close to 0%. On the one hand, that’s a stringent test as the period started with a major bear market. On the other hand, seven years is a very short time in the career of a stockpicker.
Does it outperform consistently if you back-test it over different periods of time?
N/A. I can’t back-test because the criteria I use to select stocks vary, and I would not be able to program a computer to replicate my decisions.
So what do you know, or what ability do you have that other investors do not?
As a private investor I have strengths and weaknesses, none of them unique, but the competition isn’t really private investors, it’s the pension funds, insurance companies, and hedge funds that dominate the market these days. While they have oceans of data, computing power that could probably find the meaning of life were it suitably directed, and brilliant individuals manipulating it all, private investors have advantages too. Here’s a few:
- We invest in smaller amounts, which means we can buy shares in small companies, companies that are insignificant to most investment funds. The ‘size effect‘ has been tested, and in (very) general terms, smaller companies do better.
- We don’t measure ourselves against quarterly benchmarks, and we can wait for the market to recognise the value we see in companies. The ‘value effect‘ has been tested, and in (very) general terms, companies on low valuations do better.*3
- We are not bound to invest in particular categories of stocks (like growth, or value, or UK or US, or large or small companies) like most investment funds are.
- We can be low-cost because we don’t have to pay for offices, let alone analysts, salesmen and management fees.
Despite all their firepower, professional investors are constrained. Like owning a superbike in Bermuda (any self respecting hedge fund manager knows Bermuda has a 20mph speed limit), it must be frustrating for them, and an opportunity for us.
If you are going to tell me that you have outperformed, can you tell me how high a level of risk you have taken?
Yes. The industry seems to equate risk with volatility. The riskiest companies, though, are overpriced, or heavily indebted*4. The former suffer savage price corrections when sentiment changes, and the latter risk going under when business falls off. I don’t own any of those, so, while earning higher returns by taking more risk relies more on luck than judgement, I’m not doing that.
How many small investors have you heard of who have become rich by their investments have out-performed?
Not many but… Just because we don’t know about them, it doesn’t mean they don’t exist. I met a lady in the library who’d made a fortune buying and holding through the seventies, eighties and nineties. But ordinary investors don’t brag about their wealth. Often they’re on a journey, and they won’t know they’ve arrived until they’ve cashed all their investments in (or handed them on to the next generation, charity, or the government).
Their objective isn’t the trappings of wealth but financial security - which isn’t as visible. Given our increasing longevity, the cost of living, and lower expectations of the stockmarket in future, it seems unlikely that index tracking will earn enough to give me security, so…
Shouldn’t you just give up and put your money in a nice diversified tracker fund or two with low charges, and leave it there till you retire?
No. My costs are lower, and my returns higher than a tracker, but it’s a brilliant question, and one that I’ll ask myself every few years, just in case the answer has changed.
Footnotes:
- For an explanation of the EMH, see: The way of the market - random walk.
- I picked this example because it seemed especially clear-cut. Mohnish Pabrai, who earned more spectacular returns over a similar period, also invests in uncertain situations where the risks are low, for example Frontline in this interview.
- Not necessarily right now
- See DNA of a superinvestor for a discussion of this attitude to risk.
Comments
22 Responses to “You. Investor. You’re a sucker”
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The link did not work for me Richard, although I found the article via a search.
http://pietersz.co.uk/2007/07/investor-sucker
On the questions:
No way… I have exceptional math and analytical skills and I am responsive to change.
1) Yes
2) No, I do my own research similar to what’s on my blog, http://makingsenseofmyworld.blogspot.com/
3) Yes, I do better math than most and I do not follow the crowd. I only trust when I can verify with my math.
4) Nope, and it doesn’t matter. I’m constantly analyzing and applying new information so chances are what I am doing today may very well be different than tomorrow. What a stupid assumption that what one is doing can not be change or that one follows a system that could be written on a recipe card.
5) Information about stocks does not remain constant and I change my mind when new information is available. This question assumes the world is constant and not subject to change. The belief parameter that lead to these questions are genuinely tight.
6) Well, someone else might say I took very big risks, but I trusted my homework so I thought my risks were very limited, but I could not give numbers to support what the real risk was because a risk calculation is based on a set of assumptions and is only as good as your assumptions.
7) What is rich?
Thanks for both comments Deborah. I’ve changed the link. To be fair to Graeme his assumption was that either you think you have a consistent system or you think you are a superior stockpicker. Since you are in the second category the question about back-testing wouldn’t apply (as it doesn’t apply to me). It’s great to see another active investor responding. We’ve got to put this Efficient Market Hypothesis to bed
[…] Richard Beddard’s response to my previous post, is not the end of the argument, although I will go along with his approach and answer his questionnaire. […]
Hi Richard,
Very interesting reading. I happen to agree with your points. I’m a relatively simplistic investor myself, using mostly OEICs inside ISAs as my investment vehicles (including trackers). So when you expressed your rate of return over the period mentioned I did the same with my investments. I picked a date of 1st Jan 2001 to-date and mine was 15.09%. Interesting as I wouldn’t consider myself an ‘active’ stock picker. However my investment strategy runs counter to most advice. I use a macro economic strategy, buying and selling based on national, global, or international events I feel are significant. Clear examples in the past have been war, global resource shortages (or glut), or political or large scale business shifts. Advisors advise against it, but if one is prepared to wait, it does seem to outperform the market. As a current example. US mortgage fallout seems to be driving a decline in the FTSE, however I also think a lack of confidence in the current UK gov’t administration is driving the market down also. I’m feeling the itchy finger of investment even now, but the question is, when (or if) confidence of GB in GB by the people of GB be restored? Will the market bounce, or slowly regain confidence…
Hi Larry - thanks for your comments. I’d love to invest on the basis of macro-economics and ‘big issues’ but I can’t see the wood for the trees (i.e. I can’t decide what’s driving the overall level of the market). Next time you get a strong buy signal mail me! I won’t bet on it as I do my own research
But it would be interesting to follow the story…
I have been increasingly invested in equities, (directly about 40% and through managed funds about 60%) since I sold my business in 1998. I attempt to apply common sense to investment decisions, based on a combination of macro influences and consideration of how those influences affect individual companies and the way those companies respond to those influences. I do my own research and do not pay for advice. Sucker? Possibly! But with an annualised rate of return since 1998 of 17.6% I am happy to remain one.
Enjoyed your piece. Having few analytical skills myself and not much time I have a small percentage of small emergent companies in the portfolio but mainly play the movements in FT 100 stocks like Lloyds TSB/BP/Shell occasionally picking up dividends in the process. Like strong cash flow and not too much debt in my target company. Sometimes short the indices on a fixed odds betting site but in small amounts so not really hedging my bets properly.
Results over recent years 15%-25% annual returns.
Up 25% since March this year.
Good luck
complete novice myself. like to use investment trusts and oiecs within isa. Try to do my research well and achieving returns around 25 - 30 % a year. Better than a building society. (till i get bit)
What is rich?
Just a state of mind.
FEW OF US, EXCEPT STOCKBROKERS, ARE ABLE TO MAKE MONEY OUT OF STOCKMARKET INVESTMENT.
I agree with Deborah.
I’t is ones analytical skill,that is the most important factor,and constantly adapting to new data.
I’ve only been trading for 6 mts I bought,Ive made mistake’s,but divested my lossing equities,(which have fallen since)into stocks I percieved,that has the best potential,and erased the loss.
High risk;Yes;mostly;but “The riskier the road the greater the reward.
It depends if You can sit on it until You’ve made “Your” exceptable profits;and not be bothered if You lose all that is invested.
I’ve also had sucess e.g:30% gain in 1 equity in 1 mth.Also a 22% gain in 1 mth,a 20% gain in 1 mth,and a 90% gain in 4 mts.
Also receive dividends;e.g from one it was 36.5p per share.
But I have a mix of equities some for trading,some for investments.
Dont rely on others for advice,unless you can disseminate it and equate,True/False;to the best of Your ability.
I’ll have to wait and see how I’m doing over a long period of time to determine if I can capitalise adequatly.
Although I do percieve myself to have an edge;22 years ago I was writing computer software for business’s:::Annalysis & Equations.
I totally agree with most of the comments. Having just finished Sally’s ‘Bets in the city’ with it’s refreshing honesty, it’s easy to see how people come unstuck and fall into the sucker class.
How do I get from zero to hero? That’s what matters to me. I can learn from others experience, but I am sure mine won’t be the same.
I am going to have an Idea, then make a plan, then Execute it. If it doesn’t go as well as I’d hoped I’ll get another idea, plan, and action.
I’d have loved to have known Sally in her pinball wizard days, I’m doing Internet Checkers, it’s great. When I started playing I lost every time, but now I have a couple of winning strategies, that put me ahead of the game, and I’ve just had three wins in a row! Whoopee!!!
I’ve visited most of the websites she mentioned in her book, and I’ve ordered some more books from the second hand department of Amazon, so I am going to be up to speed in the ideas and planning stages. As for the Execution, well that’s another matter. I’ve made most of the mistakes that Sally’s made on shares as opposed to future/options trading. So execution is my bugbear, that’s what I’m going to have to focus on.
Hi Richard,
Well spotted article, although what you were doing looking at investing websites on holiday I dare not ask.
I think to argue against trying to ‘beat the market’ is the same as saying ’set your sights low, as you will never get to the top of your profession in any case’.
While statistically this is probably true, it is against human nature to not try!
I actually think Graeme is wrong to say that being a passive investor is best. As our education system does not teach us about investing then the only way to learn is by being active. Eventually you will settle on a system which suites you, which may well be a passive approach. My own viewpoint is that I want to learn enough so that I can actually slightly beat more than 50% of all the current investors out there and therefore do slightly better in the long term.
I also kind of disagree that investing is a zero sum game. New money is always entering the market, either because the governments create it or new investors put their money in. Therefore, eventually this money gets distributed. For sure the new investors will lose some of their hard earned cash but they will hopefully learn enough eventually to become older and wiser investors. They will then be able to take the money from the next wave of new investors coming in
Hi Robin, nice to hear from you again. Actually I spotted Graeme’s blog the day before I went away on holiday but wanted to spend some time on the reply so I waited until I got back! Much as I’d like people to believe I slave tirelessly over this blog
As you say, beating the market is a zero-sum game but I don’t see why that means you can’t be a winner…
Graeme’s written a reply to my reply (i.e. this blog post) on his blog. Sometime I’m going to reply to that. I’m sure most people will have lost the thread by then!
There is a fallacy right at the start of efficient market theory.
The market can ONLY be completely efficient if all the players have EXACTLY the same needs and objectives. If different players have different requirements, the market CANNOT be efficient for everyone.
So that if you can identify your personal objectives, and have a credible strategy, you should be able to do better than passive investment in meeting those particular objectives.
As a recent pensioner, I want my investments to give a reasonable income, that increases roughly in line with inflation. There is no particular merit in ending up a paper millionaire gazing at the wall in a nursing home.
I am also a pension fund trustee. A pension scheme should be investing to provide a stream of income to pay pensions in 30 years time. Yet, all we look at are quarterly reports on the market value of our investments. Are these correlated in any particular way with our objectives? If the FTSE100 fell back to 3000, I would be delighted, because the pension contributions we invest today would buy twice as much future income. If it rose to 12,000, I would be worried for the future of the scheme.
This all seems common sense to me, though investment professionals smile gently, and think I am somewhere between eccentric and deluded (they are careful to be polite to pension fund trustees). One of the largest passive investment managers in the world can’t tell us what the overall dividend yield, price/earnings, cash flow and book value are for the FTSE100, or any of the other indices they track. They can’t understand why anyone should consider such information relevant.
I don’t claim to be a skilled investor, but I do believe that if you identify your objectives correctly, you can quietly beat the market while it thinks it is beating you.
Hi Michael. I think you’re absolutely right. In fact that’s crystallised some of my thoughts on risk, which I will post in a forthcoming blog. Thanks very much for the observations.
[…] they should be. That means finding inefficiencies. You can still read the blog Graeme wrote, my reply, and his reply to my reply (and if you follow that, the rest of this post should be a doddle), or […]
Robin, I did not say that investment was a zero sum game (it clearly is not), I said that out-performance was.
All the reasons you cite, and one you missed (that corporate profits make shareholders richer), all benefit passive investors as well.
Michael G,
Yes, a portfolio can (and should) be tuned to your objectives. However, this is not inconsistent with efficient markets. An efficient market offers various trade-offs of risk with return.
Any market also allows you to manipulate the forms of returns (dividends or capital gains) which may matter for tax etc. You also have sources of wealth that are not tradable assets, or held for reasons other than pure investment (your earned income, your house, etc)
However none of these is inconsistent with an efficient market. None will allow you to consistently beat the market without taking on greater volatility.
I would also argue that asset allocation at a fairly high level (e.g. choosing which index funds to invest in) is as far as almost everyone needs to go in matching investments to their needs.
What you say about fund managers is worrying. Not caring about the level of indices, and failing to explain to trustees what they are doing to meet a pension funds obligations are both simply wrong.
I can understand that the manager of an index tracker not bothering, their job is simply to track the index accurately, but someone should be considering the issue on your behalf.
Perhaps your pension scheme should look for some new fund managers who take you long term objectives seriously and explain to you how they are doing it?
You comments have already given me possible material for a blog post. If you are willing to tell me any more of your experiences (anonymously, naturally), please email me at the address on my blog.
Richard, Graeme
Thank you so much for your responses.
I hope Richard will write about risk, and Graeme will respond on risk versus return.
As a starting point, are you and Graeme familiar with a fascinating paper by Richard Fitzherbert, “Continuous compounding, volatility and the equity premium”
(www.actuaries.org.uk/files/pdf/library/proceedings/fin_inv/2002/Fitzherbert.pdf, or find it with google).
It sounds heavy going, but the take home message is simple.
Spend £1,000 each on two shares and hold each of them for a year.
After a year one share doubles in value to £2,000 and the other halves to £500.
You have £2,500 and have gained 25%.
Spend £2,000 on one share and hold it for two years.
After one year it doubles in value to £4,000.
After the second year it halves in value back to £2,000
You have gained nothing.
Risk/reward can’t be efficient for both models, so which one is correct?
Over a longer time frame, and large movements, they differ massively. Fitzherbert argues that much of the evidence in support of efficient risk/reward is based on the first model. I think that the second may be more appropriate for a pension fund or buy and hold investor.
Hi Michael. Thanks for that - I’ll read Fitzherbert with interest. I think conventional market theory only really describes what’s ‘normal’ (i.e what it can describe) and disregards what’s not normal i.e. inefficiencies - like low risk, high reward. Can I prove it - absolutely not! Although I once had a fascinating conversation with Benoit Mandelbrot, who invented fractal maths, and said as much.
Richard,
On efficient market theory, have you read the Charles Whalen essay in John Mauldin’s “Outside the box”?
www.investorsinsight.com/otb_va_print.aspx?EditionID=614
Although the “Efficient market” and Minsky models both predict that it is almost impossible to beat the market, the Minsky/Whalen model gives a far more plausible explanation of larger market gyrations.
[…] being the Efficient Market Hypothesis, a theory that I’ve taken issue with before, albeit in a slightly less scholarly […]