Monday, December 1, 2008

Superficial Investing, Misunderstanding Under (and Over) Performance, and On Being an Optimistic Skeptic

Dan Richards (no relation) has a thought provoking (and short) article in The Global and Mail here that reminds us that things are never quite what they seem, in good times or in bad. He starts off:

Psychologists talk about the human propensity to gravitate towards evidence that supports existing biases. What that means, quite simply, is that in buoyant markets, investors are prone to believe outrageous claims by market bulls – think no further than “the world has changed forever” rhetoric and best selling books like “Dow Jones 36,000” and Harry Dent’s “The Great Boom Ahead” in the tech boom in 1999 and 2000.

In the same way, in negative markets such as we’re experiencing right now, investors tend to believe even the most gloomy assertions from “media gurus” and self appointed experts - a recent New York Times article headlined “Forecasters race to call the bottom to the market” discussed the competition among market pundits to come up with the most dire possible predictions. (It’s noteworthy that the same Harry Dent who wrote “The Great Boom Ahead” has just published “The Great Depression Ahead.”)
I encourage you to read the complete article (again, it's very short), for the analysis he does of several commonly touted facts about stock market returns. Anyhow, he ends like this:
None of this is intended to say that stocks will always be a safe or pleasant haven for investors. And despite the overwhelmingly positive returns that long term investors in U.S. stocks have seen across virtually every time frame, there is always the possibility that it could be different going forward. Just remember, though, the only guide we have going forward is what happened in the past. And in looking at the past, we need to look at all the facts – not just those selected by people looking to grab newspaper headlines.
One item I'd add to it: Statistics regarding under-performance AND over-performance touted are both misleading without qualifiers and rarely as meaningful to a given individual investor as they are lead to believe. I have several reasons for stating this and, at the risk of leaving things hanging and encouraging people to misunderstand me since this also touches upon other areas of investing which I've formed strong opinions about, here are some quick reasons:
  • Some investors invest in markets (namely those who invest solely in index funds). Other investors invest in companies (those who select & invest, on whatever basis they've determined makes sense for them). And, yes, I realize plenty of folks are essentially hybrids of these two types. These two types of investors have dramatically different strategies. In many cases the returns of the various indexes are irrelevant to investors in individual companies and, interestingly, the inverse is true as well (i.e. the returns of any given individual company are irrelevant to index investors).
  • Market investors who get in (and out) at different times have dramatically different results even against long-term (say, 20+ year) metrics. This is because even over the long-term, a very small number of days, weeks, or months can account for a large percentage of the overall returns calculated into the average. Unfortunately, the majority of individuals get bit by this one far more than is often believed due to human psychology and our inability to tell the difference between temporary losses of capital and permanent (often exasperated by not truly understanding what we're investing in too)
  • Indexes are NOT actually the market. Every index is a bit different and represent some portion of the market in different ways. The Dow Jones Industrial Average for example, says absolutely nothing about mid-size and smaller companies and, for that matter, anything about any companies other than the top thirty largest (and most widely dispersed ownership) public companies. Which companies actually fall into this category actually change from time to time (imagine that). The components of the index thus are dynamic over time. That throws a bit of a monkey wrench into the possibility of even holding onto the DJIA for a long period of time (the allusion that it's not changing if you own an index fund is only because you don't own the underlying securities directly). This is to say (almost) nothing about how the weighting of individual stocks (and their price changes) is done inconsistently between indexes (and also not necessarily representative of how an individual investor would view the same portfolio of stocks if held directly).
Those who I'll call Superficial Investors are generally universally and especially hard hit anytime things are not all hunky dory in the stock market. I use the term Superficial by way of attempting an explanation and not to be judgmental. Superficial Investors are not really speculating nor are they truly investing (I define investing as Ben Graham did: where upon thorough analysis, it promises safety of principal and a satisfactory return.)

Superficial Investors (SIs) are essentially the masses of folks that have (generally) modest sums of capital in the markets by way of retirement accounts, mutual funds, college savings funds, and the like. Many also have regular brokerage accounts and can toy with investing directly in individual companies that way as well.

It's no surprise that most folks with money in the market these days have no idea what to do. After all, they really didn't know what they were doing to begin with. They were only under an allusion (of self-deception, though not maliciously or even knowingly).

Warren Buffett said just after September 11, 2001 that you only find out who has been swimming naked when the tide goes out. There's a lot of truth to that and its a recurring theme throughout history in many areas other than investing (though it may manifest itself around the search for profits more so than any other).

The credit mess (loans related to real estate but other types as well) falls into this category as well. Though my impression is that more than a few folks did understand they were being foolish - and chose to look past it for short-term gain (now, for a bit of medium-term pain too, doh!). Presumably the majority of folks were simply misinformed and did not understand what was going on...while they were also trying to honestly "get ahead" and saw an opportunity. Something essentially all Americans seek, right?

Human psychology is great at fooling all of us much of the time. Especially when things are good. But the same happens when everything is bad too.

There in lies an optimistic tone. Rarely are things as good or as bad as the popular belief at any given point in time. And there are always opportunities to make money in the market. But they are not for everyone - and that's fine.

My conclusion: Know what your place is (as in decide what it's going to be deliberately and take action that is in harmony with that decision; I'm not saying accept what someone else simply says is "your place" or whatever other clique that phrase may conjure up). And be cautious who you allow to shape your actions -- especially in areas where you are not fully informed yourself.

More specifically, unless you have a solid knowledge of the facts yourself (as well as, perhaps, aspects of human psychology and especially your own), you will be unable to combat some of the distortions and temptations you will be exposed to. If at all possible, invest the time to ramp up your understanding of history and psychology to be a better resource to yourself. If you fail to do this, be careful who you allow you shape your actions, since you are trusting that they've done their homework (yeah, that includes me).

My wife once called me cynical but I had to correct her by saying "I'm not a cynic; I'm a skeptic". It's generally my default initial position. Further, I'm an optimist too. I really don't see a discrepancy between the two.

An ironic twist I suppose is that being a skeptic makes it easier to be confident since I can trust myself more. And that (along with some other things) keeps me pretty optimistic most of the time.

All of the above has ramifications far beyond investing in the stock market - and beyond the pursuit of money - and I hope that if you've read this far that I've been successful at conveying a bit of that sentiment.


P.S. If you're further interested in the topic of human psychology as it relates to investing, google "behavioral finance" and "behavioral economics". Again, despite its (apparent) ties to finance & economics it's really all about every day human behavior and even a cursory awareness of its implications would benefit you no matter what your area of expertise or aim in life.