What Makes Us Bad Investors?

Morgan HouselThe Motley Fool

Clinton State of the Union, 2000

“We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.

We have built a new economy. And our economic revolution has been matched by a revival of the American spirit: crime down by 20%, to its lowest level in 25 years; teen births down seven years in a row; adoptions up by 30%; welfare rolls cut in half to their lowest levels in 30 years.

My fellow Americans, the state of our union is the strongest it has ever been.”

[Soon after, markets collapsed and the economy suffered its worst decade in 80 years]

Obama State of the Union, 2010“One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard.

And for those who'd already known poverty, life has become that much harder. This recession has also compounded the burdens that America's families have been dealing with for decades -- the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.”

[Soon after, stocks surged.]

What Makes the Market Tick?P/

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Variance of 10-year real stock returns explained by various metrics, since 1928

What Makes Stocks Tick?

• 3,000 stocks from 1983-2011

• 39% of stocks were unprofitable

• 19% of stocks lost at least 75%

• 64% of stocks underperformed the index.

• 25% of stocks were responsible for all the market’s gains. Source: LongBoard Asset Management

We’re Not Very Good at What We Do …

• In 2011, 84% of actively managed U.S. stock funds underperformed their benchmark. –S&P

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Median S&P 500 stock earned more than the benchmark. Majority of managers concentrated in the minority of losing stocks.

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Source: S&P Capital IQ

And It’s Nothing New …

• Vanguard Group: “The percentage of funds that underperformed the market was 62% for the 10-year period, 67% for the 15-year period, and 72% for the 20-year period.”

• "The 50 stocks in the S&P 500 with the lowest analyst ratings at the end of 2011 posted an average return of 23 percent [in 2012], outperforming the index by 7 percentage points." – Bloomberg.

Worst, we are oblivious.

• Franklin Templeton asked 1,000 investors if the S&P 500 went up or down last year.

• 2009: Stocks rose 26.5%. 66% of investors thought market declined.

• 2010: Stocks rose 15.1%. 48% of investors thought market declined.

• 2011: Stocks rose 2%. 53% of investors thought market declined.

Not as good as you think …• Markus Glaser and Martin Weber, University of Mannheim.

• Surveyed investors, then checked brokerage statements.

• Lake Wobegon: Most considered themselves above average.

• On average, investors overestimated their annual returns by 11.6% each year.

• Those with lower actual returns were the worst at judging their returns.

• “The correlation between self ratings and actual performance is not distinguishable from zero.”

So, what happened?

• Standard response is that we’ve been through an unprecedented period, or the market has changed, or Wall Street has cheated you, or some other level of blame.

• Reality is that very little has changed. Markets have been working like this for centuries.

S&P 500 has been one of the greatest generators of wealth ever known

• $1 invested in 1900 was worth $1,016 by 2013 (annual return of 6.3%).

• $1 in Treasuries was worth $6.36

• $1 in gold worth $1.92.

• $1 in cash worth $0.07.

Source: S&P Capital IQ

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S&P 500 total real return distribution1871-2011

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Buy high, sell low!

• 2007: $85 billion put into stock mutual funds.

• 2008-2009: $230 billion pulled out of stock funds.

• 2013: $68 billion put into stock mutual funds.

Source: ICI

The Three Terrors of Investing

• Trying to predict things.

• Not having enough time.

• Cognitive biases.

“It is difficult to make predictions, especially about the future." -- Yogi Berra

Economist Alfred Cowles dug through forecasts of William Hamilton, a popular analyst who "had gained a reputation for successful forecasting" made in The Wall Street Journal in the early 1900s.

Among 90 predictions made over a 30-year period, exactly 45 were right and 45 were wrong.

Examples are everywhere

• 2003-2007, Standard & Poor’s predicted 0.12% of a certain type of mortgage bond would default.

• In reality, 28% did. • In 2008, Gazprom CEO predicted oil would soon hit $250

a barrel. • It soon hit $33 a barrel. • In 2008, analysts predict the S&P 500 will earn $94. • It earned $15. • In 2010, analysts predict the S&P 500 will earn $53.• It earned $83.

“Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future.”

Source: Dresdner Kleinwort

It takes skill to be this bad …

• Ron Alquist and Lutz Kilian, 2007.

• Looked at analyst projections of future oil prices, futures prices, econometric models, company projections.

• Best predictor of future oil prices is to assume it will be whatever today’s price is.

• Does it work? Not even close. But it’s better than most forecasts.

Philip Tetlock

• Studied 27,450 predictions.

• Grand conclusion: Statistically, most expert predictions are the equivalent of random guesses.

• Most famous = least accurate.

• Least accurate = most confident.

• “Some experts are so out of touch with reality, they're borderline delusional.” Yet we don’t mind it.

No accountabilityFront page of a Wall Street Journal article, December 2008:

“Igor Panarin posits, in brief, that mass immigration, economic decline, and moral degradation will trigger a civil war next fall and the collapse of the dollar. Around the end of June 2010, or early July, he says, the U.S. will break into six pieces -- with Alaska reverting to Russian control ...

California will form the nucleus of what he calls ‘The Californian Republic,’ and will be part of China or under Chinese influence. Texas will be the heart of ‘The Texas Republic,’ a cluster of states that will go to Mexico or fall under Mexican influence. Washington, D.C., and New York will be part of an ‘Atlantic America’ that may join the European Union.”

Philip Tetlock:

“We need to believe we live in a predictable, controllable world, so we turn to authoritative-sounding people who promise to satisfy that need.”

But we live in an unpredictable world. Predictions give us a false sense of security that causes us to take dumb risks.

Three steps to avoiding predictions-- Carl Richards

• If I make this change and I am right, what impact will it have on my life?

• What impact will it have if I'm wrong?

• Have I been wrong before?

Time is Everything

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Minimum and maximum total real returns by holding period1871-2012

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Source: Robert Shiller.

“Timing the market is a fool’s game, whereas time in the market will be your greatest natural advantage." -- Nick Murray.

Henry Blodget:

“If you talk to a lot of investment managers, the practical reality is they're thinking about the next week, possibly the next month or quarter. There isn't a time horizon; it's how are you doing now, relative to your competitors. You really only have ninety days to be right, and if you're wrong within ninety days, your clients begin to fire you.”

The single most important question an investor ever needs to ask is ….

How long am I investing for?

Mental misadventures …

• Cognitive biases that lead us astray when we have the best of intentions.

• They are most pronounced at the worst times.

• The are very hard to overcome. • They are almost entirely what separate

good investors from the rest. --Pabrai

Confirmation bias• Starting with an answer, then searching for evidence to back it up.

• Munger: “The human mind is a lot like the human egg, in that the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in.”

• There are thousands of blogs, reports, news sites. Whatever you’re looking for, you can find it.

• Charles Darwin regularly tried to disprove his own theories, and was especially skeptical of his own ideas that seemed most compelling. The same logic should apply to investment ideas.

Recency bias

• Assuming the future will resemble the recent past.

• Flip a coin ten times. Last three flips have almost all control over your pattern-forming neurons.

• Causes you to fight yesterday’s war while missing that the world is always changing.

• Why do people buy at the top and sell at the bottom? Because they extrapolate the most recent experience into the future.

Skill bias

• When education and training causes confidence to increase faster than ability.

• Lauren Willis of Loyola Law School: “There is no reliable empirical evidence that financial-literacy programs are effective."

• In investing, humility is worth its weight in gold.

Skill bias

Long Term Capital Management. "The young geniuses from academe felt they could do no wrong.”

Warren Buffett on the firm's sixteen-person management team:

“They probably have as high an average IQ as any sixteen people

working together in one business in the country ... just an

incredible amount of intellect in that group....And essentially they

went broke. That to me is absolutely fascinating.”

Hindsight biasThinking past events were obvious.

Out of literally millions, only a handful of investors truly saw the financial crisis coming.

If you disagree with that statement and respond, "No, any idiot could have seen it coming from a mile away," you're suffering from hindsight bias.

Only after the fact do all the puzzle pieces make sense. That's why bankruptcies outnumber billionaires.

Risk perception bias

• Attempting to eliminate one risk, but exposing yourself to a more harmful risk.

• German professor Gerd Gigerenzer estimates that the increase in automobile travel in the year after 9/11 resulted in 1,595 more traffic fatalities than would have otherwise occurred. Add in the impact stress had on our health, and the reaction to 9/11 may have been more deadly than the attack itself.

• "People jump from the frying pan into the fire."

What you can do to avoid biases. • Avoid most financial news. Almost none of it is good.

• Talk to others about investments as much as possible. Especially those who disagree with you. Read financial news you know you’re going to disagree with.

• Sleep on every investment idea for one week.

• Use a checklist.

It’s up to you.

“People do not get what they want or what they expect from the markets; they get what they deserve.” – Bill Bonner