Tuesday, December 29, 2015

Fail: conventional investing wisdom...

Fail: conventional investing wisdom...  In an email from the Wall Street Journal (the “10-Point”), I read this with interest:
Contrary Wins the Race

It wasn’t easy to make money in most markets in 2015. The investors who did the best are the ones who defied conventional wisdom. While many star traders had a rocky year as consensus predictions persistently came up short, those who did well employed strategies including betting against already downtrodden energy stocks and taking a contrarian stance on that most golden of stocks, Apple.  
Longtime readers may remember that many moons ago I helped build electronic trading software (for three different companies), trading in stocks, bonds, and stock options for hedge funds.  I learned a lot about how those investments worked in the process; more, really, than I ever wanted to know :)  What I learned that applied to an individual investor can be summarized as follows:
  • Invest in equities (stocks) only through index funds or similarly diversified algorithmic strategies.
  • Don't listen to anyone advising you to choose particular single stocks (not even Warren Buffet, and certainly not some idiot reported in the Wall Street Journal, Fox News, or USA Today).
  • Don't touch bonds, most especially don't touch municipal bonds.  Their credit ratings are faked.
  • Find other investment vehicles, even if unconventional, so that you don't have all your investments in stocks.  For us, that's currently real estate, though I'm still looking for other attractive alternatives.
Quite a few people who have asked me for investment advice have questioned me about that second bullet.  After all, there's an entire industry built up around dispensing exactly that sort of advice, or guidance.  Why would I think it's worthless?

The reason is a direct result of my work in the electronic trading industry.  One of my bosses was very interested in what the industry calls “algorithmic trading”.  Basically that's stock picking (choosing what to buy or sell) by a computer program, and often doing so at very high speeds that a human could not do.  That boss asked me to undertake a study using publicly available (though expensive!) data.  He wanted me to figure out which human traders had the best, consistent trading record.  Then he wanted to build an algorithmic trading system that duplicated what that human trader did (assuming we could figure it out).

Well, that project never got past the first stage.  You see, when I completed the data analysis part (using 25 years of trading data, and looking only at traders with at least a 10 year record), we found zero human traders who consistently beat the Standard and Poors index.  Not one.  Nada.  Zip.  Nobody.  This was inconsistent with the widely believed lore in the business, but completely consistent with previous academic studies.

My boss didn't believe my results, so he had me do a second study: this time of “analysts”: those people who spend their entire working life trying to predict the future price of stocks.  Generally these analysts work within a small segment of the market (say, mining stocks, or auto makers); sometimes they work with only a single (large) company, like Apple or GM.  These results were even more interesting: the analysts did significantly worse than simple exponential growth models.  For instance, if we took 5 years of Apple stock prices, figured out what the annual percentage growth was, on average, and then projected that forward for the next 10 years – we got a more accurate result than any analyst.  The analysts had a significant bias to the upside – that is, their predictions were, on average, rosier by a good margin than the actual results.  You can supply your own reasons for why that might be so.  I don't actually care, myself, because the one piece of useful information in there for an individual investor is that none of these analysts were better than the simplest mathematical model one can make.  That is also completely consistent with the academic studies showing that you're best off investing in an index (or equivalent) fund...

1 comment:

  1. Many years ago, a coworker told me he was putting his money under professional management. I asked what that costs, he said they either a) charge per transaction or b) based on how much money they manage for you. Not knowing much about this stuff I asked him if you choose a, won't they be incentivized to trade a lot? even if just small numbers of shares? and if b, they take a cut regardless of whether they make you any money, and they even take a cut of the starting amount which they had nothing to do with accumulating. It seems like they make money regardless of their competence. Eventually he choose a, and sure enough it wasn't long before he would see statements with a significant number of stock trades every month, in very, very small numbers. sometimes just a couple of shares each trade and he started losing money slowly. (He didn't really have that much money to start with). If you pay a few bucks per trade, then the stocks have to make back those fees before you can even start to see profit from them. Also, the stock market is rigged against the little guy. When I learned that during an Initial Public Offering (IPO) there are prices for large investors and then the prices for everyone else. So when I bought on the IPO of UPS, there was a loss already built in for me because there were other people getting a better price. They already had a profit, at my expense. When I was trading stocks and could see "after hours trading" going on I was astonished. Or when you hear about people trading on knowledge not generally available. Or high frequency traders taking advantage of differences in speed connecting in. sigh.