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15 Little Life Hacks

Book Review on Performance Chasing and Market Timing

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I have an odd goal today. By the end of this post, I hope you’ll have a healthy distaste for financial “experts” and magazines, Wall Street’s hype, and the random people you hear pontificating about what the market will do next week. Basically, I hope you start scoffing at everyone after today.

But first, a little background. Today, I’m reviewing chapter 13 of The Bogleheads’ Guide to Investing, one of the most excellent books on investing anywhere. If you’re looking for a book to get started investing, I recommend this one–it has no hype, just sensible advice for long-term investing, based on John Bogle’s ideas (he founded the Vanguard Group).

Also, here’s an interesting twist: Each chapter is being reviewed by a different blogger, so you can get to know some of the other bloggers in the personal-finance community. Check out the full list here.

Chapter 13 is called Performance Chasing and Market Timing, so let’s get to it.

* * *

Everyone’s got an opinion, and when it comes to investments, it seems the louder someone shouts or the bigger font a magazine uses, the more attention it gets. Too bad iwillteachyoutoberich readers are too smart to get swayed by this idiotic hype. I’ve said it before and I’ll say it again: There’s a difference between being sexy and being rich.

That’s why when I’m reading some blog’s comments and I see people absolutely sure about which direction interest rates are going, or whether we’re in a bubble, or how likely P/E ratios are to stabilize to pre-2000 levels, I just ignore them (or mock them). We love to talk. But that doesn’t make us right.

So today, before we get to some actual data, I thought I’d ask when the last time you saw one of these things happen was:

  • A financial magazine proclaimed the “Ten Best Ways To Make Money This Year”
  • Your friend told you about his amazing investment and bragged about the returns
  • You saw anybody online discussing macroeconomic concepts like interest rates, etc, with a firm semse of what would happen next
  • A pundit on CNBC shared a hot stock or explained what would happen next in the near future in the stock market

If so, then you know the odd confidence that comes along with these predictions. Unfortunately, most people–experts included–are usually wrong.

Why We Can’t Time The Market
We’re really bad at predicting what’s going to happen next. The chapter goes into great detail about market timing, or trying to guess what the market will do, so I’ll just summarize some of the key points here. We’ve talked about hindsight bias, a psychological phenomenon in which things seem clearer in retrospect and we think we knew it all along. This applies to personal finance, too. As the Bogleheads authors write, they launched a contest in 2002 to predict the closing price of the Wilshire 5000 Index (it’s kind of like the S&P 500). The contest included “177 predictions [and] the forecasts of 11 major Wall Street brokerage firms. Here’s what happened:

  • 133 Bogleheads predicted a gain
  • The S&P fell from 1148 to 880–a decline of 23 percent.
  • Only three Bogleheads predicted the index would go as low as it did.
  • Only one Wall Street strategist could even guess the direction of the stock market.”

Stunning. And that was just the direction of the market. It turns out we also chase performance, meaning we buy when things are high and sell when they’re low.

  • “Over the past decade Morningstar’s five-star equity funds have earned an average 5.7 percent against a 10.3 percent return for the Wilshire 5000 (February 2, 2004).”
  • “Barksdale and Green studied 144 institutional equity portfolios between January 1, 1975 and December 31, 1989. They found that the portfolios that finished the first five years in the top quintile were the least likely to finish in the top half over the next five years.”
  • “Vanguard did a study of past performance for institutional investors. It found that of the top-20 U.S. equity funds during the 10-year period through 1993, only one stayed in the top 100 in the subsequent 10-year period.”
  • And in one of the most damning findings, “Of the 50 top-performing funds in 2000, not a single one appeared on the top-50 list in either 1999 or 1998.”

Unfortunately, we often use heuristics to make our own decisions about which funds to invest in, decisions which are usually biased. Take the Janus “Ratings & Rankings page,” which lists impressive rankings for their many funds. Wow! I better invest right now!

Not so fast. There’s a little thing called survivorship bias, which is “the tendency for failed companies to be excluded for performance studies due to the fact that they no longer exist.” This can profoundly affect the performance rates you read about in financial magazines. An analogy helped me understand when I first learned about survivorship bias, and fortunately someone named Patri Friedman has written about it (using examples of poker and mutual funds). “There is a particularly clever scam,” he writes:

Get a list of email addresses of people interested in sports betting. Say you have 32,000. Email 16,000 of them to say that the home team will win this week’s big team, and 16,000 to say the home team will lose. Now, half of the people will have gotten the correct prediction, and the next week, you do the same thing with them. After 5 weeks, you’ll have 1,000 email addresses of people who have seen you pick the winner five times in a row!. Now you pitch your 1-900 number or paid email list subscription to this amazed group.

Are The Financial Experts Right?
This part of the chapter was my favorite. It shows just how much faith we put in financial “experts” who actually aren’t very good at predicting the future (it’s really hard), are subject to hugely distorting cognitive biases, and are rarely held accountable for their calls. Some examples from the book:

  • “Mark Hulbert…did a study of newsletter portfolios. His statistics are startling. For example, Mr. Hylbert constructed a hypothetical portfolio made up of each year’s top-performing newsletter portfolio from 1981 through 2003. Over the last 12 months following their top showing, these former winners produced an annualized loss of 32.2 percent. Compare this dismal second-year performance to the Wilshire 5000 total stock market index, which, during the same second-year period, had an annualized gain of 13.1 percent.”
  • The Granville Market Letter produced an amazing return of 245 percent in 1991.” (With those kind of returns, wouldn’t you be tempted to invest? Honestly, I would.) Unfortunately, in 1992, the same newsletter dropped 84%. The result isn’t just a total 161% gain (245 – 84 percent). Instead, “the actual two-year loss is 61%…The Granville Market Letter suffered an average annualized loss from June 30, 1980 through December 31, 2004 of minus 21.5 percent. Compare that with the Wilshire 5000 Index gain of 13.0 percent during the same period.” Two key lessons for me: First, think long-term; results from a given year should hold very little weight in your decision-making process. Second, past performance really doesn’t guarantee future results.

Further Thoughts
This chapter isn’t perfect. I know of many more persuasive stories on market timing that could have gone into the book, but the authors didn’t include it. Also, even though the book was published in 2006, it’s impossible to keep up with the current news online. That’s why stories like this one, about code-breaking contest in which a group of three women who beat engineering and cryptanalysis experts from places like the NSA, couldn’t make it. If it were up to me, I would have included a recent New Yorker article on experts (one of the best I’ve ever read), and another from researcher Susan Blackmore. These disparate articles help to poke holes in our theories about experts and point out, quite convincingly, that just because someone’s an expert doesn’t mean he’s right. In fact, it’s often quite the contrary.

Still, I love this chapter and I love this book. You won’t find a size 81-font headline screaming at you about THIS YEAR’S BIGGEST OPPORTUNITIES!!! You won’t find some sexy angle on investing. You will find a sensible way to invest–one that, unfortunately, won’t seem very extraordinary to your friends. But frankly, once I’m educated about risks, investing, and the research, I don’t give a damn what other people think when I’m working towards my financial goals. By the way, the chapter had a lot of points about people not being very smart predicting what’s next.

That’s partially true and partially not. We’re not very good at predicting short-term results, which I’ve always said. But we can set up diversified systems (like index funds in different sectors, for example) that mitigate our lack of predictive power and actually work to get us superior returns. Even after you read this chapter, you’ll see that it’s not all doom and gloom about investing. There are ways to make significant amounts of money. They just don’t involve chasing the best-performing fund or investing in the stock du jour. With this book (and a few other good ones), you can use actual, real data to see what results in the best return. Instead of just being a blowhard who talks loudly about globalization this, and real-estate bubble that, you can look for trends that help you understand what’s going on–and, yes, what to do next.

Special note: JLP from AllFinancialMatters was happy enough to coordinate the publishers sending me a review copy of this book, which I’m giving away to a random commenter on this post. (I already had a copy before they sent this to me.)

What now?

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48 Comments on "Book Review on Performance Chasing and Market Timing"

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JLP at AllFinancialMatters
9 years 10 months ago

Most excellent! Thanks for agreeing to review a chapter. I know things must be REALLY busy for you right now.

Take care,

JLP

Ranjan
9 years 10 months ago

Excellent review. The info on Friedman’s scam was revealing and insightful. Keep it up.

Jonathan
9 years 10 months ago

I saw this book the other day at the store and I started flipping through it. It seemed very good, and now I see everyone talking about it. I may pick it up soon.

I also came across a book called Yes, You Can Time the Market! by Ben Stein. This odded (new word) me a little because I always thought of Ben Stein as a really smart guy. He even gives advice to not do market timing in other books, so it’s like he’s contradicting himself. Oh well – I guess everyone goofs up sometimes.

Peter
Peter
9 years 10 months ago

In a sense, you’d expect people willing enough to defer gratification that they invest in stocks in the first place would have some immunity to these get-rich-quick schemes. It’s telling that even within the subset of people with that amount of foresight and patience, these schemes continue to prosper.

Transcendental Success
9 years 10 months ago

Timing and picking stocks is 100% gambling; like poker against millions of other people. Chances are good you’ll lose.

Analysis of performance supports this all the time — 99% of the pros suck, and then we check back later we find that the last % sucks too. DO NOT PICK STOCKS UNLESS YOU SPECIFICALLY WANT TO PIT YOUR MONEY AGAINST SOMEONE ELSE IN A GAME OF SKILL.

Michael Sobczyk
Michael Sobczyk
9 years 10 months ago

I see the point, however people as a group tend to behave rather rationally in terms of investing – check out the book “The wisdom of crowds”.

Derek
Derek
9 years 10 months ago

Have you read any other chapters in the book? What’s your take on the other chapters? Anything in partiular that stuck out as extremely excellent in your mind?

Rian Trost
Rian Trost
9 years 10 months ago

Thanks again for helping me pull my head out of my ass once again.

…I’m really not sure how the hell it keeps finding itself up in there.

John
John
9 years 10 months ago
Ah, yes, I have read this book and it is a good one. A couple other books that tie in real well are the “Guide” books by Larry Swedroe (a Boglehead)–one on indexing and one on bonds. The indexing book was the first investment book I ever read and probably still my favorite. And I saw your post about bonds not being for young people (BTW-dumbest thing I’ve heard a smart person say in a long time), but it’s still a good book. The only possible caveat I can think of is if you don’t have enough money to ladder… Read more »
NLG
9 years 10 months ago

Good review Ramit, very detailed!

I wish I had more time to read all this good information, maybe I need to get rid of this day job…

NG

Duane Gran
9 years 10 months ago
By the end of this post, I hope you’ll have a healthy distaste for financial “experts” and magazines, Wall Street’s hype, and the random people you hear pontificating about what the market will do next week. Basically, I hope you start scoffing at everyone after today. Mission accomplished, but in all fairness to the twenty something crowd (for whom you write to) it needs to be said when and why you work with financial advisors. Popular as it is to claim that advisors deflate performance through fees and don’t know anymore than you do, there are exceptions. You owe it… Read more »
Kay
9 years 10 months ago

Fabulous review (and more). In your analysis of “experts” I kept hearing that old saw about how it’s time to get out of the market when the crowds are rushing in. Research, goal-setting, patience and persistence offer better payouts.

Jim English
9 years 10 months ago

As a fervent follower of the Vanguard school of thought, I can’t wait to check this book out — or see if I can win it =)

As an aside, I’d like to inquire about anyone’s thoughts on “balanced” funds — those that automatically rebalance themselves as time wears on. It seems like a win-win to me…am i missing anything?

Schizohedron
9 years 10 months ago

Something is very wrong in my employer’s 401(k) fund lineup when it includes seven Fidelity sector funds — loaded with fees for buying, selling, and timing — and only TWO index funds. Bogle is right. Those exchange and administration fees are better vested in my pocket, not some cokehead active-manager-type’s midlife crisismobile. Thanks for routing me to the book!

Ben Casnocha
9 years 10 months ago

Gimme gimme

John
John
9 years 10 months ago
For Jim in comment 12: I’m also a big fan of Vanguard and indexing. I enjoy spending some of my free time on the Boglehead chatroom at Morningstar.com. I’m still not fully convinced of the Efficient Market Hypothesis (EMH) that goes hand-in-hand with indexing because you can see how other factors–psychological or whatever–influence stock pricing. However, I don’t have the time or energy to try to benefit from it–without any guarantee that I will–so I mostly index. Not to mention that EMH did win a Nobel prize. Anyway, to the point: FWIW, I think balanced funds have both advantages and… Read more »
bzer
bzer
9 years 10 months ago
This post brings up some good points about investing. Timing the market is very tempting to try but will rarely pay off, if ever (one of the reasons I chose Sharebuilder). As for individual investing in stocks, I feel that very few people truly want to and have the time to research the stocks they choose. It’s most dangerous shortly after reading a quick blurb about what all of the stats on Yahoo Finance mean and it all ‘makes sense.’ As for balanced funds, if you’re talking about the Vanguard Target Retirement Funds then I’d say you’re right – they… Read more »
Tim
Tim
9 years 10 months ago

Very interesting – as always. I’ve been hearing a lot about that book and will get to reading it some day.

That sports betting scam is kind of like continually making predictions until one of them eventually comes true. If you can hide your other predictions, then you look really knowledgable.

Carlin
Carlin
9 years 10 months ago

The thing to watch out for on balanced funds is the layering of fees. If the balanced fund invests in other funds, you end up paying the balanced funds fees PLUS the fees of the funds it invests in. Also be careful of how often the fund rebalances, because that could generate reduce your returns because of trading fees incurred by the fund.

Anonymous
Anonymous
9 years 10 months ago
Duane in comment #10, I disagree with your last paragraph. Going with an actively managed mutual fund vs. picking stocks yourself is probably an easy choice to make for most, but when comparing passively managed index funds vs. actively managed funds there are no advantages to active funds because you’re paying more for smaller returns. There really are no downsides to index funds, and it’s more a question of tax advantages with different types of ETFs, than anything else. On the topic of balanced funds, John in #15 has already said it (and some others), but repetition is good. There… Read more »
David
9 years 10 months ago

Good review. Definitely makes me want to go get this.

Did you choose the chapter to review? (Just wondering whether you picked a chapter that you particularly liked, which might obviously influence your enthusiasm)

Ramit Sethi
9 years 10 months ago

David, yeah, I chose this specific one to review (it seemed like the most fun for what I wanted to write about).

Mr P
9 years 10 months ago

Great review of the chapter Ramit! Ive followed your blog a lot but am posting after a long time.

For comments about balanced funds. Dont get into the trap of thinking they have expense ratios less and 0.10%. They fact is that they invest in various funds and the total expense ends up being close to ~1.1%. Check morningstar.com with the fund ticker for the correct expense ratio and other info. Also my personal suggestion is to ignore the star rating.

Tark
Tark
9 years 10 months ago

Interesting chapter – I can’t wait to read the book.

Duane Gran
9 years 10 months ago

I should have clarified my lack of enthusiasm for index funds. Probably the best explanation comes by way of Dan Melson’s excellent site:

http://www.searchlightcrusade.net/posts/1147577266.shtml

This isn’t to say that you shouldn’t buy indexed funds, but once you have a sizable portfolio you can afford to avail yourself of professionals if you wish.

Vernon
9 years 10 months ago
Great review. But I ask what is said in this book that is actually new? I assume that ultimately the book recommends we invest in low-cost index funds on a reguar basis. Getting rich is as simple as spending less than you make and putting your money into index funds. I’m amazed that there are so many books, articles, etc. that are written based on what I’ve summed up in one sentence. You can put the steps to being rich on a flyer and hand it out for free. But then again, where’s the money in that?
John
John
9 years 10 months ago
I completely agree with Mr P’s suggestion to ignore the star rating. So many people take these things as the Almighty Word. The first financial advisor I ever went to see tried to convince me that I should invest in some front-end load funds that he was pushing because they had 4- or 5-star ratings. Fortunately, I wised up to what was going on before I handed over any of my money. Star Ratings are particularly useful if you happen to own a time travel machine because they strictly report what has happened in the past. Otherwise, they’re not nearly… Read more »
Rugby
Rugby
9 years 10 months ago

Great chapter review. So far the most thorough review of the 13 chapters reviewed so far! 🙂 Thanks.

Very interesting info on the Patri Friedman scam. As well as the Janus Hype. I own some Janus funds already.

Anand
9 years 10 months ago
I’ve been researching this topic for a while, and what I’ve discovered is more or less well reflected in Ramit’s review. However, one aspect of investing that I’ve been interested in over the last year has been quantitative methodologies – where ‘expert’ opinion and ‘stock picking/timing’ do not play a role in the selection of stocks – however models are used to determine suitable porfolio’s. (fixed mathematical variables) Three examples where emotion, ‘expertness’ and variability do not seemingly come into play would be http://www.validea.com, http://www.valuengine.com and the Zacks rank http://www.zacks.com. Due to the mathematical nature of the investing, many have… Read more »
Jonathan
9 years 10 months ago

To John in post 8, or anyone else who wants to answer:

What do you mean a prudent investor can do well similarily with bonds? Is there a way to invest in bonds that earn the same rate as a stock index fund, such as the Vanguard 500?

Kimber
9 years 10 months ago

Oh, I’m great at timing the market. After I do my research, decide upon a stock, and buy, the stock usually goes down. Every single friggin’ time. Can never catch the bottom.

But over the longer run, it goes up and I mostly invest for income.

MyNameIsMatt
MyNameIsMatt
9 years 10 months ago
I was the Anonymous poster in #19 by accident. Anand #28, quantiative methologies are expert opinion and market timing disguised as unbiased and infallable math, and many of them are formulas that include variables for human emotion and irrationality. It’s trying to take the expert out of being an expert by quantifying what an expert does. The mathematical nature of investing, or at least the kind used with technical analysis, is a false sense of security. The kind of math that you should be worried about is the kind that tells you that experts are wrong 90+% of the time… Read more »
ccoutlee
ccoutlee
9 years 10 months ago
Compliments on the blog, and great links in this post, especially Dr. Blackmore’s article. I’ve been struggling with the index fund vs. managed fund issue recently myself, hearing convincing arguments coming from both camps. It’s tough, since at my post undergrad age, a small difference in performance (a few percent, say) compounded over the next 40 years would make a big difference in my ending portfolio. This tends to magnifying the importance of making intelligent decisions to start with and maintaining effective strategies throughout my investing lifetime. It makes for some decent pressure to “get it right.” My default perspective… Read more »
Jonathan
9 years 10 months ago

The problem I have with market timing strategies is this: if it works now, it won’t work for long. Once everyone finds out that it works, and everybody starts doing it, then it will no longer work.

It’s the same with index funds. If everyone started investing in index funds tomorrow, and stopped going into debt, our economy would go WAAAAH.

MyNameIsMatt
MyNameIsMatt
9 years 10 months ago
ccoutlee #32. I understand where you’re coming from with the EFT, and not exactly trusting it. You’re right that there are some managers who can beat the market. There are a bunch that do every year. The problem is that very few can do that for more than three years, and usually end up at the bottom of the pile where they’re losing money after that time. And yes, there might be a few that can beat the market long term, however, your strategy then becomes that of picking that person. And lets be honest, looking at the stats, the… Read more »
jonas
jonas
9 years 10 months ago

http://www.ifa.com contains an enormous amount of information, tools, and historical data supporting investment in index funds.

Check it out and save the $20 you would have otherwise spent on a book. In fact, the content of the site has been packaged as a book and sells for $20 on amazon .

John
John
9 years 10 months ago
To Jonathan in 29: Let me ask you this. Can you tell me what the Vanguard 500 Index Fund (which I happen to own, so I obviously like it) is going to return over, let’s say, the next 20 years? Of course not; none of us can answer that. But I ask it to prove a point: We don’t know exactly what is going to happen in the future. All we can do is statistically analyze the data we have to make a prediction of the expected annualized return in the future and the standard deviation around that return (aka… Read more »
Alex
Alex
9 years 10 months ago

Cool review – i’ll probably buy the book.

Even cooler that you had bought the book before you got the free one.

J
J
9 years 10 months ago

Hmmmm, this sort of goes with an article I read comparing Phil Fisher to Ben Graham yesterday. Supposedly, Fisher had a good track record with picking growth companies, but he never held more than 30 at a time, he knew the industries inside and out and his strategy was to buy and hold and hold and hold and hold. He also avoided hype.

Cat
9 years 10 months ago

This seems like a very instructive book, from the reviews I’ve read on different blogs. I look forward to reading it. My husband and I have also been reading “The Warren Buffet Way,” and it also has great investing advice.

Jonathan
9 years 10 months ago

To John in 36:

Okay, I see what you mean now. Yes, I agree that having some bonds in your overall portfolio is a good idea.

loi tran
9 years 10 months ago

My portfolio currently has 25% invested in fixed income. Fixed income CEFs are good investments that few people use.

Hermann Klinke
Hermann Klinke
9 years 10 months ago

Hi Ramit, I recently read “How I made 2 Million in the stock market” by Nicolas Darvas who made that much money in only 18 months in the 1950. This book is fabolous and you can read it for free at http://www.nicolasdarvas.org/.

There is so much to learn about investing in stock by reading this book. You’ve got to read to it! After investing some time Darvas concluded that trading like Wall Street is like gambling. Darvas also wrote another book called “Wall Street: The other Las Vegas”.

FIREFinance
9 years 10 months ago

Great Review. Thanks a lot.
Cheers,
FIREFinance

GaryP
9 years 10 months ago

I have considered buying this book and after this review and the others it has moved to the top of my ‘buy’ list.

Thanks.

Jonathan
9 years 9 months ago
I’ve been thinking a lot about market timing lately myself. I’m a young guy (22) so an extra 1-2% annually over 40 years would make a big difference. But after all is said and done, I think I’ll stick with the “average” indexing. And I’ll tell you why. I study money in my spare time, as a hobby. I’ve read around 20 or 30 personal finance and investing books. I’m not a full time active fund manager, responsible for A LOT of money. It makes sense that these fund managers will spend a lot more time researching than I have.… Read more »
Catch a Gideon
9 years 8 months ago

Excellent post. Many of the Bogleheads posts just give a brief description of what the chapter was about. Good job!

I also covered Bogleheads and Market Timing

N N
N N
7 years 2 months ago

While I agree that most mutual funds are a scam, keep in mind that John Bogle is trying to sell something as well. His Vanguard Mutual Funds.

There are many opportunities to make money, and fairly consistently, with lower risk then the overall market. Volatility trading, arbitrage, mirco/small cap investing, high-frequency trading, etc. etc.

So keep open to investment ideas, try to differentiate between leveraged beta & alpha. If you can’t do it, find someone who can or diversify across non-correlated assets for long term investing.

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