Spot the mistakes in this post

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There are a lot of idiots on forums.

Listen, it’s not a problem if you’re not the sharpest tool in the shed. I know I’m not.

But I DO have a problem when you (1) don’t know what you’re talking about and (2) condescendingly tell everyone else they are dumb…WHEN YOU ARE THE DUMB ONE.

The worst is when you see someone doing this with investing, a complicated topic with seemingly contradictory findings where it’s easy to bamboozle ordinary people with fancy phrases and hand-wavy findings. Soon enough, you have a tribe of people following your decrees.

A few days ago, I was reading a forum filled with a bunch of people who think they’re smarter than they really are. Because they’re good at one thing (programming), they tend to believe they’re smart at everything else. Medical research? Ha! Peer-reviewed papers on psychology? I’ll tell YOU how humans behave, old crotchety researchers.

But when one of them posted these comments (below), I had to show them to you.

Here’s the thread. Who can spot the mistakes?

Just for fun, I bolded some of the most….“interesting” comments.

[ORIGINAL QUESTION IS INNOCENTLY ASKED BY SOMEONE]

“Dumb question, as I literally know nothing about stock or savings: isn’t it generally a bad idea to put 100% of your long term money in any one place?”

[NOW, THE RESPONSES BEGIN]

“Isn’t it stupid to just to have one job, one car, be a citizen of one country, have one house and one family. I mean really – one must diversify. What would you do if you lost any one of those?

No, it’s not stupid to concentrate wealth. Problems only arise when you do it stupidly, like buying too big a house, being part of the wrong family, living in the wrong country or buying an unsafe car.

Diversification does not reduce risk but it cuts your returns in half. All correlations go to one in a crisis and you can’t hedge the end of the world.

Note: To all downvoters – putting all your eggs in multiple baskets does not protect you from an asteroid impact any more than a person with all eggs in one basket.

People who think diversification makes them safe are frankly wrong.”

[I STOPPED CHOKING LONG ENOUGH TO CONTINUE READING ON. HE CONTINUED...]

“If you want to diversify you need to actually buy reverse correlated assets. So go ahead – hedge with options, hedge with futures, hedge with shorting the indices.

But don’t think buying disparate companies protects you – it doesn’t.

I fully understand the arguments for diversification. Just like I fully understand CAPM, modern portfolio theory and the assumption that var=risk.

But it’s all bullshit. Why are you investing in companies that have that risk? If you understand which companies return higher returns – why aren’t you all in on them?

It’s bloody hard to find good companies and when you do – why on earth would you diversify into their worse off counterparts? You need to have heavy concentration in great companies where you are perfectly fine having a 10 year hold on at the right price.”

[I CANNOT STOP READING NOW]

Risk and return are not correlated. There are risks and there are returns. See AAA bonds during GFC. Great businesses are great companies at reasonable prices not overvalued growth stocks.

Most of modern economic and finance theory is based on fundamentally broken models of risk and return.

[MORE]

Diversification doesn’t work. It not only leaves your risk essentially the same in case of catastrophic market failure (see GFC/debt crisis – bonds are safe RIGHT?).

It also cuts your returns in half and brings you down along with everyone else – and gives you a false sense of security – nothing is safe – not even shorting the world (end of the world/counter party/regulatory risks).

As an investor you must think long and hard about the future/companies/investments make very few super high signal, super high impact trades/positions/companies that you know inside and out (financials/GDP winds etc).

I’d rather invest in 20 companies I know inside and out than 500 mediocre ones that I know nothing about. But that’s me – most people don’t know anything and they SHOULD diversify.

If you don’t know anything – the best thing you could do is assume no better than random.”

[FINALLY, HE SAYS...]

“Local failure is obviously much more common than catastrophic failure (although the latter does have a much greater impact).

I like to think of it in terms of car crashes and catastrophes.

Companies are represented by cars – I pick good cars, with good people driving them, surrounded by a safe environment and hope they don’t crash – it’s how risk works.

Hurricanes destroy everyone – no matter how good the driver is – no exceptions.

The whole point of investing is to make above and beyond the S&P 500 benchmark over the long term – and that requires taking concentrated risks where one must bet on the right drivers with the right cars in awesome environments (most critical) and watching the horizon warily for distant hurricanes (debt crisis/nuclear war/WWIII/currency devaluations/governmental collapse).

I really can’t do any more than that. It’s a trade off obviously.

I understand local failures quite well – I rely on my ability to make decisions to mitigate that risk and the fact that I’m still young (older people should not do this).”

Ok, by the time you read this, I may have sat in my garage and gassed myself to death while eating $14 of Taco Bell. It would be a sweet death.

But assuming I’m still here, can you spot the mistakes? Don’t just mention what he said that’s ludicrous. Also analyze the techniques he used to convey his message (one hint: He constantly references a highly unlikely galactic meltdown to make his point).

Leave your comments below. This should be good.

Also, if I ever catch one of you using what you learned on this site to intimidate other people like this, I will kill you myself.

Want help sorting through what’s real (and not) — along with systems and strategies to automate your savings, invest easily, and live a rich life?

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36 Comments

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  1. This writer uses scare tactics rather than a well-reasoned theory to argue his point. The equivalent to a hurricane or nuclear war would be the stock market completely crashing, which, ironically, makes his theory of investing in great companies also a bad idea (you would lose everything with his investment strategy as well).

    “I understand local failures quite well – I rely on my ability to make decisions to mitigate that risk and the fact that I’m still young”: even very smart people that invest full-time don’t often beat the market. Even if this individual is smart enough to beat the market (very unlikely), it certainly doesn’t help the person asking this question… who would not know how to beat the market if they are asking a question like this.

    “Diversification doesn’t work.” A lot of data suggests that’s wrong (I don’t want to gather the data and point to it, but a search would indicate the opposite of this statement).

    “It also cuts your returns in half.” If you invest in perfect companies that outperforms the market, yes, it will lower the profit you make. But a major point of diversification is to lower risk. When the companies lose money, you will lose less.

    “As an investor you must think long and hard about the future/companies/investments make very few super high signal, super high impact trades/positions/companies that you know inside and out (financials/GDP winds etc).” If you knew 20 tech companies inside and out right before the DOT-com bubble burst and you only invested in this companies, you would have lost a lot… even though you knew a lot about those companies.

  2. Buffett said diversification is a hedge against ignorance. To that I would add that it’s a hedge against things you can’t control. I don’t know about rest of your audience, but I am nearly completely ignorant about what moves the market and the things that I think I know are completely out of my control. Maybe this guy knows something I don’t or he has his hand on a lever I can’t reach (though I doubt it) – I can’t say whether his advice is appropriate for him, but it’s certainly no good for me.

    He says that diversification is no protection from a general disaster, which is true – but it seems to be at least as true for specialization, unless you know the nature of the coming disaster and have picked your assets based on some unique ability to withstand it.

    I’ve read several times – one of them probably from you – that in the long term stock pickers can’t do better than random. If that’s true, why should I expect my “ability to make decisions” to protect me?

    But the bottom line is that I don’t have the time or the inclination to “get to know 20 good companies inside and out,” especially since that would likely require achieving intimate knowledge of many more companies to establish what “good” even means.

  3. His introduction makes NO sense. How is owning one house relevant to choosing not to diversify your investments? Most people can’t AFFORD a second house, and the ones that can, typically do own more than one! You can compare diversification to owning different credit cards, but then it does make sense to have more than one, since that reduces your risk of not being able to pay for something (eg. you’d want a visa, mc, amex so that if one type is not accepted you have a back up).

  4. Viktoriya, I agree with you. The two aren’t even worthy of comparison. This is why I get so scared when people take all of their information from the Internet and think they now know a subject well. Does the person realize he knows nothing about this? I am guessing not, but he will defend his “knowledge” with all his might. Yikes.

  5. The only thing I had a problem with is the blanket statement that most programmers are egotistical know-it-alls. There are people in other professions which you could say the same. Please do not let this one idiot or group of people in this forum represent the rest of the people who program for a living like myself. I agree. I hate it when people sensationalize things to scare people.

  6. The first and biggest mistake is “Diversifying cuts your profits in half.” That in itself is a completely idiotic statement. Diversification, by itself, does absolutely nothing. The profit always depends on what you invest in. And if you diversified into German DAX companies, UK and German bonds and American Housing CDOs, you are still REALLY well off today. If you put it into American Housing CDOs only, BOOM, and it’s gone.

    The statement implies that he does not know what the fuck he is talking about. He even says “I would rather invest in 20 companies I know” which is DIVERSIFICATION YOU *”§”§*”. He just diversifies around his knowledge.

    One of the main problems is that as has been said before, fund managers that can BEAT the market long term through their choices are black swans. A lot of managers get their quality year where they come in with their personal 15-20% and rock the world. However, there are only three to four managers right now that can do it consistently. Any single one of them does not even make the headlines, since they seclude their methods so much. They are black swans and their methods will likely be temporary and outdone by a super computer soon.

    So in that regard, investing in the market, when it is down, diversifying as far as you can (Index Funds for example) with a MAJORITY of your assets, and saving when the market is up, is the most stable strategy I know of. If you want to be smart here, you can also take countries for index funds. US, Japan, China, Russia, Germany, UK, France. You can choose those who are lying on the ground. The market will likely always pick up again. You can play with 10-20% of the money.

    The only way to make quick money in this market is daytrading. And this is a fulltime job. And a very risky one with total failure possibility.

    And another thing: We do not need to diversify against a meteorite. We need to diversify against investors who make an economic hit. And against singular catastrophes like GM, Fanny Mae and Freddy Mac. So that is a strawman argument. He has a lot of classic logical fallacies there, but I am too lazy to point them out. His post was not good enough to make me go that far. He just does not deserve this kind of specific attention…

  7. This one made my day! He has emotionally attached to that idea and thinks that by writing with a lot of jargon, he can convince the world.

    There are 54362 (or so) logical fallacies here, but i’ll address just 2:

    - The guy advocates HUGELY diversifying already (20 companies)
    - Diversification does NOT cut returns. He has no idea about statistics. Diversifying decreases variance (then RSD or st.dev.) so that when you diversify you will have less outliars less years (or months) with huge gains or losses. The predicted average is the same.

    Diversification is a great psychological tool that convinces us to stay in the markets when things go wrong for some time.

    • Hi Mert,

      I super like your first fallacies and totally agree with it.

      He has already contradicted himself by telling the world to diversify in 20 companies “that he knows inside out”.

      How can 20 companies be the same in their business cycles and models.

      I really wonder what’s the purpose of this joker telling people not to diversify.

      Weird man.

  8. This guy can’t be real? Can he?
    In all seriousness, someone really can’t be that deluded after having lived through TWO massive bubbles (housing/banks and the dot-com).

    If it is real, then one of the biggest problems with his plan, and lets assume it actually works without any problems for a second, is that the time taken to know any large company inside out will take a disproportionate amount of time compared to the gain you’d get compared to say a low cost index fund.

  9. I don’t know if people still do this, but…. *slow clap*

    Maybe this was just me, but did anyone else feel like that post was the oddest mix/abuse of Warren Buffett’s punch card metaphor and Nassim Taleb’s Black Swan theory, tied together with more reductio ad absurdum than you can shake a stick at?

    “I’d rather invest in 20 companies” Buffett asking the question of how your portfolio would look if you could only ever make 20 investments in your lifetime.

    “If you want to diversify you need to actually buy reverse correlated assets. So go ahead – hedge with options, hedge with futures, hedge with shorting the indices.” Sort of what the Taleb talks about, by losing money for years, waiting for those big hedges to pay off.

    “car crashes and catastrophes”, “asteroid impacts” “demonstrate that a statement is true by showing that a false, untenable, or absurd result follows from its denial”

    References:
    http://beginnersinvest.about.com/od/investingtips/qt/buffett_tickets.htm
    http://en.wikipedia.org/wiki/Black_swan_theory
    http://en.wikipedia.org/wiki/Reductio_ad_absurdum

    • I saw it as the opposite of what Taleb advises. His recommended “Black Swan Portfolio” would be something like 80-85% AAA bonds with the remainder in extremely high-risk areas like venture capital.

      Incidentally, Ramit – I’d love some pointers for how little guys can break in to VC. Anywhere I look requires you to be an accredited investor. Are there mutual funds for that sort of thing?

    • I’ll agree with you that he doesn’t sound like a successful investor, but neither do people who parrot “Invest in index funds, save 10%, etc”. He probably read some of the information you mentioned and is using the forum to validate himself.

      As we all do now for ourselves :)

    • Jarrod: You need money and experience otherwise you will lose. Anyone with a good business will have better VCs coming with money plus a good name, connections, and experience. If you do manage to invest just a tiny amount in a “huge winner” then it will likely be a huge loser in the end.

      You can try crowdsourcing, but I think better to network with people higher on the food chain than you to learn from and get a slice of deals. Or you could try funding more mundane businesses like someone’s beauty salon or food kiosk.

      You don’t need to be an accredited investor to put money into a company you know about and are personally involved in (which you should be as a VC). You need to be accredited to participate in arm’s length deals where someone brought the deal to you and you’re just giving money … that’s not really much of a VC but you’re at least moving into richer opportunities than the regular stock market.

    • Alex-

      I don’t mind losing if I learn by doing so. My problem right now is that I can’t even find a table to play at (so to speak). I’d be very interested in something like Kickstarter but for investing in the startup rather than just trading cash for a reward (though arguably Kickstarter has made the very idea obsolete).

      I wouldn’t even mind those mundane opportunities. In fact, they might even be better since they could provide more ability to monitor the situation. But it all comes back to not having enough cash on hand to fund a startup by myself (not without leverage, which I don’t want to do) and not seeing opportunities to crowdsource it.

    • @Jarrod

      The accredited investor restriction was created during the Great Depression to “protect” small investors from risky and illiquid investments (like venture capital), hence your difficultly in finding a way around it. In fact, crowdfunding for equity is illegal under securities current law. You can’t do it on Kickstarter or any other platform.

      However, you’ll soon be in luck. Early this year, congress passed the JOBS act, which eases restrictions on crowdfunding for equity. Once the SEC figures out all the rules (maybe by the end of the year), crowdfunding for equity will be legal in smallish (< $10,000 per year) denominations. Kickstarter has stated that they aren’t interested in equity, but I’m sure other platforms will pop up all over the place to accommodate.

      As for VC mutual funds, I’m less knowledgeable. Not many exist, and most are too costly to be worthwhile. If you are interested in a solid treatment of these and other alternative investments, I recommend Swedroe’s “The Only Guide to Alternative Investments You'll Ever Need.” He goes over venture capital (among other alternative investments) with returns, correlations, and their place in a smaller investor’s portfolio.

      Hope that helps.

      References:
      https://www.sec.gov/answers/accred.htm
      https://en.wikipedia.org/wiki/Jumpstart_Our_Business_Startups_Act
      http://www.amazon.com/Only-Guide-Alternative-Investments-Youll/dp/1576603105/

  10. I don’t think it’s so bad. I think we should spend some effort to see where others are actually coming from rather than immediately slam them because they don’t like diversification. Diversification is what you use when you DON’T KNOW. It assumes that stock returns have a large random component and it is the way of averaging out that random component.

    Diversification is for the ignorant, which nearly all people are. And he is totally right that most people truly live undiversified, high risk lives lives (not you Ramit, you probably have 10 or more income streams but most others have just them and their spouse).

    Retail diversification instruments like index funds are the very very basest form in investing. I don’t even call it investing. It’s just saving because there is absolutely no control or intelligence involved. He is trying to generate superior returns compared to an S&P index for example, and that is a fine goal. Not sure why he should be slammed for trying to explain his rationale.

  11. There are grains of truth (fat tails and Gaussian risk models) ill-expressed and which have little to do with the question. The question was never about beating an index, in fact, it should have spawned more questions.

  12. He’s singing the same song as Mark Cuban, except Mark Cuban is a multibillionaire with proven results and this guy just sounds like an impoverished jerk. http://blogmaverick.com/2011/08/13/wall-streets-new-lie-to-main-street-asset-allocationdiversification/

  13. Ok…am I missing something here?

    In the original question the guy said “I know nothing about stock or savings…”

    The guy who answered said diversification is a bad idea and goes into his reasoning and uses CAPM, long, short, reverse correlation, etc. and other industry jargon as an example but then goes on to say that most people don’t know enough and should diversify?

    Does he expect the person asking the question to know what “var=risk” means? Seems like a case of someone who wants to show off knowledge first and not really answer the question at hand.

  14. “The whole point of investing is to make above and beyond the S&P 500 benchmark over the long term”

    This is the one that was unexpected for me, and just jumped out. For me, the goal of investing is to have more money for retirement (or other things) than I would if I put my money in the savings account at the bank. The S&P 500 benchmark doesn’t sound bad from that perspective.

  15. This is why I avoid reading about serious topics on Reddit.

  16. Blatant emotional blackmail to sell bad information. Sadly, some poor schmuck (look it up if you don’t know Yiddish) will believe it.

  17. Kenneth Westgaard Link to this comment

    Joe: My thoughts exactly!

  18. “Most of modern economic and finance theory is based on fundamentally broken models of risk and return”

    I think this is actually correct (depending on your definition of the word “most”).

    Risk is the “permanent impairment of capital,” not “volatility” as is used in traditional asset pricing models.

    http://alephblog.com/2012/10/16/with-preston-athey-at-the-baltimore-cfa-society/

  19. Ramit, if you ever do carry out that plan, I hope that $14 worth of Taco Bell includes at least one Mexican Pizza. I mean, treat yourself, buddy.

    I would like to call out more mistakes, but unlike the original poster, I know what I don’t know. Personally, I don’t think it’s the end of the world if some investments merely keep pace with the S & P 500, contrary to his assertion that the “whole point” of investing is to out-perform it.

  20. I felt dumber after reading this post (more specifically the comments you’ve extracted from the forums). Stay safe in the storm.

  21. I think what is particularly troubling is that the original commentor is actually getting financial advice from a comment thread. That’s just sad. Conducting REAL research is the only way to do it; while asking trusted ones about their opinions can be valuable as well, I can’t imagine that this person can just trust some random commenter on the internet.

  22. What’s interesting to me is the domineering tone he’s talking in. Reminds me of some of the ‘Relationship Managers’ that worked with the various banks i’ve been employed with in the past. Whether they were talking to us marketing (read dumb-in-finance) people or the doe-eyed-customer, they adopted the same tactics :

    “Use & abuse all lofty finance words for as long a tirade as possible. So that the other person feels so stupid about themselves, that they don’t ask you any questions & meekly agree to the investment options you’re selling today.”

    And you know what, it works. Customer after customer trust these chaps with their money. Of course the ‘relationship’ manager ditches the customer the moment a better opportunity comes his way.

  23. I assume this was posted because it reinforces this concept:

    People would rather be sexy than rich.

    Now let’s deconstruct all of these statements.

    1. Risk and return are not correlated.
    How are they not correlated? There are exceptions to risk/return correlation when extreme events happen. But in the general case, they are correlated.

    2. Diversification does not work.
    This is another blanket statement that just reeks of ignorance. Diversification is the best hedge for an average investor. It’s easy to understand and not complicated.

    3, It also cuts your returns in half.
    Where did this come from? This is so ridiculous.

    4. I rely on my ability to make decisions.
    People are awful at making decisions with money. And unless you’re a quant on Wall Street with some tools that the general population does not have, your decisions are not going to do jack. Sorry.

  24. This feels like a college class where everyone is trying to impress the professor but all end up being wrong.

  25. One question for this guy.

    Did you forget about Enron?

  26. The first problem I see here is that catastrophe man seems much more interested in sounding smart than helping the original poster. I know very little about financial theory and the OP made it clear that s/he didn’t either. That reply was so full of vague references and bizarre metaphors that I wouldn’t have understood it even if the argument was based on sound advice. This person is just pretending to help and showboating instead.

    This reply also claims that an awfully large number of people and ideas are wrong without offering much solid evidence.

  27. This whole diatribe is a circular argument. He places something out there in a paragraph and references it later as if it’s a fact because he said it before. Like a cheap carnival ride, I just kept getting more and more dizzy (trying to follow the logic) as I read, until I thought I would puke.

    But before I head out to Taco Bell, let me just address the first sentence “Isn’t it stupid to just to have one job, one car, be a citizen of one country, have one house and one family. I mean really – one must diversify. What would you do if you lost any one of those?

    Umm, yes, actually, it is rather “stupid” to have just one (and I’ll paraphrase here) source of income, mode of transportation, place where you are a citizen, place to call home, and (ask any teenager) family. While there’s not much you can do about your family, you can (and I personally believe you should) do something about the others.

    1. Source of income: Just go here http://earn1kreview.com/ and read.
    2. Mode of transport: Let’s say your car doesn’t crash or get hit by an odd meteorite. What do you do if something more mundane happens, like it has an oil leak and you need to take it into the shop for a few days? Take a bus, ride with a friend/workmate, zipcar, bike, whatever! Just have a plan!
    3. Citizenship: Getting another passport opens new avenues of employment and travel at the least. It can also open new investing arenas, as well as places to bank. At the very least, you’ll never end up like Tom Hanks in the movie “The Terminal”
    4. House: Let’s go back to that meteorite. Let’s say that it does come and it just happens to smash directly into your house. Fortunately, no one was home. But, now that it’s a declared disaster area, where are you going to live? Oh yeah, that second house you didn’t need to diversity into. And if that disaster never happens? See #1 and get some rental income from it!

  28. Any “advice” written with that much hyperbole and scare tactics should throw up several red flags.
    Really, each End of The World reference probably should throw up an additional red flag.

    I feel like this is almost a drinking game….