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).
Chapter 13 is called Performance Chasing and Market Timing, so let’s get to it.
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.
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.)
- You can buy the book here
It’s about $16 and, if you apply what you learn, it could make you thousands of times that money back.
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