Thursday, 12 June 2014

Lean To The Index

As repeat visitors to this blog will know, I like to keep an eye on the more traditional financial markets as well as the sports markets, and although I long ago realised that I had no edge in stocks, options, futures or commodities markets, stashing money away “every pay day in a few diverse index funds and forget about it” is as solid investment advice as most of us ever need, and I only wish I had heeded that advice in my twenties rather than my thirties. The “forget about it part” isn’t that easy though.

Although it’s completely pointless, I am in the habit of checking in on the markets at least daily, on good days perhaps several times. However, as stock prices fall on roughly 50% of days, this means that half the time you are likely to feel bad. The general upward trend of the market means that by checking less frequently, you get bad news less often – about 38% of the time if you check on a monthly basis, and 28% if you check annually.

I say it’s a pointless exercise to check daily, but even more than that, it can distract you from making smart long-term decisions. By the time you hear about important news, it’s not news.

I do like to look at some of the finance pages though, taking much of the content with a grain of salt. Lots of articles with dramatic headlines, and lots with question marks in them.

On a typical day, (yesterday), there were links to articles with the titles “Are Stocks Getting Into Dangerous Territory?”, “How Long Can Stocks Maintain All-Time Highs?”, “Cramer - Prepare For Stock Declines”, and “Is a Stock Market Correction Overdue?” – all very bearish in tone, if lacking any real substance, and then a ray of sunshine with an article titled “These are the most obvious signs the market is heading higher”. Peter Nordsted himself couldn’t do a better job of hedging his bets.

The fact is that no one knows. By definition, some managed funds will beat the average one year, and some of those will beat it a second year. Fewer still will beat the average in years three and on, unless of course they have some kind of an edge, which would be illegal, and no one does anything illegal.

One of the authors of Freakonomics, Stephen Dubner, says:
“No one is really good at predicting the future. Investors tend to get overconfident about the market, but no one is really good at predicting the future—including the experts. We tend to believe more in ourselves than we should," he said. "We all think that we can do better than average and that can be a trap. You gotta play it smart, you gotta lean to the index when you feel you need to and then depend on really smart guys … if they are indeed much smarter."
I don’t agree that we do all think we can do better than average when it comes to traditional financial investments. That seems a little unrealistic, and really smart guys tend to be really average guys who had a really luck spell.

It's not the first time Dubner has warned about stock-picking advice. Last month he said:
"If you look at stock-picking advice, you find that the experts … are generally about as good as monkey with a dartboard."


Prabhat Mukherjea said...

You clearly believe in the somewhat ludicrous efficient market hypothesis. A couple of reasons to think it's absurd.

1. There's enough statistical evidence that most retail traders consistently lose amounts of money (far exceeding transaction costs), implying obviously, that doing the opposite of what they did would yield a profit.

2. There are many traders who have very long track records of success. I am familiar with the "thousand monkeys hypothesis", but really it's a non-falsifiable claim that anyone who is a winner is lucky. Would you really lay even money on George Soros having a winning year?

3. You say "unless of course they have some kind of an edge, which would be illegal". Only insider information is an illegal edge, and even that doesn't apply to futures and commodities, forex and the like. Superior analysis is an edge that people can have.

I could replicate all of your arguments and apply them to sports-betting too, are you just a lucky chump, no matter that you've been a winner over sample sizes greater than 10/20,000 games?

Sorry for the rant, but I detest this defeatist, mediocre nonsense about financial markets being efficient and 'no one can beat the market, don't even try'.

If you are so sure markets are efficient, why invest in index funds? That's an implicitly bullish bet as well? How can the market be efficient if it's more likely to go up then down?

Marty said...

"How can the market be efficient if it's more likely to go up then down?"

Because systematic risk justifies a return for that risk

Prabhat said...

Marty, I don't understand your point, if one is systematically short of a stock index, that's just as much (or more, if we assume it's more likely to go up) a risk as if one was systematically long. Simply taking risks won't justify returns or make them probable.