Why Smart Investors Struggle to Beat the Market: Over-emphasis on Recent Performance
The individual investor does not beat the market, but actually trails by a significant margin. It is not a matter of intelligence.
The habits and skills that help smart people succeed in their jobs and recreational life actually mislead them when it comes to investing!
I am writing some posts subjects that have great current significance. These are issues where the average investor has a lot of money at stake. There is currently a lot of buzz about 2016 performance. This morning I heard a pundit explain that hedge fund managers had to go into “catch up” mode since so many of them trailed the market. As we enter the last quarter of the year, there is already focus on that annual grade card. Should you care?
Everyone has heard, of course, that past performance does not assure future results. Still, it must provide some kind of indication about the future? Doesn’t it?
Let us investigate further.
As I elaborate, please keep in mind this story about Ken Uston, one of the greatest blackjack players of all time. In his excellent book, Million Dollar Blackjack he describes both his system and the implementation in team play. Card-counting nerds would signal “the Big Player” who would seem to flit from table to table, cocktail in hand and a woman on both arms. The Big Player would make large bets, but only when the odds were in his favor. As a result of this team method (no longer effective given casino counter-measures), Uston played exclusively in situations where he had an edge of about 5%.
The Relevance of Past Performance
Suppose that you adopted a system where you took all of your money each day and bought the stocks that did the best the day before. That would be past performance on a one-day time frame. I suspect that most readers will think that is silly.
Suppose that you looked at the stocks and sectors which did best in the past year. Buy them! That may seem reasonable, but it is also a regular loser.
How about choosing the managers that did the best over the past year? Or the ETFs that were strongest? That is simply a closet method for following last year’s top picks. The top investors and managers for last year owned the popular FANG stocks, utilities, and consumer dividend payers. We know that it worked last year, but will it continue?
Warren Buffett, on a monthly basis, beats the market only 51% of the time. He has had multiple losing streaks. None of this has stopped him from being a great investor.
Evaluating performance requires relevant, long-run data.
What is the long run?
The average investor thinks of the long run in terms of time. This is a big mistake. The long run relates to the number of decisions, not time. Here are some illustrative examples:
- High frequency trading firms rarely have a single losing day! This is because they make tens of thousands of trades each day. They reach the “long run” in an hour or two.
- Single-theme managers may lose for many years. The heroes who called the housing market collapse and were memorialized in The Big Short, endured years of losses and many angry investors –often locked in by contract. The past performance of multiple years was certainly no indication of what was to come.
- Thematic managers (like me) might have 5 or 6 themes. Even a strong strategy does not get into the long run in a given year. When the theme hits it is a huge winner.
The “long run” should be measured in the number of decisions, not the calendar time. If you try to cut it into arbitrary times, it either fails, or creates the wrong incentives for managers.
Is Performance Even the Correct Test?
Some investments are chosen without the “beating the market” concept in mind. If you make such a decision, it is wrong to revisit the results with a specific market benchmark. Here are some examples:
- Suppose you choose an income program. If the income meets the target, that should be the test.
- Suppose you fear a particular threat. One of my concerns is a cyber-attack. I suspect that the frequency is under-reported and bigger cases loom. If it happens, it would be helpful to hold a leading company in the field. I have chosen Palo Alto Networks (PANW) because it is a good company with a strong client base and real earnings. The stock was crushed today because of cautious comments in their outlook. The earnings and revenues were fine. We bought more. Should I be concerned that this hurt my performance? Should my clients? If they are worried, they have the wrong manager. Nothing fundamentally changed. If there is a big cyber event, we’ll win big. We are not trying to beat the market each month or year with this stock.
- Suppose you want downside protection. If you go with a manager like John Hussman who buys puts to hedge your position, that was your choice. Even if the puts expire worthless, he did his job. You should expect reduced performance when the market does not decline significantly.
- Suppose you select a portfolio with a large cash or bond component. This is often exactly what you should do. Do not second guess yourself by wondering if you should have taken more risk.
- Suppose you invest in a “value” program. Buying cheap stocks (on an earnings basis) has been out of favor for the last few years. Should you expect this to continue, or for the pendulum to swing? My approach is to buy regional banks (STI is a favorite), technology, and homebuilders. This will work, but maybe not in the next few months. You should not worry about that.
Revisiting Mr. Uston — despite the big percentage advantage, he describes a period of time where they had a losing streak lasting more than a month! Please note that this includes thousands of hands played. They started questioning error rate, methods, the skill of their counters, theft, etc. I like the example since it is possible to compute a valid benchmark result for what they were doing. Eventually the winnings returned. It shows that you must have confidence in your system, and stick with it through some improbable losing times.
In similar fashion, value investing is a fundamental part of my approach. It may be difficult, even for the smartest investors, to see this. It is a good problem to analyze.
Anthony Fogler (via ValueWalk) explains why value has been treated unkindly, and why sentiment is likely to change. Here is an illustrative chart:
The chart provides some idea of what time frame you should consider to reach the “long run” in value investing. Not one or two years, but more like five.
There are many other traps for the really smart investor. The most intriguing is that most of our reading in our professional life is designed to educate and help us. In the investment world, many are trying to sell us or scare us or both. But that is a subject for another day.