Tuesday, December 2, 2014

Dead Cat Bounce

Back near the end of the high-tech boom, Gail Vaz-Oxlade wrote an investing book called Dead Cat Bounce. Following Gail’s advice in this book would certainly have helped many of the people I worked with who made terrible investing decisions, but not by much. This book is a product of its time when everyone and his dog thought they were stock-picking geniuses.

After completing the bulk of this book review I realized that it is mostly critical, and this makes me uneasy because I’m a fan of Gail’s. I handle money well myself, but she has taught me a great deal about how to help friends and family who don’t handle money well. That said, I still think I need to warn people about many parts of this book.

The main focus of this book is on stock picking. To her credit, Vaz-Oxlade recommends studying a company’s financials prior to buying its stock. Back during the tech boom I remember hearing thing like “Do your own DD [due diligence], but Pets.com is going to the moon.” For most people, due diligence amounted to looking at a stock price chart, checking analyst ratings (almost all of which said “buy” or “strong buy”), and reading some online hype.

But only a small minority of individual investors will really study a company’s financials. And even if they did, there is little hope that they would ever learn anything that the rest of the market doesn’t already know. The truth is that the vast majority of people should not have concentrated portfolios of individual stocks.

A lesser focus of the book is mutual fund investing. To Vaz-Oxlade’s credit, she discusses the importance of keeping costs low, but she also advocates choosing funds based on past performance and chasing star fund managers. At least she stresses that we should not “pick funds based on how they have performed most recently.”

The book advocates using “limit orders instead of market orders and using stop-loss orders, to protect yourself from market volatility.” Limit orders are a good idea, but stop-loss orders make little sense. If you really know that a company is a good investment, why sell when it gets cheaper? Stop-loss orders are mostly for gamblers.

Vaz-Oxlade defines long-term savings as a time horizon of at least 7 years. Interestingly, she then says “Long-term money is money that’s bound for the stock market.” This probably makes sense for some people, but few mainstream commentators advocate a 100% stock allocation. To be fair, she may have changed her mind since then; almost everyone was bullish on stocks back in the tech boom.

In a risk profiling test, the author says those who score the highest “could look at aggressive-growth stocks, start-up companies, commodities, options, and investment real estate.” Yikes.

In a second, purportedly better risk profile test, I actually scored in the most conservative category. This is nonsense; the questions are just bad. One question asks “You’ve lost $500 at the track. How much are you willing to risk to get back your $500?” My supposedly conservative answer was zero because I know that race tracks offer bad bets, and I evaluate all bets on their merits and not based on how much I’ve already won or lost.

The book’s model portfolios are just plain funny for anyone with a mathematical eye. Here is “The Growth-Oriented Portfolio”:

5% Money Market
15-25% Bonds/Fixed Income Funds
25-50% More Aggressive Stock
40-60% Blue-Chip Stocks/Funds

Note that if the third category is at 50%, the minimum total allocation to the other categories is 60% for a total of 110%. In another model portfolio, if one asset is at its minimum, then using the maximum for all other assets only gives a total of only 95%. With this type of error, it’s hard to take these model portfolios seriously.

In a discussion of blue-chip shares, it was funny to see GM included in the list. I’m guessing the investors who lost all their money in GM wouldn’t call it a blue chip. In general, people have way too much confidence in familiar stocks that have been around for a long time.

Some excellent advice for the average investor is “make sure you’re diversified not only by asset type, but also by industry and region,” and “don’t buy on margin.” On the other hand, “check how your stocks are doing regularly—at least once a day” is not a good idea for most people.

The author claims that managers of balanced funds have the ability to shift to fixed income during “declining market conditions,” and when “stock market conditions are strong, the fund will invest in more equities.” There is no evidence that fund managers as a group can successfully time markets this way.

The book has some good advice to avoid stock-picking contests because they reward “an extremely aggressive investment style” and “teach very little about the long-term skill of investing.”

Vaz-Oxlade was ahead of her time in warning about the cost of currency exchanges. Back then return expectations were so unreasonably high that few worried about losing a percent here or there.

My main goal of reading books is to learn something new. I had never heard of freeriding before. Normally you have 3 days to settle trades. Apparently, buying a stock and then selling it before the trade settles is considered freeriding and can get you in trouble.

The author makes a mistake about the math of margin investing. If you have enough money for 1000 shares and use 50% margin, this means you can buy a total of 2000 shares, not 1500.

“Options are also a relatively safe way to increase your exposure to risk.” The few people I know well who traded options lost all the money they traded with. The point the book tries to make is that a combination of 10% in call options and 90% in fixed income better protects you against losses than direct stock ownership. But this doesn’t matter much if the typical individual investor who trades options takes ridiculous risks.

It was good to see the author use only 12% as an example average yearly return. It may be hard to believe today, but during the tech boom many investors believed that expecting 15% or 20% per year was conservative.

The author advocates checking on your stocks’ earnings on a quarterly basis. “If a company’s growth or profits are disappointing—you can see this before they show up on the bottom line by doing your homework with the raw data—you can react and sell before the rest of the market catches on.” It’s ridiculous to think that you can sharpen a pencil and crunch some numbers before the worldwide army of professional investors does the same thing on their computers.

Despite Vaz-Oxlade’s obvious skill at understanding people who overspend and helping them fix their financial lives, this skill does not appear to carry over to investing. Despite the fact that reading this book at the time it was written may have helped some people escape the worst of the mistakes they made during hi-tech bubble, I can’t recommend it to readers today.


6 comments:

  1. Yes, Gail would appear to have strong skills in personal budgeting and finances (short-term), but would best leave the specificities of investing and long-term financial planning to others.

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    1. @Anonymous: The parts of Gail's skills that impress me the most are 1) understanding what's going on in the minds of people who manage their money poorly, and 2) knowing how to intervene in a way that changes their behaviour.

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  2. Hi Michael,

    Nice review. The freeriding part was surprising to me too. I'll have to look into that more, as I just bought and sold a stock in the same day. I was trying to buy it at one broker, but their system was down, so I bought the shares temporarily at the other broker I use, and then sold them when the original broker came back online. I just assumed this was common enough behaviour for day traders, never thought it could backfire.

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    1. @Gene: If I understand the explanation on Wikipedia correctly (http://en.wikipedia.org/wiki/Free_riding), you only get into trouble if you don't have the capital to cover the trade. So, if you held enough cash for the purchase, it seems you're OK. But you could imagine an investor buying stock without having enough cash and selling on the same day. Then when the trades settle 3 business days later, the investor just uses the cash settlement from the sale to settle the purchase.

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  3. So why was it called Dead Cat Bounce? Other than that two thoughts come to mind. First - I am sure that you can go back and review many books and find that they were influenced by the climate in which they were written and now the thinking has changed. That would be the measure of solid investing advice that is was valid 10 or 20 years ago and is still today.

    Second, like you I am a fan of Gail - but it does bother me that in her show she tells people just set aside $500 a month and in 20 years you will have this enormous retirement saving. She never explains the risks, assumptions or how to invest to get that return. Maybe that is too much detail for her 30 minute show but it is a key piece of the plan that she is giving people.

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    1. @Peter: I think "dead cat bounce" is just one of the more colourful investing terms and Gail liked it for a title. You're right that it's sensible to see whether a book stands the test of time. IMO, this book doesn't stand the test of time.

      To be fair, in her show Gail is dealing with people whose financial lives are swirling the bowl. Talking about building wealth down the road seems meant mainly as an incentive to keep these people on track. I think it would be a different show to sit down with these people later and plan their investments. It's also a show that would never make it to television. Even the TDDUP shows need the "relationship rescue" component to bring in viewers.

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