Thursday, April 14, 2016

How Much Do You Have to Learn to be a Good Investor?

In one sense, you need to know almost nothing to be a good investor. However, in another sense, you need to learn quite a lot.

The recipe for investing better than almost all other investors over the long run can be dead simple. Buy three low-cost index ETFs and rebalance mechanically based on some fixed rules. Within reason, these fixed rules don’t matter much as long as they remain fixed. We could teach this to a 12-year old.

Where you need deep knowledge is to avoid screwing up the simple investing recipe. Imagine yourself balancing on a wobble board following this simple investing recipe and trying not to fall over. Unfortunately, most of the financial industry is trying to knock you off.

First we have the never-ending media reports about an impending market crash. These are designed to turn you into a market timer. All the evidence says you are most likely to get out of the market at the wrong time, but the articles calling for a crash are very scary and convincing. More money is lost being out of the market than has been saved avoiding crashes, but that brings little comfort as you feel yourself falling off your wobble board.

Next there’s the lure of expensive mutual funds with the promise of star managers getting you higher returns and steering you clear of big losses. Of course, they can’t do these things, but the appeals to greed and fear are often enough to knock you off balance. Over the years you give away one-third or more of your savings waiting for the out-sized returns that never come.

Then there’s the lure of choosing your own stocks. When the world tells you you’re smart enough to beat other investors, your ego can’t resist. Steady media stories about “5 hot stocks” keep you off balance. Trading against the best in the world rarely works out well, but you remember your winners. Somehow, though, your portfolio never grows the way you hoped it would.

Banks, insurance companies, fund companies, and brokerages can’t make money unless they take it from you. So, they do their best to keep you off balance. Their messages can be extremely persuasive. It takes a lot of investing knowledge to tune out all this noise, stick to the simple plan, and stay balanced.

18 comments:

  1. Michael,

    This post might get you into the big leagues of truth tellers.

    Good one.

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  2. Being a good retail investor is far more psychological based than market knowledge based. You will succeed or fail depending not on how much you control the markets but how much you control yourself.

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  3. It's interesting that with many subjects, and particularly with investing, you need to know a lot about it to understand what you don't need to know, which is most of it.

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  4. Paraphrasing Munger, if you're trying to figure out what you need (or what's good for you), cut out everything you don't need (or is bad for you), and you'll be all that much closer to your goal. So, yeah, you do kinda have to know about some of the garbage that's out there in investment land just so you can figure out what's good for you.

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  5. Perhaps a better of saying what I meant to convey in my earlier comment, is you need to know a lot about investing to understand what are the rather few things that are really important.

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    1. Which leads to another paraphrased Mungerism regarding successful investing: make only a small number of really good decisions.

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    2. @Grant: I'd say there are 3 broad categories: important things to understand, things that are not important to understand, and things that are important to ignore.

      @SST: It's unclear to me whether Munger intends this advice to extend beyond stock-picking.

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    3. re: Munger -- it's applicable to both investing, summoning Buffett's '20 Stock Punchcard', and life in general -- spouse, career, education, etc. A few great decisions can set you up for life and put you well ahead of the crowd.

      Also interesting is his definition of risk, "Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” Taking this into account, one would do well to 1) invest in indexes (they shouldn't "fail"), and 2) match controllable savings rate with guesstimated return rates to make sure your total return is adequate.

      MJ should comb his archives and compile his own list of quotables.

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  6. I'm playing devil's advocate to some extent.

    I think a case can be made that one can market time at extremes. Read Jack Bogle's statement about market timing carefully. He says that no one market times well consistently. But he doesn't say you can never market time. He did it around 2000, and so did Larry Swedroe. Jonathan Clements did it in 2008-2009.

    About stock picking, I would agree that very few people should pick stocks using fundamental analysis. But what about creating a DIY small cap value fund? A small cap value fund is about relatively simple quantitative investing. I'm not convinced, that if you spend enough time learning about quant investing, that you can't create your own SCV fund.

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    1. @Anonymous: The average person who tries to time the market at extremes will very likely fail. That doesn't mean nobody can do it; it just means you have to above average (among pros).

      A small cap value tilt may well be a winning strategy. However, the average small cap value stock picker will lose to a small cap value index (which you can buy in the form of Vanguard's VBR).

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  7. People seem to forget that behind every index there is a group of "pros" who are already doing the stock picking for them. By trying to formulate your own DIY index (i.e. picking the best of their picks), you'd have to know even more than those same "pros". Seems like a waste of time & energy to me; the average investor has no idea what "quant investing" is, let alone will spend "enough time learning about" it.

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    1. @SST: Agreed. Even when Vanguard tries to make an index of all stocks they end up having to sample among the small caps.

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  8. I used to be a devout indexer, but now I'm lapsed. On the Bogleheads forum, I asked the question, how does an indexer deal with bubbles. I felt I didn't get a good answer.

    An example of a bubble would be the Japanese stock market at the end of 1989. It had a PE10 of around 90. The peak of the Nikkei 225 was around 39000.

    What's happened since? It's 2016, more than 25 years later, and the Nikkei 225 is at 16,848.

    At the peak in 1989, the Japanese stock market was more than 40% of the world stock market by market cap. A devout indexer paid the price for being devout.

    For a more recent example, the S&P500 reached a peak PE10 of over 44 in 2000. The corresponding peak of the S&P500 was around 1500. The present value of the S&P500 is 2080, and the PE10 is 26.

    The following is from "Lifecycle Investing" by Ayres and Nalebuff p. 86:

    "It's only when the PE ratio goes above 27.7 that our number crunching suggests that people should completely stop investing in stock. When the market is this overpriced, the expected future stock returns don't justify the risk."

    When they mention PE ratio, they mean CAPE. 26 isn't that far from 27.7. Around 1965, the CAPE of the S&P500 was almost 25. This was followed by a period of about 17 years, where the return of the S&P500 after inflation and dividends was zero; that ignores taxes.


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    1. @Anonymous: Simple arithmetic says that most market timers must lose money in their attempt to make more money, but that isn't necessarily going to be your fate. Maybe you'll be one of the exceptions.

      On a pickier point, I don't think it makes sense to be a "devout indexer". To invest well, we can't afford to be dogmatic. It's hard to come up with a plausible scenario where indexing stops making sense, but there are implausible ones. For example, suppose the government imposes a huge tax on index investing somehow. It pays to avoid being dogmatic.

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    2. Google (GOOG, P/E 33) "countercyclical indexing". It's basically a 'buy cheap, sell expensive' type strategy, but still indexing.

      But...there have been a handful of good no-BS pros who have stated that an elevated CAPE might be a new normal, thus not as expensive as you beleive.

      And using Japan as an example of what can happen to an index is a bit of a red herring. There are a few things which have condemned the Nikkei which are not present in the rest of the world to the same degree.

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    3. https://personal.vanguard.com/pdf/s338.pdf

      According to the Vanguard research paper that you can reach with the above address, even the CAPE left almost 60% of the variation of future stock returns unexplained...

      Sure, higher prices mean lower future expected returns, but I would not abandon or alter my investing plan over it.

      A bubble drastically raising values of some asset classes in a diversified portfolio would cause you to rebalance and control your risk. Your overall portfolio can of course lose money in the aftermath of a bubble, but it should be accounted for in your risk tolerance. This strategy is imperfect, but I cannot think of a better way to deal with such a situation.

      (Yay, first post!)

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    4. @Jason: Well said. I'll stick to my plan.

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