Tuesday, June 28, 2016

A Wealth of Common Sense

In his book, A Wealth of Common Sense, Ben Carlson explains why the best investment plans use simple strategies with diversification and minimal trading. But his heart seems to be in trading. Maybe this makes his book most useful for those who are currently trading themselves into losses and need to be told to form a strategy that takes their own opinions out of the mix.

The section that best illustrates Carlson’s tendency to think like a trader comes late in the book and is titled “Vetting Your Sources of Financial Advice.” After explaining the problems with most pundits who make extreme stock predictions based on oil prices and other economic indicators, he recommends that you “look for balanced viewpoints that look at both the potential rewards and potential risks.” I’d say that the average investor is crazy to trade frequently in the first place, and no amount of looking for the right talking heads will help. But, if you can’t help yourself, at least take Carlson’s advice on avoiding the worst talking heads.

The bulk of the book contains solid advice. Fifty years ago, individual investors made up more than 90% of stock trading volume, but that has dropped to less than 5% now. It’s important to understand that your neighbour is not your trading competition. “Professional investors now control the markets.”

“In most areas of our lives, trying harder is great advice. But trying harder does not mean doing better in the financial markets. In fact, trying harder is probably one of the easiest ways to achieve below average performance.” Well said. Another good quote: “Stock picking is for home-run hitters who will likely strikeout.”

In paraphrasing Daniel Kahneman, Carlson says “Even smart people need to systematically weed out their irrational impulses, because intelligent does not mean rational.” This can be hard to admit to yourself, but I now see some of my own irrational tendencies.

Carlson has a tendency to overstate things, which can be confusing at times. One example is “there’s no such thing as passive investing.” In reality there are degrees of active/passive investing. It’s only when you decide to think in extremes that you get Carlson’s statement. All he means by this is that even passive investors have to make some decisions, particularly up front.

Most investors think of diversification among stocks as roughly meaning the number of stock you own. However, Carlson seems to mix this definition with a different one: the number of different strategies you use, such as factor tilts toward small caps or value stocks. He observes that trying to follow too many strategies can leave you with an expensive portfolio that isn’t much different from the broad market. For some reason, he calls this “overdiversification.” I’d call this self-imposed closet indexing. The problem is cost, not the degree of diversification.

“Investing really comes down to regret minimization.” I couldn’t make much sense of this one. I certainly don’t want to experience more regret than I have to, but this doesn’t dominate my investment choices. Staying well diversified certainly cuts down on the regret from selling a stock too soon or buying a bad stock. However, I avoid stock picking because I believe I’ll end up with more money by indexing, not to minimize my regret.

“The perfect portfolio or asset allocation does not exist.” My first thought was that among the many asset allocations I could choose, one of them will turn out to make the most money. All Carlson means is that you can’t know in advance which asset class will perform best, so you need to diversify.

“Diversification is worthless without rebalancing.” This is just way overstated. Rebalancing is a great way to control risk, but diversification still has value even if you never rebalance.

“No one has successfully figured out a way to arbitrage long-term thinking.” I’m not sure exactly what Carlson means by this, but investing for the long term is a form or arbitrage. The risk premium is unreasonably large and I exploit it by investing in stocks for the long term. If enough others think the same way, our collective arbitrage will shrink the risk premium.

“Emotional intelligence counts for much more than IQ.” Just as you need both your heart and your lungs, you need some IQ and some control over your emotions. So, on a certain level, there is no point in trying to decide which is more important. But if I had to choose my own mix, I certainly wouldn’t go for all emotional intelligence and no IQ.

“Most investors assume that benchmarking is mainly for measuring performance against the indexes to compare over- or under-performance against the market. But in the advisor-client relationship, the main reason for measuring performance and benchmarking is to improve communication between the parties.” I disagree. Better communication could be a side benefit, but the main purpose of benchmarking is to see how you’re faring against an appropriate mix of indexes.

“The only benchmark that matters is achieving your personal goals, not beating the market.” If the goal is to get people to accept market returns and not risk going for more, I can see why Carlson says this. However, I see too many stock pickers protect their egos by not benchmarking. I recently wrote a post explaining the subtleties of when benchmarking makes sense and when it doesn’t.

Overall, this book can be valuable for overconfident investors to see some the pitfalls they’re likely to encounter using complex strategies that rely on gut feel. If it had been around 15 years ago, it might have helped jolt me sooner out of the delusion that I could be a successful stock picker.


  1. Knowing your natural tendencies is a good thing. Then learning to control them is even more valuable. I think deferently from most and I often want to take advantage of it. Last friday (and then yesterday), I could'nt stop thinking how I can catch the falling knife (Brexit) like buying a few grants of VGK. I finally did nothing because my AA is almost on target and I should have pulled cash from EF to invest otherwise.

    Thanks, but no thanks.

    My actual plan is to repay 20k$ of mortgage principal within the next 10 months then make my RRSP contribution, probably 15k$ of VBR or VXUS.

    1. @Le Barbu: It sounds like you've chosen to stick with your plan in the face of Brexit. Good idea.

  2. Over confident investors? How can there be any of those left? The problem also is, if you see an investing advisor, it is in their best interest for you to make many trades (some (I am sure) may not be like this, but not as many as I'd hope) in a period.

    Stock picking is for much smarter folks than me.

    1. @Alan: There is always a new crop of people who haven't been beaten up by their own stock picks yet. There used to be many brokers who got paid based on your transactions -- not so much any more. The main people who benefit from a crowd of individual investors making stock picks are the investing professionals. You can't outperform unless someone else underperforms.

  3. "I avoid stock picking because I believe I’ll end up with more money by indexing"

    But you own a small cap value ETF: that ETF is based on stock picking. I think it's a good idea that you own it, but nevertheless, it's still stock picking.

    1. @Anonymous: No, it isn't. It is a deviation from a pure market-weighted index, but I'm not stock picking.

    2. http://dictionary.cambridge.org/dictionary/english/stock-picking

      stock picking: the activity of choosing shares or bonds in which to invest

      Stock picking is a synonyn for security selection.

      The stocks (securities) in your small cap value ETF are being picked (selected) on the basis of value and small cap criteria.

      Security selection and market timing are the tools of active management.

      Your small cap value ETF is an exercise in active management.

    3. @Anonymous: I've heard these arguments before. Someone has to pick the stocks in every ETF and we all have to trade, so we're all no different from day traders. It's nonsense. There are qualitative differences among different approaches to investing. A stock picking approach is qualitatively different from my portfolio approach.

      Active/passive is a continuum. My portfolio is (slightly) more active than if I didn't own VBR. To label it "active" or "stock picking" makes no sense.

  4. Rather than pick stocks, Index investors pick ETFs. They succumb to the same behavioral traps such as chasing past performance, frequent trading, and bailing out at the worst time possible (as a group).

    1. @Anonymous: It must be true that many investors trade in and out of index ETFs, but I haven't met anyone who admits to this. However, the high trading volume of ETFs must be coming from somewhere.

    2. The annual turnover of the 100 largest ETFs is 864% which shows that ETFs are far more “active” than most people think.

      In 2015, the average annualized turnover of the shares of four of the most active ETF providers ranged from 953% to 10,308%.

      The problem with this ultra liquidity and hypersensitivity is that it leads people to obsess over every little move. This creates the risk of behavioral biases.

      ETFs and index funds are very much "active" financial instruments (inside volume from management, outside volume from industry), but if you can definitely hold an active instrument in a passive manner.

      Kinda like having a hyperactive dog who loves to run around the backyard for hours every day. It's still the same dog day after day, year after year. It's the people who get a new dog every six months who will experience problems.

    3. @SST: It doesn't make sense to label all ETFs as active. The degree of activity is important. An ETF like VTI has some activity, but is clearly toward to passive end of the spectrum. The way investors trade VTI may be largely active, but the ETF itself is mostly passive.

    4. Turnover: ZCN 19.5%, VTI 3.5%, VBR 15.5% and VXUS 2.5%

      According to my AA, my average turnover is 11%

  5. @Anonymous, I am an indexer and make 3-5 trades/year at most. 2 of those trades because I usualy do 1 Norbert's-Gambit to buy US listed ETF and the others for adding new money in different accounts. My last buy were ZCN and VXUS wich are both lagging VTI for few years now. I almost never sell because new money and dividends are enough to get my AA back in balance.

    You are right that indexer have to take some decisions (active vs pasive debate) but can get rid of the individual stock risk. I got exposure to almost 10,000 stocks with 4 ETFs and still, because I sliced and diced a bit.

  6. The fact that individual investors have gone from 90% to 5% of market trading volume is truly remarkable. Gives me a whole new appreciation for the futility of trying to beat the market.

    1. @Juan: I find it striking as well. I know I'm no match for multiple teams of professionals.

  7. I read the book a few months back and I thought it had a lot of important investing insights. My take is that he is saying that because behaviour is the most important part of investing, it's more important to choose an investing strategy you are comfortable with (so you stay the course) than the most efficient one, which of course, we all know is passive indexing! For some, who just love to pick stocks, dividend growth investing might be a better fit. Passive indexing is just too boring for them and they just wouldn't stick with it, so they probably are better off by going with dividend growth investing. To be honest, I didn't really pick up the thought that he is a trader at heart.

    I wouldn't say that using factor tilting is a different strategy - it's more of a higher level of complexity within the strategy of passive indexing. A different strategy would be dividend growth investing, value investing or momentum investing.

    I really liked the book and highly recommend it.

    1. @Grant: Between his book and blog, I see a lot of discussion relevant to stock selection and the timing of purchases. It's almost as though he is talking himself down from activity so he can stick with a solid plan. Perhaps others don't see this in his writing. Despite this, his main messages steer people toward diversification and long-term buy-and-hold, which is good.

      By definition the only strategy that can work is the one you'll stick to. There are different approaches that can all work reasonably well. What they have in common is minimal turnover, diversification, and low costs. Dividend growth investing can have these properties, but many investors have little diversification or trade too often.

      As long as the factor tilts don't change over time, they seem like a small departure from market-weighted indexing. However, some people end up trading the factor tilts actively, which is a much larger departure.