Book Review: How Not to Invest

Before reading Barry Ritholtz’s book How Not to Invest, I wondered if the “Not” in the title was a sign it would be filled with gimmicky ways of giving investment advice.  It isn’t.  Investing well is simple enough, but the world tries to push us towards many types of poor choices that lose us money.  The best advice is a list of the many things to avoid when investing.  This book gives readers the benefit of Ritholtz’s extensive experience with staying on the simple path to investing success.

The book is organized into four parts: Bad Ideas, Bad Numbers, Bad Behavior, and Good Advice.

Bad Ideas

Part of what makes it so easy to push investors toward bad ideas is that we believe secret ways to create wealth exist when, in fact, they don’t exist.  “We don’t like to admit it, but nobody knows anything about the future—not just you and me, but the so-called experts too.”  

I’ve had the experience of getting people to agree that the future is unknown, and then they immediately ask what I think will happen with interest rates.  It’s hard to get people to really believe the future is unknown.  Ritholtz does an excellent job of going through some high-profile examples of the futility of forecasters.  Instead of searching for the right seer, he suggests having a “financial plan that is not dependent upon correctly guessing what will happen in the future.”  “Don’t predict what will happen, but rather, assess the range of possible outcomes—what could happen.”

So much of the information we see about investing is just noise.  Ian Cassel said “The maturation of every investor starts with absorbing almost everything and ends with filtering almost everything.”

It is freeing to admit we don’t know what will happen and to plan for a range of possible outcomes.  What too many people do is “Make predictions, then marry those forecasts.”  If they’re wrong, “This usually leads to catastrophic results.”

Bad Numbers

This part of the book starts with a good section on economic innumeracy that discusses denominator blindness, survivorship bias, mathematical models, and the fact that we respond better to anecdotes than data.

Part of what makes this book a pleasure to read is Ritholtz’s optimism.  Paul Volker once said “The only useful thing banks have invented in 20 years is the ATM,” but the author lists 20 useful financial innovations, including index funds, ETFs, low costs, fast trade clearing, and cash-sending apps.  The challenge for investors is to benefit from these innovations rather than lose money with them.

The author sees bull and bear markets as secular periods characterized by either high price-to-earnings (P/E) ratios or low P/E ratios.  I’m not sure how he thinks investors should use this information.  In my case, I use P/E levels to make modest formulaic adjustments to both my asset allocation and my expectations for future stock returns.

Sometimes people overestimate how much the news of the day will affect markets.  Some industries were devastated by Covid-19.  However, it turns out that these industries represent a small fraction of overall markets.  If in “mid-2020, the 30 most economically damaged industry categories were delisted, it would have shaved off just a few percentage points from the S&P 500.”

There is a winner-take-all tendency in many areas, including stocks.  “Just 1.3% of the public companies listed in the United States account for all the market gains during the last three decades.”  We can “find the best-performing stocks by buying them all” in an index fund.

“Simplicity beats complexity every time.  A portfolio of passive low-cost indexes should make up the core of your holdings.  If you want to do something more complicated, you need a compelling reason.”

Bad Behavior

“Bad behavior leads to bad investing outcomes.”  Ritholtz categorizes bad behaviour into ten areas, and he illustrates some of them in an amazing story about a billionaire family called the Belfers.  They lost money with Enron, Madoff, and then FTX!  “Has there ever been a greater, more unholy trifecta than this?”  Even billionaires make some terrible choices.

“If only we made better decisions, we would all be so much better off.”  If we could eliminate all investing mistakes for everyone, we might be better off on average, but there is a zero-sum aspect to investing mistakes.  Your loss is someone else’s gain.  The main overall benefit of eliminating all investing mistakes is that those employed exploiting such mistakes would move on to do something useful for society.

“Few mistakes are more costly than chasing yield.”  “The three most common ways to chase yields are: 1) Buying longer-duration bonds, 2) Buying lower-rated, riskier paper, or 3) Using leverage."  I agree.  I stick to a duration of 5 years or less, I stick to federal government bonds, and I don’t borrow to invest.

On the subject of investor sentiment, “we are deeply affected by whatever the stock market has done over the past six months.”  After a rally, many say “I am a risk-tolerant, aggressive investor.”  “This is greed speaking.”  After prices drop, many say “I am a risk-averse, conservative investor.”  “This is fear speaking.”  “Neither answer is fully accurate.”

Ritholtz credits Michael Mauboussin with making a distinction between risk (unknown future outcome with a known distribution) and uncertainty (unknown future outcome with an unknown distribution).  I’m not aware of any widespread convention that uses these precise definitions for “risk” and “uncertainty,” but the distinction matters.  We can devise strategies for the possible outcomes from gambling at cards (risk), but we don’t know what will happen in war (uncertainty).

On the subject of the trend from active to passive investment management, “the active part of the money-management industry is still being downsized—or more accurately, right-sized.”  Good one.

“To better manage our behaviors as investors, we need some strategies to outfox our own brains.”  The author suggests five steps to do this.  Two of these are to seek out opposing points of view and to choose data over anecdotes.

Good Advice

The author offers ten steps to becoming a better investor topped by “avoid mistakes.”  A few others are to mostly use index investing, own some bonds, and to be skeptical of alternative investments.

In a section discussing the gap between the returns produced by investments and the returns investors earn, called the “behaviour gap,” some of the data in the book is questionable.  I wrote about this in an earlier post.

“In my experience, fiduciary rules protect investors from advisor malfeasance, while suitability rules protect brokers from investor lawsuits.”  This is the best explanation I’ve seen for why investors should seek advice from fiduciaries.

We’re used to hearing that the advantages of using low-cost index funds are “lower costs (and taxes),” better long-term performance,” and “simplicity.”  Ritholtz explains two other advantages: “owning all the winners” and “less bad behavior.”

Interestingly, the author only recommends having about 70% of your assets in indexes and the rest as “satellite,” which means scratching the itch of betting on guesses like a particular country or artificial intelligence.  He even advocates having 3-5% in a mad-money account for wilder investment ideas.  However, he doesn’t say what to do when the satellite and mad money investments flame out.  If you keep refilling these accounts, you’re draining away your savings.

Sometimes people are in a position of suddenly having large investment gains, such as with employee stock options.  To help people make the right choice in selling some of their winnings, he asks them to think about how they’d feel in two scenarios.  1) What if you don’t sell any and their value drops to one-tenth of what it is now?  2) What if you sell half and their value soars to ten times what it is now?  Scenario 1 is devastating, and in scenario 2, you’re still doing great.

Ritholtz is in the go-ahead-and-buy-your-latte camp.  He goes on at length about how buying $5 lattes is fine.  I get that some on the other side of this debate overstate things (think Suze Orman).  But not everyone has above-median income.  For some people, spending $1000 per year makes a difference in their lives.  If you think $1000 per year is worth it to you to have a latte on most days, then go for it.  But think about the dollar amounts before taking advice from well-to-do people who say that lattes and other small amounts make no difference.

Some excellent advice: “My experience has been to focus on what I can control and roll with the punches for what I cannot.”  The author goes on to discuss the many things we can control and the many things we cannot.

Conclusion

Overall, I highly recommend How Not to Invest.  Ritholtz’s perspectives on investing come from extensive experience helping others invest well.