Danger of high octane approaches
If I offered you the opportunity to play a simple game with the odds fixed 60/40 in your favour, do you think you could win? No doubt you would answer ‘yes’.
The stock market is really a simple game. And the odds are in your favour. In the last 50 years the S&P 500 has provided a return of 10.923% compounded with dividends reinvested. Even taking inflation into account the total real return over this period was 6.796%. Investing in a low cost index fund would have generated close to these returns. With a well thought out investment approach one can do even better.
The odds in the stock market are fundamentally different from a casino. There the odds are against you. In the stock market, the odds are in your favour. The stock market is more like the 60/40 game.
But, many investors have a way of making things complicated. And, by doing so, they lose a winning game.
Finance and economics students fail to take advantage of odds of 60/40
A remarkable experiment that directly documented our ability to lose a winning game was conducted by Victor Haghani of Elm Partners and Richard Dewey of Pimco and reported in a paper in Social Science Research Network on October 19, 2016.
The paper was titled “Rational Decision-Making under Uncertainty: Observed Betting Patterns on a Biased Coin”. Haghani and Dewey devised a simulated coin flipping game to determine whether a group of finance and economics students and young professionals at finance firms could successfully take advantage of odds of 60/40 in their favor on each and every flip of the coin. The edge in the odds on each flip was explained to the subjects before the experiment. They were each given a $25 starting stake and could bet any amount on any simulated flip of the coin. The game lasted 30 minutes.
The paper notes with genuine disbelief: “We were surprised that one third of the participants wound up with less money in their account than they started with. More astounding still is the fact that 28% of participants went bust and received no payout.”
How could this have happened with an educated group of subjects? Surely the way to take advantage of the odds is to bet a reasonable amount on any simulated flip. There is a 40% risk of losing any flip. One wouldn’t want to bet too much on any flip because one’s stake could easily be destroyed. That is too risky. Betting too little on any flip and you are not taking advantage of the odds in your favor.
The betting errors made by the subjects included over-betting, under-betting, erratic-betting and betting based on previous flips. The authors write: “Without a Kelly-like framework to rely upon, we found that our subjects exhibited a menu of widely documented behavioral biases such as illusion of control, anchoring, over-betting, sunk cost bias, and gambler’s fallacy.” (Emphasis added) These terms describing different behavioral biases are explored in my posts. For an introduction to investment psychology see here.
What we learn from this simulated 60/40 coin flipping experiment is that a speculative, erratic approach can lose even a winning game. To read the paper see here.
Lessons from Maynard Keynes
John Maynard Keynes was a towering figure in macroeconomics whose ideas are still central to the debate over fiscal and monetary policy. He was also an extremely successful investor, both in his personal investments but also on behalf of others. The level of his success is suggested by the investment performance of the Kings College Cambridge investment fund he managed. During the years from 1927 to 1946 the Chest grew at an annual compounding rate of 9.1 per cent while the general British stock market fell at an annual compounding rate of slightly under 1 per cent. maynardkeynes.org
By 1920 Keynes was already a well-known economist in Britain. For example, he was an economic advisor to the British delegation at the post WWl Versailles peace conference in 1919.
But, from immediately after World War l into the 1930s, Keynes was also a speculator trading on his own account mainly in currencies. An article in the Financial Times notes that Keynes pursued ‘outrageously impulsive adventures in art and currency’ speculation. In the 1920s he was wiped out financially. To read article see here.
In the 1930s he turned to true investing and eventually amassed a substantial fortune.
In 1938, Keynes wrote his manifesto for sound investing using a concentrated, balanced portfolio. He proposed:
“ •A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
•A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake;
•A balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible, opposed risks.
His view of investing versus speculation was: “Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market.”” (Emphasis added) (maynardkeynes.org)
Justin Fox quotes from a letter Keynes wrote to a friend in 1942: “My purpose is to buy securities where I am satisfied as to assets and ultimate earning power and where the market price seems cheap in relation to these.” (Fox, The Myth of the Rational Market, A History of Risk, Reward, and Delusion on Wall Street. 2009) p.115.
My own lesson
While I was learning true investing, I experimented with various aggressive strategies on the side. These included warrants, options, short selling, straddles and various other high octane approaches. I ultimately learned that these did not work. I wasn’t wiped out because the amounts at stake in the experiments were small enough that I lost very little while learning some good lessons. I ultimately came around to the Keynes approach, which is also the Warren Buffett approach.
Kelly formula
Reference is made above to a ‘Kelly-like framework’. It was devised by John Kelly and published in 1955. It tells you how much of your total stake to bet on each bet. Basically, one apportions investment positions or portfolio weightings according to one’s informed estimate of each stock’s probable return; it is the weighting that provides the highest geometric mean of outcomes; betting your beliefs. To read more about the application of the Kelly formula to investing read my post here.
Conclusion
Investors are fully capable of losing money in the stock market. This is quite amazing really. After all, the stock market is a winning game. The odds are in your favour.
It’s worth reminding yourself from time to time that in spite of being given a favorable betting edge 28% of an educated group of subjects went bust, a result that can only can be called miserable. Any one of us could have been those experiment subjects.
The good news is that with a sound process, investment success is entirely likely. In 1974 Ben Graham remarked in a speech that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.” (Lowenstein, Buffett, The Making of an American Capitalist. 1995,2008) p.160.
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For readers wishing to dig further into the idea of a sound investment process check out The Motherlode Part 4: Principles of Operation
This Part contains four chapters:
24. Business objective
25. Investment Styles
26. Buying with a margin of safety
27. Sound Principles of Operation
Also you can take a look at these posts:
Understanding Ben Graham’s Principles of Operation
Which is better: top down or bottom up investing?
Bending our core investment principles
Do quants with algorithms have an advantage over other investors?
Conservative investors win – conventional investors lose
Thoughts on beating the market
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You can reach me by email at rodney@investingmotherlode.com
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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