Monday, September 10, 2012

Investors Are Often Their Own Worst Enemies, Part II

A follow up to this post.

Investors Are Often Their Own Worst Enemies

This paper*, created by Professor Terrance Odean and Professor Brad Barber, asserts the following:

"...active investment strategies will not outperform passive investment strategies. Both the theoretical and empirical work on efficiency supporting this view have led to a rise of passive investment strategies that simply buy and hold diversified portfolios (Fama (1991)).

Behavioral finance models that incorporate investor overconfidence (e.g., Odean (1998b)) provide an even stronger prediction: Active investment strategies will underperform passive investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below-average returns. Consistent with these behavioral models of investor overconfidence, we provide empirical evidence that households, which hold about half of U.S. equities, trade too much, on average. Those who trade the most are hurt the most."

Odean and Barber don't really attempt to address how valuation fits into the equation.** The paper is mostly about just how much investor overconfidence and trading hyperactivity meaningfully subtracts from returns.

This Forbes article makes the point that most would be better off just buying index funds while minimizing trading and, based upon the evidence, it's hard to argue with that.***

Buying and holding index funds (and ideally having at least some sense of when the market is selling at valuation extremes) for anyone that does not have the background to effectively evaluate the shares of individual companies. The paper doesn't address, understandably given its focus, buying shares of the great durable business franchises and owning them for a very long time. Yet, owning high quality individual stocks for a very long time (ie. extremely low portfolio turnover much like an index fund), carefully evaluated and bought cheap, is a legitimate alternative to indexation for some and ought to be considered on its own merits.

One of the papers key conclusions is that less trading activity produces better results.

Well, owning long-term a basket of high quality individual stocks, minimally traded, would seem to fit that description. In any case, I'm suggesting it shouldn't be lumped in with all other active investment strategies just because an infrequently traded stock portfolio (quality shares bought with a margin of safety, of course) is not part of an actual index fund. It's fairly obvious, at least it would seem to be, that not all forms of "active" investment management are equivalent. An investor with an individual stock portfolio with turnover of 2 percent is technically "active" but shouldn't be put in the same category as those with 200 percent.
(An average holding period of 50 years versus just 6 months...just think of the difference in frictional costs that have to be overcome!)

With low expenses (fewer frictional costs) and minimal turnover (likelihood of fewer mistakes) there is, much like an index fund, substantial long-term advantages to owning a portfolio of well chosen individual stocks.

The ability to judge individual business value consistently well is, of course, essential.

In addition, this approach may help to mitigate though doesn't eliminate the many reasons investors can be their own worst enemies.

Otherwise, like owning a broad-based index fund, the returns are driven by growth in per share intrinsic value of the businesses themselves, not unusual trading skills. It is, naturally, a necessarily more concentrated approach than most index funds. So diversification is certainly lost but:

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

"Diversification is protection against ignorance. It makes little sense if you know what you are doing." - Warren Buffett

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken." - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group

Those not comfortable judging the risks associated with individual stocks clearly require more diversification will find indexation make more sense. Knowing one's own limits, as always, is the key before a penny of capital is put at risk. Choose the approach that fits real (not imagined or hoped for) capabilities.

Index funds tend to outperform (not traded excessively) many active participants. They do so, at least in part, because of the low frictional costs and the fact that value creation comes from the increase in per share intrinsic value of the businesses themselves over time. If traded minimally, it's a convenient way to avoid the pitfalls like the illusion of control and, more generally, the overconfidence that hurt investor returns. Those who know how to judge businesses well (and what to pay per share) but otherwise take a rather passive approach can gain a similar advantage by owning individual stocks.

No matter what approach is chosen, the potential adverse effects of overconfidence never completely disappear. Some might dismiss or underestimate overconfidence as being a minor factor when it comes to producing attractive risk-adjusted returns. That's a mistake. It's a big factor for most and the paper does a nice job of revealing this. The temptation to sell or buy too frequently -- causing investors to trade excessively -- leads many to make costly mistakes.

Individual stocks can be owned long-term with returns primarily driven by the the performance of the businesses themselves. The approach has little need for extraordinary trading skills and by its nature minimizes frictional costs.

Both index funds and purchasing individual stocks -- with the intent to own long-term -- can be wise alternatives to the many all too popular casino-oriented approaches. There's just so much focus on near term price action with them.

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

Compare the ratio of advertisements on the various business media outlets that emphasize generating returns via passive strategies (i.e. primarily generating returns via the per share intrinsic value created by businesses over the long haul) to those that emphasize active strategies (i.e. primarily generating returns via bets on near-term price action). That ratio reveals much about the current extremely short-term oriented culture of speculation in lieu of investment.

It simply plays into the worst instincts of investors.

An overly confident view can lead to excessive trading but the downside is hardly just the explicit additional frictional costs. There's evidence that, at least for many participants, the added moves are just an opportunity to make (and frequently become) additional mistakes.
(Though it's not easy to convince a highly confident participant of this.)

To me, it's folly to allow excessive trading costs, and a too optimistic assessment of near-term informational advantages, to be the wind in your face. Better to allow the long-term effects -- the compounding of business value over time -- to be the wind at your back.

The returns derived from a good businesses bought when Mr. Market happens to offer shares at a discount to value doesn't require exceptional trading skill or something like a near-term informational advantage. Instead, it requires understanding long-term prospects, what those prospects are worth, and yes, at least a reasonably even temperament.

In fact, whether passively an owner of individual stocks or index fund, the intrinsic value created by the businesses themselves does the heavy lifting as far as generating long-term returns.

The price paid versus value (buying with margin of safety) naturally always matters.

The key is really just having a long time horizon, the patience to wait for a good price, and, again, reasonably good judgment of what businesses are worth (and how that worth is likely to change intrinsically over time).

Not everyone buys a stock or an index fund with the idea that they have a near term informational advantage or extraordinary trading skills. Nor is every participant is trying to outsmart the market near-term (though I think fewer should be trying to do so and instead be focused on long-term values). As the paper maintains:

"Active investment strategies will underperform passive investment strategies."

I believe the evidence to support that is substantial. Yet it sometimes seems to be assumed that an index fund is the only passive strategy available to investors. It isn't.

Investors sometimes underestimate how much investor overconfidence, excessive trading, and other frictional costs subtract from returns.

The illusion of control is just one of many good examples how overly optimistic appraisals of prospects and abilities actually hurts long-term performance. If one enjoys creating additional activity for its own sake I suppose that's fine, otherwise, it's extra effort that's often less than fruitless.

Adam

Related posts:
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

"Trading Is Hazardous To Your Wealth"
** Clearly, whether you are buying an individual stock or an index fund, what's a smart buy at one valuation is rather less so at another. (See what Warren Buffett calls "The first law of capital allocation" in the Share Repurchases section of the 2011 Berkshire letter.) Buying with the idea of holding long-term when a quality stock (or basket of stocks) is selling at ~ 30 times earnings or more, in all but the exceptional case, likely doesn't make much sense. Some may even be able to reliably find those exceptional cases without making big mistakes along the way. Just watch out for overconfidence. It wrecks returns. Now, when shares of good businesses (those with durable advantages, high return on capital, reasonable debt levels, etc.) can be found at 10 times earnings or less...
*** Many index funds were tough to own this past decade plus but that's mostly the result of extreme valuations that were prevalent across many sectors. Many indexes were a decade and more ahead of themselves in terms of valuation (though plenty individual stocks were not). 30 to 40 times earnings and more was all too frequently the norm. In the late 1990s, valuations for many stocks (not just tech) were just plain silly. In more recent times...much less so. 
(Even if today's market indexes aren't particularly cheap, more than a few individual stocks have been cheap often enough to make buying shares of good businesses to be held long-term more doable.)

Buffett and Munger Writings & Speeches
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