Thursday, September 5, 2013

Deadly Sins Of Investing

This Wall Street Journal article, The Seven Deadly Sins of Investing, covers some things that tend to get investors into trouble; things that lead to reduced returns, or worse, maybe even disastrous results.

Here's a quick summary of the first three "Deadly Sins":

1 Chasing Recent Performance

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

Chasing what has done well in the recent past just isn't likely to be a path to riches. During the tech bubble many market participants couldn't get enough of the high flyers -- stocks that went from already very overvalued to valuation extremes rarely seen -- while many bonds and other much less exciting marketable securities were rather more reasonably valued if not cheap.
(At least by comparison cheap if not absolutely cheap.)

"Recency bias" can be very expensive for investors.

That crazy time in the stock market wasn't solely caused by recency bias, of course, but the tendency played at least a supporting role.

2 Being Overconfident

It's easy to mistakenly believe more is known about something than is actually the case; to think that what will happen can be reliably predicted when, in reality, there is a rather wide range difficult to gauge future outcomes.

Outcomes that few if anybody can predict with consistent success.
(Though, no doubt, someone in the prediction business who correctly -- even if mostly through random good luck, less via skill -- predicts an outcome they will heavily tout the accomplishment for marketing purposes.)

"The illusion that we understand the past fosters overconfidence in our ability to predict the future." - Daniel Kahneman in his book Thinking, Fast and Slow

In any case, for investors, thinking that future business prospects can be understood to a greater extent than is possible is no small pitfall.

As Warren Buffett has previously explained:

"If a business is complex or subject to constant change, we're not smart enough to predict future cash flows."

Buffett goes on to say that the best way to combat this reality is to 1) own simple, understandable (to oneself...that's necessarily unique to each investor), and stable businesses while 2) always buying with a margin of safety. An acute awareness of limits doesn't hurt. What matters is not how much the investor knows; it's rather how well they understand what they do not know.

That might make sense for someone who rightly concludes they can pick individual stocks. John Bogle would more than suggest too many kid themselves in this regard. 

Hard to argue with that.

Related: Fighting Investors' Greatest Enemy: Overconfidence

3 Overlooking Costs

Frictional costs of all kinds, if minimized, play a huge role in achieving satisfactory or better long-term returns.

As John Bogle said in this Frontline report earlier this year:

"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

Bogle: High Investment Costs Destroy 'Magic Of Compounding Returns'

2.5% in annual frictional costs means that way too much of investment returns does not go to who is putting the capital at risk. A large proportion of the long-term compounded returns is going to someone who isn't exposed to the risk of permanent capital loss.

Wait, isn't 2.5% too high? Mutual funds usually charge a whole lot less than that, right?

Well, explicitly yes, but...

According to John Bogle, if you include all the costs -- some explicitly visible, some less so -- it's more like 2.5% or so.*

Here's what Bogle had to say in this not at all recent but still very relevant PBS interview:

"...the financial system -- the mutual fund system in this case -- will take about two and a half percentage points out of that return, so you will have a gross return of 8 percent, a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000. One hundred ten thousand dollars goes to the financial system and $30,000 to you, the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

So what does Bogle say to those that think they can "beat the averages"?

"I say, don't kid yourself, pal."

He also said the following in this Forbes interview:

"I look at [the] investment system as being deeply troubled. Our system costs too much and does not provide enough value. The more you pay, the less you get net. If the market gives 8% return and it costs 2.5%, you get 5.5%. That's what is called 'the relentless rules of humble arithmetic.' There is too much cost in the system and not enough value.

There is too much speculation and not enough investment."

Absolutely true. Still, whether this is well enough understood or not, it seems likely that way too many investors will continue to incur these huge costs.

Unfortunate, but it's not like there isn't convenient ways to not incur these costs.

Three down, four to go.

More in a follow up.

Adam

Deadly Sins of Investing - Part II

* Anywhere from 2% to 2.5% has been used by John Bogle at various times from what I've read. Either way, it comes out to quite a material amount of money over the long haul.
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