Tuesday, April 3, 2018

Chasing Money Ghosts

Dumb luck or smart strategizing?

Update Apr. 17, 2018: This post has been

I'm a fan of Jim Collins, also known as jlcollinsnh after the URL of his blog.

Apparently, Google is also a fan! They hosted him for a Talk at Google in Chicago, which you can view in its entirety on YouTube, right here:

Good stuff! But one commenter with the handle 'jimbush80528' posted that "several strategies are earning 18% per year (the past 10 years) while the SP500 is averaging 7%."

That whooshing sound you hear is Collins' point going right over this commenter's head! Furthermore, as several other commenters pointed out, the S&P 500 has averaged far better returns than 7% over the past 10 years [7% is the inflation-adjusted historical return since the late 1920s].

Notice how every investment product has the disclaimer "Past performance is no guarantee of future results." That's no accidentthe SEC requires it.

Do you want this sneaky guy to mislead YOU about an investment?
Do you want some sneaky person telling you that, since a certain investment did well in the past, 
it'll definitely make you rich if you invest in it right now? Didn't think so...
I'd like to analyze this comment a bit. So here goes:


While it's entirely possible that some strategies have taken advantage of particular market conditions to beat the S&P 500 over the past several years, the market gains since the 2009 crash have been absolutely incredible! The strategies mentioned by this commenter may do well when the market is rising at a nice clip.

But what will happen when the market drops? I suspect the tradeoff for the good performance in the 2010s is catastrophic failure whennot if, but WHENmarket conditions change. To use an analogy, market-beating strategies in a bull market are akin to a high-revving race car engine: it may make more power than its competitors, but also has a higher risk of blowing up as the track gets hotter. 18% returns are unbelievably high. If it were a) legitimate/legal, and b) sustainable indefinitely, the secret would come out and everybody would be doing it!

If anyone promises you 18% returns on an investment...run away!

Somebody who beats the market by 0.5% consistently may be skilled at exploiting market inefficiencies. But if somebody beats the market by 10% consistently, you should smell a rat. The history of investing is littered with extraordinary returns that ended up being illegitimate.

Yeah, I know, this is a mouse, not a rat. Whatever, the picture is royalty-free and beggars can't be choosers...
I would stake a sizable wager that costs like management fees and capital gains taxes are not included in the "18% returns." If those costs were included, they would narrow the gap considerably vs. a buy-and-hold indexing approach.

CAN SLIM? Or 'can slim' your wallet?

In a subsequent comment, jimbush80528 cites the CAN SLIM approach of William O'Neil. Ben Carlson at A Wealth of Common Sense reviews the CAN SLIM approach here, and demonstrates that Vanguard's mid-cap growth fund yielded better returns in the real world than a CAN SLIM-type mutual fund. His analysis does count things like costs and taxes.
This is a perfect illustration of somebody looking at historical returns, using a technique like multiple regression to devise a strategy, and then trying to apply it to the market right now. This is a fool's errand; such an approach amounts to chasing ghosts.
By the time the back-tested strategy has been thoroughly vetted, the market will have probably fundamentally changed in unpredictable ways. What worked back then—no matter when 'back then' is—isn't necessarily going to work in the future. In fact, it's probably NOT going to work in the future! Hence the SEC's disclaimer about "past performance."

Don't chase ghosts when you're investing
Don't chase these; they're supposed to chase you!

Nobody, not even Jim Collins, is saying that beating the market is impossible. What he's is saying is that beating the market consistently over a long period of time across different market conditions is vanishingly difficult. And when some strategy successfully beats the market for several years in a row, that's probably due to dumb luck, not smart strategizing.

Numerous studies by academics with no vested interests have shown that consistently high performance is incredibly rare. There's one key question that Bogleheadslike Jim Collinswant to know about any strategy: "Is it sustainable?" One study by the S&P Dow Jones Indices (summarized here by the New York Times) showed that 2 out of 2862 professionally-managed funds stayed in the top 25% of performers for 5 straight years from 2010-2014.

That's just shy of 0.07% of investment managers that were consistently among the top quarter of their profession. Not 7%, not 1%, not even 0.1%.


That's 7 out of 10,000. There are two possibilities here:
  1. Less than a tenth of a percent of financial experts are skilled enough to consistently beat three-quarters of their competitors.
  2. Less than a tenth of a percent of financial experts got lucky.
Remember the stock-picking cat from a few years ago? The one that outperformed professional investment managers? If you think possibility #1 applies to the top-performing fund managers, then if Orlando the cat continued his well-above-average picks for 5 years, you'd have to assume that possibility #1 applies to Orlando as well.

Throw enough of these, and you'll eventually hit the bulls-eye. But when you do, it doesn't mean you're a pro...
Throw enough of these, and you'll eventually hit the bulls-eye through sheer dumb luck.

Another analogy: if you played blackjack 10,000 times and hit a 'natural' 7 times, would you conclude that you're a skilled blackjack player? Or would you suppose that you just got lucky on a very small proportion of your games?... Jim Collins, along with many other Bogleheads (like myself) argue that #2 is the casewhether you're talking about a professional fund manager, a cat, or an algorithm.

The Boglehead investment philosophy is that it is wise to avoid the headaches of trying to pick winners, because if you try to pick winners and dump losers, you. will. fail.

And, of course, buy-and-hold indexing has been shown to be very effective in the long run, spanning a variety of different market and legal conditions.

Don't chase money ghosts. You'll only outsmart yourself.

P.S. If you watched Jim Collins' talk, you'll hear him relate the apocryphal story about a Fidelity study finding that dead investors performed the best. Funny, and a good story, but not true.

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