Thoughts on investing (and self reminder)

Investing is a difficult task, and similarly any degree of involvement in the decision process relating to managing one's portfolio (that starts with selecting or not an adviser) is a tedious endeavor considering, in the end, your lifestyle will be directly impacted by the overall performance. Thereafter is a summary of different thought processes involved in assessing one's annual financial strategy in view of one's financial plan. It could serve as a starting point for any further discussion with one's competent counsel in the matter of money management during annual reviews, as well as an objective evaluation of oneself when self-managing one's portfolio (for retail investors). The thought process I will present relates to the following 3 questions:

1. - How much should I invest?
2. - Can I follow the strategy I have defined, eventually supported by competent counsel in the matter of money management, or was the strategy properly executed?
3. - Can my portfolio beat the market, or some index I define as being my benchmark? 

How Much To Invest? ... is not the right question ! 

 

As a retail investor there are 2 questions to be addressed, and common wisdom is most probably not the appropriate answer: (1) How much excess cash flow do I have throughout the year, taking into account living, utilities and any maintenance expenses as well as required costs of insurances ? and (2) How much of that excess cash should I invest in a particular investment strategy in view of my current financial plan that may/should have more than 1 strategy?  .. which should trigger a third question relating to the relevancy of different strategies in view of one's financial objective(s).

Once the previous 2 or 3 elements have been addressed, the next step is to ground the notion of Investment, as defined by Benjamin Graham:

"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." — Ben Graham

Thus, the allocation of one's excess cash flow to an investment strategy shall be thought as being better off managed through one's portfolio investment strategy, rather than the following conception: "as soon as I have made enough profits, I will withdraw my original contribution and keep playing with the house money". The later has to be speculation, as apparently either the strategy involved carried too much risks for one's tolerance, or the contributed cash is actually required for your everyday expenses.

Finally, as one will investigate a strategy for potential investment, it may be relevant to ground the notion of price as a function of the previous statements such as:

We can think of market prices as hovering between two poles: (1) the “intrinsic value” price, the maximum price that investors would be willing to pay to own a cash flow stream if there were no liquidity, no ability to sell the investment, ever, and (2) the “bubble” price, the maximum price that investors would be willing to pay own a cash flow stream, however paltry, if they were certain they would be able to get out of the investment without losing money, and hopefully be able to get out of it making money, realizing a return simply from the trading process.

At that point, retail investors should be ready to objectively evaluate different strategies to participate in reaching one's financial plan, and start investing by following (=executing) the trading signals of selected strategies.

Following a Strategy

 

Once your strategy is defined (quite a subject in itself, and not to be discussed here) .... a very simple step remains: Following the strategy's investment signals (Buy, Hold, Sell) and start trading. Consequently, one could argue that the most important aspects of successful trading are discipline, consistency, and confidence, where discipline has very much to do with understanding the Role of behavioral finance in investment decisions, consistency relates to adjusting one's strategy and financial objective to one's time to manage such or partner with a competent counsel in the matter of money management, and confidence relates to understanding the rationals for the strategy that could partially be gained from strategy backtesting analysis.

Discipline: behavioral biases affecting you, and your performance

Many investors biases have been identified since the domain of behavioral finance was investigated as a scientific field, since late 1960 and initially by Daniel Kahneman and Amos Tversky. It is represented as the combination of behavioral and cognitive psychological theories with conventional economics and finance to provide explanations for how people make financial decisions, and most specifically those irrational ones. From my point of view, the early motivation, that still prevails, is the investigation of irrational and illogical investors behaviors that disrupt the efficient market theory of modern finance. Nonetheless, Eugene Fama, the founder of market efficiency theory, noted that many of the anomalies found in conventional theories could be considered shorter-term chance events that are eventually corrected over time. But a question remains: over what time frame, and are you, as a trader, negatively impacted by such during your decision ? 

My intuition is that retail investors are subject to these anomalies which have a statistically significant impact on their performance, principally due to the fact that their portfolio does not "represent", size-wise, the market, thus capturing part of these anomalies but without the benefit of long-term "market efficiency".

Behavioral Finance

A great introduction to Behavioral Finance and related investor biases is provided by Behavioral Finance [Vanguard] and Investopedia. There are lots of biases to be aware of but the following are the one I periodically remember myself of:

Representative Heuristic, my favorite when identified during introspection; From Efficient Markets Theory to Behavioral Finance [R.Shiller,2003]. This relates to judgments that tend to be made whereby people try to predict by seeking the closest match to past patterns, without attention to the observed probability of matching the pattern. Furthermore, this condition is usually enhanced by a biased self-attribution, a pattern of human behavior whereby individuals attribute events that confirm the validity of their actions to their own high ability and attribute events that discount their actions to bad luck or sabotage.

Disposition Effect and related Inertia; Are investors reluctant to realize their losses? [T.Odean,1998] ; This represents the tendency of investors to hold losing investments too long, and sell winning investments too soon. Investors' reluctance to realize losses is at odds with optimal tax-loss selling for taxable investments, which leads to Inertia, that is at play when people know they should be doing certain things that are in their best interests but find it hard to do today (saving for retirement, dieting ...). One negative aspect of the Disposition Effect is that it prevents investors from capturing tax losses by selling their losing investments whereas sophisticated investors reconcile tax-loss selling with the aversion to realize losses through a tax-swap, selling the losing position and purchasing a stock with similar risk characteristics, effectively maintaining a similar risk exposure.

Herding; Memoirs of Extraordinary Popular Delusions [C.MacKay,1841]; This illustrates a "price-to-price feedback theory", amongst which the famous tulipmania ! word of mouth leads to extreme upward or downward price movements as one individual envies the success of another (or vice-versa). Interestingly enough, findings in Predicting financial markets with Google Trends demonstrate that historical search volume interest for keywords applied on suitable assets carries highly predictive information on future trend, that is yet another illustration that word of mouth is a driver for generating investment interest, unless at any given time non-biased investors have uncorrelated similar trend.

Dunning-Kruger Effect; Unskilled and Unaware of It: How Difficulties in Recognizing One's Own Incompetence Lead to Inflated Self-Assessments [J.Kruger, 1999]. "People tend to hold overly favorable views of their abilities in many social and intellectual domains [...] in part, because people who are unskilled in these domains suffer a dual burden: Not only do these people reach erroneous conclusions and make unfortunate choices, but their incompetence robs them of the metacognitive ability to realize it." [...] Fortunately for the willing retail investor, there is also evidence that "paradoxically, improving the skills of participants, and thus increasing their metacognitive competence, helped them recognize the limitations of their abilities." [...] Thus periodic objective self-assessment should prevent "overestimating oneself, being satisfied by a minimal threshold of knowledge, theory, or experience that suggests one can generate correct answers", although without falling into the reverse condition that "without even an intuition of how to respond, people do not overestimate their ability, instead if people show any bias at all, it is to rate themselves as worse than their peers".

The previous biases may illustrate why the true cost of shorting stocks is probably much higher than the explicit interest cost of borrowing the shares, and why only sophisticated investors should use them; there are additional psychological costs that inhibits short selling : unlimited loss potential that short sales entail. When an investor buys a stock, the potential loss is no greater than the original investment. But when an investor shorts a stock, the potential losses can greatly exceed the original investment The effects of this pain of regret have been shown to result in a tendency of investors in stocks to avoid selling losers, but the same pain of regret ought to cause short sellers to want to avoid covering their shorts in a losing situation. People prefer to avoid putting themselves in situations that might confront them with psychologically difficult decisions in the future

To conclude on behavioral biases, I believe periodic objective self-assessment should lead to the following thought: Do Financial Experts Make Better Investment Decisions? [A.Bodnaruk and A.Simonov,2014]; "Private investments of fund managers perform on par with investments of investors similar to them in terms of age, sex, education level, income, and wealth. Even more striking, mutual funds managers’ investments perform more poorly than the private investments of the wealthiest 1% of investors. [...] Our results can be best summarized in the following way: financial expertise is of little value for investors in the top decile by investable wealth. It is plausible that marginal effect of financial expertise on investment decisions is trivial for these investors (note: the 1%), but is of larger importance for less well-off individuals." Although interesting for anyone partnering with competent counsel in the matter of money management, there remains a fundamental question to address: what type of retail investor can identify him/her- self to the 1% ? Considering these 1% are highly dependent on the country under consideration, there must some generic behavior attributable to the 1% for our specific interest of money management. My intuition is that it may be a direct correlation to ownership and education; ownership as making decision for your personal financial situation and eventually being responsible for poor decisions and correcting them, and education as a mean to objectively determine if one is able to self-manage one's wealth, either partially or entirely, or not at all but educated enough to select appropriate competent counsel in the matter of money management with the underlying understanding that involvement will nonetheless be required annually for financial plan review.

As a side note, and being a believer in diversification (although proportionally to one's wealth), I do believe this applies to who is managing one's funds. Thus even if self-managing, its always a good thing to partner with a third-party adviser with partially allocated funds as part of the overall portfolio strategy.

Consistency

 

It is most probable that a strategy was selected as part of a financial plan from the analysis of past performances. A strong hypothesis is that future performances should be similar to past ones, but there is yet a similarly strong assumption that, unless the analysis was carried out by randomly taking into account part of a strategy trading signals, following each trading signal will be performed blindly, consistently, in other words mechanically. The later assumption carries quite some risks for retail investors, but hopefully, being better equipped with the understanding of behavioral biases and their impact on financial performance, such an issue may be mitigated by increasing self-control.

High Self-Control Predicts Good Adjustment, Less Pathology, Better Grades, and Interpersonal Success. [J.P. Tangney,2004] Anecdotal impressions and assorted research findings suggest that substantial individual differences exist in people’s capacity for self-control. Some people are much better able than others to manage their lives, hold their tempers, keep their diets, fulfill their promises, stop after a couple of drinks, save money, persevere at work, keep secrets, and so forth. These differences seemingly ought to be associated with greater success and well-being in life. [...] Regulating the stream of thought (e.g., forcing oneself to concentrate), altering moods or emotions, restraining undesirable impulses, and achieving optimal performance (e.g., by making oneself persist) all constitute important instances of the self overriding its responses and altering its states or behaviors. More generally, breaking habits, resisting temptation, and keeping good self-discipline all reflect the ability of the self to control itself, and we sought to build our scale around them. [...] Central to our concept of self-control is the ability to override or change one’s inner responses, as well as to interrupt undesired behavioral tendencies and refrain from acting on them. 

This notion of self-control and consistency can be enhanced by sufficient confidence in a given strategy, as a grounded rational when doubt arises ... and it will. This partially explains why I keep saying "Maths talk, people mumbles", that Jack Bogle (founder of Vanguard) would apparently tend to agree with:

"Confidence in the mathematics — the relentless rules of humble arithmetic — enables you to get through"

Confidence

 

It is no surprise, at this stage, that I'm a proponent of Mechanical Trading Systems (MTS) to automate the entire decision process of trading, and ideally Automated Trading Systems (ATS) to automate both the entire decision process and the entire management of trading orders. ATS would prevent most of behavioral biases besides few selected ones (being better than your system, shutting down for whatever reason), but requires a relatively sophisticated approach to financial investment. Thus most retail investors would rely on MTS during which all of the previously stated biases may occur. To that end, I recommend 2 easy and short reads that gives a practical illustration of a group of participants following the same MTS: The original turtle trading rules, and the story of pre-retirees shifting their strategy from absolute value return, to Dividend Growth Investment.

Before we go any further, remember the following from the Mathematical Investor: The Renaissance Fund, an ATS fund founded by brilliant mathematician James Simons, has produced an average annual return of 35%, after fees, over a period of 25 years. Yet other quantitative funds have failed, sometimes miserably. Solid, mathematically-driven investment methods are as profitable as they are scarce!

There is a need to build confidence in a MTS and that is achieved by backtesting and understanding fundamental economical rationals enabling the formulation of said strategy. To backtest strategies in a proper way, the following 5 steps should be involved:

1. - Look-ahead bias: Preventing the use of data that would not have been known during the simulation period. This could be easily avoided if using an event-driven backtesting framework such as Quantopian, PyAlgotrade for python savvy investors on their way to building ATS, or ETFreplay (and similar) for non-coders evaluating MTS.
2. - Survivorship bias: Preventing the tendency to exclude from the data (=universe of financial instruments carrying a potential of investment) failed or delisted companies during a simulation. This could inflate your results or simply show as profitable a non profitable strategy.
3. - Liquidity bias: Preventing non-realistic investment in illiquid stocks, that would not have been able to be purchased in such quantity, or at all.
4. - Investigating performances before and after broker commissions.
5. - Using in- and out- of-sample data for development and validation respectively to prevent over-optimization (curve fitting). 

Again, at this stage, a retail investor is well equipped to perform backtesting investigations on different strategies for inclusion in the overall financial plan. But remember, the underlying objective of these actions is to provide support when doubting a strategy endangers Consistency (following trading signals). To deliver the required and expected support, backtesting should also be investigated objectively, that is understanding its inherent limitations.

Past Performance is No Guarantee of Future Results 

Although to this stage the discussion may provide a high level of confidence for a given backtested strategy, keep in mind that "past performance is no guarantee of future results", that is future returns. A great example of MTS shortcomings is the Google flu trend system detailed in "Detecting influenza epidemics using search engine query data ; Nature 457, feb. 2009". Although it carried great potential and demonstrate strong performance during backtest and some level of forward testing, occasionally the Google flu trend got confounded by previously unseen events that negatively impact performances; As stated by John Brownstein, an epidemiologist at Harvard Medical School in Boston, Massachusetts: 

"You need to be constantly adapting these models, they don’t work in a vacuum. You need to recalibrate them every year."

This assertion is perfectly suited for MTS and ATS. Consequently, during periodic objective self-assessment, one should carry a review of the selected strategies for assumptions confirmation, in view of supporting backtest, as a grounding effort to support Consistency in following future trading signals. Eventually, this might explain why long-term successful retail investors say "the fewer parameters in a model, the stronger your confidence could be", that similarly illustrates the following concept that the fewer the number of parameters involved in a MTS thus required to adapt to unforeseen (future) events, the better.

Finally, disregard the concept that confidence arises from data, or stated differently the more data does not mean the better. Indeed the more data, the better insight, but only for the statistically savvy strategy designers that do understand big data pitfalls, and seek for causation rather than correlation; "If you have no idea what is behind a correlation, you have no idea what might cause that correlation to break down."

So we are getting there, but one aspect remains while defining, and following, decisions relating to investment. What rational should be involved in assessing the performance of investment strategies in view of one's financial plan: does your decision effectively provide you with a market edge, compared to buying'n'holding market-like indexes as suggested by Warren Buffett:

My advice … could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

Although setting performance rationals is part of one's decision, and no generic answers could be provided as it should be a direct relation with one's financial situation and objective, it is important to understand the notion, and extend of, Beating the market.

Beating the market

 

The long-term dynamic of beating the market, is very well analyzed in "Mission Impossible: Beating the market forever". It basically concludes that:

1. - Earning 25% — or more — compound annual returns over long horizons is virtually impossible, as one would end up owning the entire stock market.
2.  A “doable” 20% a year implies that an investor will own 0.026% of the market at the end of 2013. With a $25.6 trillion total market value as of 31 December 2013, this implies a personal stock portfolio worth $6.6 billion — not a bad retirement plan. Proof is: Warren Buffett and a selected few others represent some of the richest people on the planet.

In essence, the previous analysis can be illustrated by the following excerpt:

If value-weight market returns reflect a binding constraint on the collective investor experience, how long can an individual investor “beat the market” before he actually becomes the market? As it turns out, compound growth prevents skilled investors from beating the market forever. This result is counter intuitive but follows the established behavioral bias that humans have a hard time understanding the implications of compound growth. Al Bartlett, professor emeritus in nuclear physics at the University of Colorado at Boulder, states this bias succinctly: “The greatest shortcoming of the human race is our inability to understand the exponential function.”

Consequently, when defining financial objectives, and related strategy benchmarks and threshold performances, a first step toward building Confidence as support for Consistency to further prevent behavioral biases negatively impacting your performances, is to define realistic objectives (subject for another blog post).

Conclusion

 

It is my personal opinion that knowing who you are in terms of investor (Goetzmann and Massa, 1999) is fundamental, and it may be very different than who you are in your professional and personal life. This explains why I'm a firm advocate for periodic objective self-assessment in view of your financial plan. You may very well conclude that at some point in your life your ability is adequate to self-manage part of your wealth, while not adequate at all at another point in time as a direct result of past life events, or by objectively assessing one's ability to take responsibility for future considerations (ownership of potential failures in planing for retirement). Nonetheless, periodic reviews should provide a rational decision that is comfortable, although it may oscillate between the two.

There exists lots of literature to support the notion of objectively assessing oneself. I personally use the following non-directly related literature, to both educate myself and question my past decisions and rationals for investments:

1. Cognition, creativity, and entrepreneurship [T.Ward,2004]
2. Warren Buffet's Berkshire Hathaway Inc. shareholder letters.
3. The Intelligent Investor, by Benjamin Graham

On average though, do remember the following from the Dalbar reports:

Every year the conclusion [of the DALBAR report] is the same: On average, investors earn less than mutual fund performance figures imply. Sometimes they earn much less. … One conclusion: No matter whether the market is booming or busting, “Investor results are more dependent on investor behavior than on fund performance.” Investors who buy and hang on are consistently more successful than those who move in and out of the markets. 

Over the past 20 years, “equity fund” investors achieved an average 5.02% annualized return, which is 4.2% less than the 9.22% that he/she could have achieved by simply investing funds in an S&P500 index-tracking fund. This gap expanded in 2013, for only the third time in ten years.

Nonetheless, I will leave you with the following personal intuition as a positive end note: At relatively similar investment competences and abilities, self-managing your investment portfolio will statistically carry higher chances to beat the market, as a direct relation to its value compared to the overall market size; Similarly, the larger a portfolio value, the more market-like it becomes, and thus the more skilled one has to be to beat the market, which illustrates the inherent limitation to be aware of when investing in large funds.

NOTICE if some material/information is lacking reasonable references to the original author, kindly email me of such with appropriate information and I'll make the necessary changes.