Paladin Money

This is the first chapter in what will be a three-part series on self-directed investment management.  This part deals with some issues of investor behavior that we should acknowledge and determine how we are going to handle.  Part II will deal with investment timing and various entry and exit strategies.  Part III will deal with stops and protective strategies.

In this article we are not addressing a high-frequency trading model, although that doesn’t mean the findings here don’t apply.  The article is aimed at investors or trinvestors — those who partially apply trading rules to their investment decisions.

This article first started to take shape in my mind while I was reading an article in a  magazine written for financial advisors.  The gist of the article was that most individual or retail investors are hard-wired to buy high and sell low.  The reasoning being that people will invest when they are comfortable with the investing environment, i.e. when the market is nearing a high.  But they will sell when they are uncomfortable or frightened, i.e. at or close to a market bottom.  While we may all protest loudly that we don’t indulge in such behavior, I think if we’re honest we’ll certainly admit to having acted that way in the past or feeling as if we want to act that way on occasion.  The assertion made a lot of sense to me, and I have observed such behavior in others.

Now fast-forward to the Money Show in Las Vegas, and the Investors Business Daily presentation.  Here the argument was that Buy Low, Sell High was not a workable strategy in many cases — or at least not optimal.  The reasoning being that when a stock is at its low, it has so much pressure from above — that is, from folk who bought a lot higher, hung on along the way down to the lows, and will nowsell on any desperation rally –  that a stock can remain in the doldrums for a long time before it can recover.  Better, say the folk from IBD, to Buy High and Sell Higher.  A rising stock, they argue has no pressure from above, in fact below, and therefore, properly selected stocks will give the investor enviable gains.  I somewhat buy this argument, and I’m a sucker for momentum plays anyway.  In any event, if we can ride market perception of a particular stock, industry or sector, we are going to be way better off than trying to fight the market.  I think the good folk at IBD would allow that there are both fundamental and technical components to their stock picks, as evidenced, for example, by the IBD50.

I will always be one of the first to argue that Buy-and-Hold investing really ought to go the way of the Dodo.  My personal contention is that the technological advances that have radically changed how we all trade and or invest are partially responsible, but apart from that we are still looking a decade with zero gains from the S&P500 (actually negative if you nix out the dividends), a bear market every five or so years that takes a long time to recover from, and more.  All that said, in this month’s AAIIJournal there is article  by newsletter guru Mark Hulbert that should make you stop and pause before you start turning over your portfolio .  Hulbert describes how he “freezes” advisors’ newsletter portfolios and then compares them to the traded or adjusted portfolios.  Hulbert reports that two-thirds of the portfolios would have done better if the hadn’t “traded” — and, in fact, the traded portfolios made, on qverage. 3.4% a year less in returns (actually a 19% delta).  Hulbert also refers to some research from UC Berkley and Davis (The Courage of Misguided Convictions: The Trading Behavior of Individual Investors).  The full article is available from this link to the abstract.  The authors, Barber and Odean, make this opening statement:

This paper highlights two common mistakes investors make; they tend to disproportionately hold onto their losing investments while selling their winners and they trade excessively. We argue that these systematic biases have their origins in human psychology.

The researchers go on to conclude, and by the way, they analyzed a lot of trades:

…the entire sample over a one year horizon the average market-adjusted return on a purchased stock is 3.2 percent lower than the average market-adjusted return on a stock sold.

So, if investors had held on to their original purchases they would have been better off.  Therefore it should come as no surprise when the authors conclude:

These investors are not making profitable trades.

And flying in the face of my condemnation of Buy-and-Hold that:

“….the quintile of households that trade most frequently underperform their “buy-and-hold” portfolios, on average, by 7.04 percent annually.”

By now you are probably asking what the heck is going on here.  We are going to come back to these behavioral issues in steps II and III — but the one conclusion that cannot be escaped from this piece of research is that many, no, the majority of investors surveyed, will more easily sell their winners than their losers.  Do you know anyone like that? Perhaps intimately?

We will come back to this article briefly in the other two parts of this article but the initial conclusion is that investors should not be left to their own devices, as they are more likely to decrease their portfolios than swell them.  And the cause of this? Emotions and flawed judgement, but you knew that all along, didn’t you?  But what’s the fix?  The inescapable conclusion is then, that emotions and flawed judgement have to be removed from the equation as much as possible.  In practical terms, this calls for  a mechanical rules-based investing methodology that the investor might develop, but then not mess with.  The fewer judgement calls involved, the better.

In the next chapter we will look at removing judgement from entries and exits.

Tags: buy-and-hold