Moneyball for Investing

Michael Lewis wrote the book Moneyball (which was later turned into a movie) about how the Oakland A’s used statistics to put together a winning baseball team.  Prior to the “nerds” running the team, they followed the status quo, using traditional scouting and talent development.  And why not?  This was the way it was done since the beginning of the sport.  In the same context, Nate Silver is a statistician and New York Times columnist who has been involved in all sorts of disruptive projects using statistics, but is most well known for his accurate prediction of the last presidential election using data from polls and not following any particular pundit or narrative being espoused by the media. 

He was recently interviewed by Fortune magazine and had some interesting things to say about data and how it can be manipulated.  What I found most compelling is that much of the media and narratives that were told about the election were from people that had a particular agenda.  That can be a dangerous thing since they will tend to ignore data that doesn’t support their cause while focusing on the data that helps make their case.  As I thought about this, you can see this in many of the areas where “Moneyball” is being played:

  • A right or left leaning political pundit will focus on data that supports their point and ignore the rest
  • A traditional baseball scout will tell you that math and stats should not be as important as their own experience in judging talent
  • A recruiter would typically interview a candidate based on personality and past experience and their own gut feeling of a good or bad fit

There are two things that these people have in common.  First, they have something to lose if their traditional systems were to be changed.  Second, they don’t take an objective view of the data.  This idea of using data to challenge conventional wisdom is very compelling to a firm like ours, who focuses on the data.  So, when Nate Silver was asked about investing, I was curious to see his response:

Can people use data or analytics to accurately predict the stock market in any way?

The problem is the stock market is this whole contest where you’re competing against other creators. So the question is: Are there some traders that are better than others? I think the answer is probably, Yes. I’m not a pure markets guy, I played poker long enough which I think has parallel skills to trading in many respects where you know that some people are better over the long-term and better at accounting for uncertainty and so forth. But there’s a lot of volatility and a lot of luck where a market cycle can last for months or years. There are a lot of perverse incentives that get in the way. So while I think there are some good traders, in the near term, even over a period of five or 10 years, it will mostly be dictated by luck, so it’s tricky.

One of the great parts about being an independent advisory firm that does not accept commissions is that we have no incentives to sell a certain product or focus on a particular strategy.  We believe our model removes the problem of having something to lose that plagues the baseball and political professions.  While investors love to hear stories and narratives, we do believe that data should be the overwhelming factor in developing an investment strategy.  Silver’s point that performance is mostly dictated by luck is not a narrative that investment managers want to hear.  This is their livelihood at stake so it is not an idea that will be echoed by the industry even though the data overwhelmingly supports his view.  As this idea of Moneyball (using data to dispassionately make decisions) becomes more prevalent in our industry the traditional money management business will have a hard time surviving in its current form.

Why We Don’t Use Stop Losses

Many advisors recommend that their clients use stop losses as a risk management tool in their portfolios.  A stop loss is a type of trade that executes once a stock falls below a certain value.  A typical strategy would be to have a stop loss sale happen when a stock drops 5 or 10% below what you paid for it.  On the surface this makes total sense….if the market is falling I want to get out before any real damage is done. 

If only it were that simple. 

Here is a piece of data that I have shown before that is relevant to this discussion:

Average Frequency of Market Corrections (1900-2010)
5%:  3 times per year
10%:  Once per year
20%:  Once every 3.5 years

The market falls 5% three times a year on average, but it only drops 20% once every three-and-a-half years.  That means, on average, the market will drop 5% or more 10 times before it actually loses 20%.  If you are using stop losses when the market loses 5%, you are getting out of the market each time this 5% loss is breached.  There is a very good chance you are getting back in at higher prices.  You may miss the big drop, but the other 9 times that the market reverses course is probably costing you money.  This is the textbook definition of getting “whipsawed”.  

There is no silver bullet when trading.  We believe the best strategy continues to be developing an allocation that you can live with (in regards to risk and return) and sticking with it. 

Apple Lost a Google

Apple has been a spectacular company and stock over the past couple decades.  Since the debut of the iPod, the stock is up some 9,300%!  They became the largest company in the world only to realize a spectacular crash since September of last year, losing their top spot to Exxon Mobile.  The company has lost approximately $250 billion in market capitalization, equivalent to the size of Google!

Here lies the problem of investing or concentrating your assets in one company.  The risk and return characteristics are just not favorable.  The expected return of an individual stock and the overall market tend to be similar.  The difference is the risk.  Here is a risk/return chart from IFA of the the market versus the individual components of the Dow Jones:

It is a little hard to read but the grey “SP” represents the S&P 500 while the blue squares are companies within the Dow Jones Index.  What you will find is that the S&P had returns similar to the average of the companies in the index, but it had less risk than every one of them.  This is another great example that the only free lunch in investing is diversification.

Entertainment vs. Advice

Jim Cramer, the popular television host of Mad Money, is a larger than life celebrity who started as a hedge fund manager and has now moved on to media mogul.  His show, which is aired daily, dispenses stock market wisdom in an entertaining style.  As investors, it should stop there…as entertainment.  Unfortunately, there are many who view his show as advice, and this has been detrimental.  Here is the Pundit Tracker Blog who recently audited his performance:

On average, Cramer’s picks returned -0.08% versus the 1.35% S&P 500 return over the corresponding period. That amounts to 142 basis points of quarterly underperformance, or 568 basis points on an annualized basis, which amounts to an F grade in our grading system. (We award an A for 500+ basis points of annual equity outperformance and an F for 500+ basis points of underperformance).

Performance aside, the point of this post is not to bash Jim Cramer or any other TV or radio host.  It is to remind you that professionals that don’t know you, can’t give you worthwhile advice.  Managing your assets has more to do with things like the amount of risk you are willing to take, the time horizon of when you will need the assets, inflows and outflows that will happen in the portfolio, and your past investment experience.  A true professional can take these client related issues and combine them with external factors like current economic conditions, investment markets, and risk management factors to develop and implement a plan.  It’s not as sexy as screaming on TV but a real advisor will have a much greater impact to your wealth.

This is Your Brain on Stocks

In the famous anti-drug commercial, a man holds up an egg and says “this is your brain”.  When he cracks it in a frying pan, he then states, “this is your brain on drugs”.  When it comes to investing, It seems as if our human brains are hardwired to struggle.  This chart from Blackrock confirms it. 

S&P 500 Index Performance vs. 12-month Equity Mutual Fund Flows

In order to survive our ancestors had to develop a fight or flight response to threats.  While this response has protected us from all sorts of danger throughout history, it actually has a negative influence on our investment performance.  Investing requires us to do what is unnatural…to run INTO the fire, so to speak.  This chart shows that most investors have a hard time fighting this emotional response.  Money invested in mutual funds plummet at the same time the stock market hits bottom.  It seems as if the old adage of “buy low, sell high” has been replaced with “buy high, sell low”.  It is just too hard for us humans to overcome thousands of years of training.  

As investors we should try to set up systems that can help counteract these emotional tendencies.  Things like dollar cost averaging, rebalancing and professional money management can help lessen the burden of investing and bring discipline to the emotions that will ultimately come with seeing your hard earned dollars rise and fall.  In the end, those of us who can conquer our flight response to threats in the investment markets will be handsomely rewarded.  

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.