Sunday, May 13, 2007
Weekend Blogger Book Review, Part III
So in the last part of the article, I expressed my own doubts as to whether the retail investor can realistically expect to achieve the same returns as a well-connected, professional money manager (such as "The Fly"). In addition to Broker, it seems that many of you are at least somewhat skeptical too.
Now that we've briefly examined how corruption on Wall Street and luck tend to make the playing field uneven, I think that we can safely assume that "the game" isn't fair-- there doesn't really seem to be any debate on that point. However, I think that we ought to appreciate that "the game" is amenable to degrees of fairness (this is the part where the arguing comes in).
In thinking about this, we might wonder if the stock market is as fair as say, a slot machine (where your results are based entirely on chance), or is it more like Monopoly, where, while luck is a big factor, a lot of the game is also a function of one's skill. (Way on the other side of the spectrum, there are probably some people who would even argue that the stock market is more like Chess, where the role of chance is virtually zero.)
I think that the stock market is more like Monopoly (poker seems like a good analogy too). Sure, you might have some "unlucky" rolls of the dice and end up spending a lot of your time in the slammer, but if you're good at the game and know how to manage your properties, your skill will be rewarded. A good example of how skill trumps luck in Monopoly comes from my own childhood. Back in the good old days, me and my best friend used to play on a "team" against my brother and my dad-- and wouldn't you know it, those guys would beat us every single time (although there were a lot of games that we almost won). Of course, I always used to complain just before we lost about how they "just rolled good," and then I'd overturn the game and all of its pieces into my brother's face. But looking back, I now understand that we lost every time because my dad was way smarter than I was. I guess that, in a loose sense, he had "insider information." The only influence that luck had was in determining how much we lost by.
On the other side of the coin, there are many examples of how the savvy trader or investor is able to more than compensate for the occasional, "unlucky" setback with numerous, profitable trades ("The Fly" serves as an example).
But enough about that-- I'm getting off topic. So let's get this thing back to the main point (can the retail investor realistically expect to achieve the same returns as a well-connected, professional money manager?). Thus far in the paper we have developed the following assertions:
* It's a fact that Wall Street is at least partially corrupt.
* It's a fact that people have lost, and continue to lose money because of the corruption.
* It seems to be the case that the average investor is at a significant disadvantage to the professional (since the money manager benefits from the phenomenon of "asymmetrical information distribution"). Luck also appears to ensure that the playing field remains uneven, but its role becomes increasingly diminished across large data sets. As such, skill appears to play an increasingly significant role as data sets increase.
Given these obstacles to the individual trader/investor, it would seem that I'm at a disadvantage. So do I still think that the stock market is a game worth playing? Absolutely. The way I see it, I don't have to be doing better than--or as good as--Broker (or anyone else for that matter) to be successful in the market. Over the long-term, if I average even, say, 10.4% per year (the geometric mean of the S&P 500), I'm still winning. Thus, we can confidently anticipate success in the stock market merely by indexing. [Notice that indexing also appears to help diminish the influence of "luck"]
From the perspective of the "success through indexing," the question of whether or not the game is fair seems to become a non-issue. Only now does it become clear that we've been asking the wrong question all along! It seems that a much better question to ask would be, "is indexing the best way to make money in the stock market, and if isn't, then what is?" At first glance, my reaction is that indexing is not the best way to make money. But it doesn't seem obvious to me what that "better way" would be. To say that the "better way" is active portfolio management seems too vague-- we need something more specific, something such as a trading system that has a set of finite, rigid and well-defined rules. This is what I believe should be our new focus-- finding a method that exceeds the profitability of indexing.
In addition, the question itself appears to be problematic since it's hopelessly vague. As it happens, there are lots of different ways that we can pose this question (depending on how we characterize the terms within it). As a result, our answer (if we can even generate one at all) will change as our definition of the question changes.
In conclusion, I just want to say that this whole topic is much more complex than I thought that it was when I started writing this paper, and it seems to be raising more questions than answers-- which I think is still a really good thing. We could go on and on about this and talk about it much more, but for the sake of keeping things manageable, I'm afraid that I'll have to cut it short here (although there is plenty of more room for discussion in the "posting" area).
For next time, I'll try to tackle something a little less philosophical and a bit more practical. I also intend to have the entire article finished at least a week prior to its due date such that the structure "flows" and is more coherent (as this article tended to wander and drag us into a subject that is simply beyond the scope of just one weekend).
Later.
http://www.fpanet.org/journal/articles/2007_Issues/jfp0107-art6.cfm
So if a well-connected, professional money manager can't beat the indexes, what does that mean for the individual, or retail investor? I don't know. It is interesting to ponder, though.
While the well-connected money manager has an edge based on what I call "assymetrical information distribution" (they know things before we do, have better research, etc.) they are often unable to capitalize on such information due to the size they must trade, fear of SEC regs, the charter their fund operates within, etc.
Futhermore, professional money mgrs. are subject to the same biases as the retail investor. For example, Fly mentions losing millions in the early 2000s before he realized the market was not going to come back.
My point is I think that separating the professional money mgr. from the individual/retail investor muddys the water in terms of whether the market is "fair" or not. I can see distinct advantages on both sides.
I am a peon compared to the mutual fund fuckers. However, many of them are clueless.
That's a whole other story.
I believe there is a lot of variability in the way retail investors conduct their due diligence. Many will just rely on analyst reports and what they read on news websites online- secondary research.
Other retail investors will go a step further and do some primary research as well, in addition to filtering through the secondary research.
I believe it is this primary research, that plays a big part in their success rate compared to the 'other' retail investors.
Meanwhile, is it safe to say that almost all money managers conduct primary research? I would think so...
If so, then the playing field would seem to be more level within the world of money managers because they pretty much have access to the same types of information in general.
The skill part comes in for both retail and institutional investors, and it is mainly based on HOW all the information gathered is filtered and organized, in order to make the investment decision that will maximize profit.
I hope I didn't sound like a newb.
http://biz.yahoo.com/seekingalpha/070510/35190_id.html?.v=1
I too have been spending a lot of time thinking about the "passive beats active" phenomenon. I had actually bookmarked a page about it in Junuary:
http://www.marketwatch.com/news/story/paul-b-farrell-lazy-portfolios/story.aspx?guid=%7bDABA48D1-0DDA-43F7-8700-275FEF592BD1%7d&print=true&dist=printTop
I'm really interested in reading that link when I get a few extra minutes-- it looks promising.
So is it safe to say that the small investor/trader has enough distinct advantages over the larger mutual fund / professional money manager's asymmetrical information distribution to place them on equal footing in regards to market opportunity and "fairness?"
I don't think so. I believe that problems with liquidity, SEC compliance, and charter restrictions are a small price for them to pay to be in the privileged position that they're in. That is, I think that it seems like a good trade off for them-- but since it's difficult to actually quantify, I guess that it's tough to say. The fact that I've never had to face those problems also makes it difficult for me to offer up an opinion, as I can only imagine what they're like.
Anyway, you bring up a lot of interesting points -- keep 'em coming.
do not forget that there are many traders that never perform even the secondary research, nor primary research you speak of. They simply buy a stock because of the relationship between price and at least one other variable.
While there have been many traders who have been successful with this method, it is hard to say whether a more fundamental approach is better--hence the continued disagreements between technical analysts and fundamental analysts.
Jeremy-
With the research showing that the majority of professional money managers do not beat the indexes, I'm trying to figure out how the playing field is skewed in their favor.
In order for the professionals to hold an advantage, it must mean that the retail guy is performing much worse than the indexes. If that is the case, why do they continue? How many years do they continue underperforming before they quit?
It could very well be likely that most of the bloggers and traders that visit the blogger's sites have either been lucky, or skillful. It is likely that attrition has accounted for the unlucky and unskillful, and that is why we do not hear very much from that group.
Is anyone reading this willing to admit they've been underperforming a benchmark for any length of time? I have underperformed this year. Be honest. Who the fuck cares; no one knows who you are.
We do have research that shows that most daytraders don't last more than a year (I don't have the report handy, but it was based on brokerage reports). However, their failure is likely due to lack of skill and general naivete rather than an unequal footing overall.
What we need is about 100 retail investors (like we could really trust them?) willing to provide their annualized returns for as far back as they can go.
I'm still not convinced the fund mgrs have any advantage over the little guy. But if you pinned me down on it, I'd say the one advantage that cuts across markets, mgrs., skill level, etc. is CAPITAL. Starting out under capitalized is surely a disadvantage, and it may well be the one advantage that the professional fund mgrs. have over the rest of us.
Often, it's what people DON'T buy that determines their investment success.
That being said, the individual investor does have some advantages over mutual fund managers. For example, fund managers are at a disadvantage when there are massive redemptions by all the unwashed and uninformed masses. That forces a manager to liquidate all or part of a position that they might otherwise want to hold. The intelligent and informed investors simply hold or buy more stock at lower prices (like Fly has done with MVIS.)
Also, in bear markets, cash inflows to funds tail off significantly. That limits the funds available for fund managers to buy stocks at attractive prices.
One other phenomenon that I think works against fund managers is the practice of "window dressing." Did XYZ stock end up being the glamour stock for the quarter and is up 10% for the month? They will make sure it is in the portfolio in time for the quarterly report. They end up buying old news. The average Joe doesn't even know that they bought it 2 days before the quarter end--but wow, look at the top ten holdings for the fund!
It is no wonder that many fund managers do not outperform a passive index.
Not to be outdone in underperformance, individual investors also create their own failures. For example, take short term trading, or the stupidest thing an individual can do--day trading...(talk about putting yourself at a huge disadvantage to the pros!). How many times have you traded in and out of stocks only to find that the stock you sold has doubled or tripled six months later? And...the new stock you bought with the sale proceeds?...it's down 25%. (Not that something like that has ever happened to me, of course.)
I think that you're on the right track by trying to make our definition of little guy more precise by suggesting that somebody gather the data of 100 amateurs. That might help us to resolve the debate as to whether or not the pro has any real advantage-- but it still wouldn't be terribly useful since it couldn't give us a well-defined idea of what the little guy's potential is or how he would achieve it.
So yeah, I think the question is just a bad one altogether and that we should instead focus on trying to find the most profitable method available (whether that be passive indexing, Fly-like FA, Woodshedder-like TA, or Jeremy-like SA).
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