Thursday, June 22, 2006

>> Apprenticed Investor



[Apprenticed Investor: Know Thyself]

"He who blames others has a long way to go on his journey. He who blames himself is halfway there. He who blames no one has arrived."

Statistical evidence suggests a high probability that you underperformed the broader market last year, and most investors will likely underperform again this year. But it's not just retail investors. The pros are barely any better. In fact, four out of five investors will do worse than the S&P 500 this year.

The problem, it seems, is a design flaw.

Indeed, many classic investor errors -- overtrading, groupthink, panic selling, marrying positions (i.e., refusing to sell), chasing stocks, rationalizing, freezing up -- are mostly due to our genetic makeup. Humans have evolved to survive in a harsh, competitive landscape. To do well in the capital markets, on the other hand, requires a skill set that is very often the antithesis of those innate survival instincts.

Why is that? The problems lay primarily in our large mammalian brains. It is actually better at some things than you may realize, but (unfortunately) much worse at many others you are unaware of. Most people are unaware they even have these (for lack of a better word) "defects." The fact is, when it comes to investing, humans just ain't built for it.

Psychology Vs. Economics

In order to understand how humans invest requires more than the study of economics; one also needs to comprehend behavioral psychology. Combining both cognitive science and behavioral economics can yield powerful insights into the conduct of investors.

I recommend Cornell professor Thomas Gilovich's book How We Know What Isn't So to investors all the time. The professor's contribution to the investment community is his study of human reasoning errors. More specifically, Gilovich studies the inherent biases and faulty thinking endemic to all us humans. These faulty analyses are pretty much hard-wired into our species.

How do these defects manifest themselves? In all too many ways: Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing.

We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate "systematic errors" or blind spots in our analytical reasoning.

And that's only a partial list of analytical imperfections you have inherited.

The good news: These defects can be overcome.

We can develop an awareness of these specific defects, and we can learn to employ strategies that attempt to overcome these inherent analytical shortcomings.

What Have You Learned in the Past 2 Seconds?

Let's place these defects into a historical framework within the context of the capital markets. My favorite illustration as to why humans simply aren't hard-wired to undertake risk/reward analysis in capital markets comes from Michael Mauboussin, Legg Mason Funds' chief investment strategist.

Mauboussin takes our evolutionary argument -- the mind is better suited for hunting and gathering than it is for understanding Bayesian analysis -- and places it into a chronological context. In an article titled What Have You Learned in the Past 2 Seconds?", he creates a timeline of human history scaled to equal one day.

He starts at the beginning: Homosapiens came into existence 2 million years ago. Next, Mitochondrial Eve, the common female ancestor among all living humans, lived less than 200,000 years ago. Last, he notes that modern finance theory, the framework to which investors are supposed to adhere, was formalized about 40 years ago. If all of human history were a day long, then investing is only about two seconds old. Is it any surprise that most humans do it so poorly? The vast majority of human history has been spent learning to survive, not analyze P/E ratios.

Learning to fight nature won't be easy. To outperform, you sometimes must go against the crowd, despite the appeal and seeming safety in numbers. You must be humble and willing to admit error; meaning you'll have to overcome your ego's predisposition to avoid embarrassment, so as to maintain status amongst your tribe (and thereby enhance survival probabilities).

Most investors are overconfident to a fault. Don't believe me? Consider the following anecdote: A man was terrified to fly, yet thought nothing of roaring down the street -- sans helmet, no less -- on his Harley. That reveals a high degree of confidence in his own skills vs. a highly trained pilot's. That's some risk-analysis engine you got there, bub.

That blind faith in our own abilities may have come in handy on mammoth hunts, but it is hardly beneficial when to comes to picking stocks. And that's before we even get to the "flight or fight" response. Our natural instinct during periods of volatility is to stop the pain, not to endure it with patience. The natural reactions to discomfort or threat -- coupled with a natural inability to be patient -- doesn't serve us well in the market. During market bottoms, most of the herd is selling. To buy during periods of intense selling means leaving the safety of the crowd, standing out, risking humiliation.

We simply were not designed for that.

Why Not Just Index?

This overconfidence leads to the optimistic yet misguided belief that most of us can beat the market. We must believe we can outperform the major indices. Otherwise, the rational thing to do would be to simply buy a major index and forget about it.

A few recent studies support those conclusions. One in USA Today found that most people are no good at investing, and another in The New York Times revealed that people have a poor grasp of basic economics.

Most investors -- the 80% who underperform -- would probably be better off going the index route. If you're still interested in trying to outperform -- despite all we discussed today -- then I admire your gumption. Over the coming months, we will share some tools to do just that.

Next week, we take a closer look at the competition. (Be afraid ... be very afraid.)

[Apprenticed Investor: Bull or Bear? Neither ]

This will be one of the few Apprenticed Investor columns written in response to current events. I'm doing so because I feel it's necessary to address last week's topsy-turvy market action. More specifically, the investor reaction to it.

A brief background: In my day job, I advise institutional investors on the state of the markets. When risk, according to my metrics, has risen unacceptably relative to reward, I become cautious. When the reverse happens, I get more aggressive. This has been my style for some time, and it works for me. Once I explain the process, I'll lay out the mistakes the public makes in reaction to these market calls.

'Are You a Bull or a Bear?'

I've heard this question countless times the past few weeks. And I find it a stunning rejection of Darwinian logic that proponents of such blather have managed to evade extinction. Investors simply never get asked a more distracting and pointless question. Effective investors find their style, then read the market and adapt accordingly.

Of course, in discussions about Wall Street, the bull and bear are mesmerizing. How often do we hear a newscaster somberly intoning: "The bears got gored by the bulls on Wall Street today..." The very next day, we hear the same talking head reverse course: "On Wall Street, the bears came out of their caves to chase the bulls, as the Dow dropped..."

The markets we saw last Wednesday and Thursday are textbook examples of why the colorful imagery of the bulls and bears is magnetically attractive to copywriters and repellent to good investing.

Why is this such a problem? Because of the "folly of forecasting": Once people commit to a position, there is an unfortunate tendency to root for that perspective. Even worse, people stick with their forecast, regardless of what is actually happening in the market. We addressed this in the very first Apprenticed Investor, Expect to be Wrong. But instead of preparing, people dig their heels in and cost themselves money by being more concerned with trying to be right rather than making money.

Surely, there are cheaper places to look for validation than the stock market.

Bull and Bear, a Matched Pair

In a firm I worked at during the bubble years, many of the brokers had bulls on their desks, but no bears. I used to take away their bulls, and refuse to return them unless they promised to display the bear also. I did this to prove a point: There are two sides to every market.

If you ever meet a money manager/broker/financial adviser who only has bulls displayed, run -- don't walk -- to the nearest exit. Why? Because it reveals a fundamental lack of market understanding: Markets go up and down; the bull and the bear each have their day.

And that's why the bull or bear question is inane. Stockholders should be watching market signals, economic issues and corporate earnings, with an eye toward adjusting their risk profile and investing outlook. Why? Because just like markets, risk goes up and down also. But once an investor commits to the bull/bear question, it leads to the unfortunate tendency to cheerlead for their last call rather than focusing on protecting capital. This very quickly can become an expensive hobby.

Red or Green: A Case Study

Here's a hypothetical example: Let's say you have a few errands to run that will require your driving a car. Before you turn the key, decide the following: Are you a "red" or a "green?"

You have to be something, so pick one before you leave the garage.

Now, apply that choice at every signal you hit on your errand. If you're a red, come to a dead stop at every signal. If you are a green, just drive through the next red light. When the cop asks why, just tell him it's because you are a "green." (Good luck in court).

Clearly, this is absurd. Rational people observe the color of the light, and step on the brake or accelerator as appropriate. Yet when it comes to the markets, many otherwise rational people do just this. They have predetermined their intentions and invested their dollars -- regardless of the many signals the broader market gives. One need look no further than recent history to see that ignoring market signals is a recipe for disaster.

Let's say you are a bull, and the Fed is tightening, corporate earnings are sputtering, the yield curve is inverting. Do you drive straight through the red light, going aggressively long the Nasdaq-100 Trust (QQQQ:Nasdaq - news - research)? Or do you notice the signal?

Now imagine you're a bear and sentiment is at an extreme negative, year-over-year S&P 500 earnings have gone from bad to so-so, and the Fed is cutting rates. Do you stop at the light, shorting the Spyders (SPY:Amex - news - research), even though it's bright green?

Savvy investors get long or short (or move to cash), as conditions dictate. When all the signals line up in the market's favor (regardless of style (valuations, sentiment, monetary policy, etc.), the smart investor gets long. When the indicators line up the opposite way, that investor gets defensive.

The terms bull and bear are anathemas to me. You can be long or short or mostly cash at various times -- sometimes all at the same time. So why commit to dogma? The market does not require you to declare your party affiliation or sign up for a religion. "Are you now, or have you ever been, a bear?" is not a question on a new account form. If there's a perceived advantage to being bearish, you should get bearish and vice versa.

Now, on to the public's reaction to bearish or bullish calls: One of the typical emails I get, particularly after making a bearish argument is: "In the long run, doesn't the market tend to go up? Isn't that reason enough for a bullish bias?"

It depends. If you bought stocks in 1966 when the Dow first hit 1000, well, the long run hardly bailed you out. The Dow didn't get over 1000 until 1982. How'd you like to spend 16 years and end up with a precisely 0% annual return? And that's before factoring in inflation.

The problem with the so-called long run is that it overlooks the here and now. "This long run is a misleading guide to current affairs," wrote John Maynard Keynes in his seminal 1923 work, A Tract on Monetary Reform. "In the long run," Keynes noted, "we are all dead."

It has also been an excuse for some terrible advice. Example: "Buy and Hold" works well during some periods (1982-2000) and poorly during others (1966-1982; 2000-2005). If you noticed a pattern here, you are already ahead of the herd.

Adaptability is the key to surviving these longer-term cycles of boom and bust. It is important to have a degree of sensitivity to changing market and economic conditions. Once you recognize a transition is taking place, or hear someone who does, you must be flexible in your response. It's a lot like Darwinian evolution: Adaptability remains the key to survival. This is just as true for investors as it is for iguanas.

Ignore the market's reality in favor of the long-term view, and you'll die with your conviction intact -- but likely little else.


[Apprenticed Investor: The Wrong Crowd ]

Has this ever happened to you? You've been waiting to deploy some fresh capital. You've done your homework -- checked the charts, looked over the fundamentals. You are ready to make a buy.

But moments before you pull the trigger, someone casually mentions something negative about this new target. It could be a coworker or some talking head on TV. Regardless, you hesitate, decide to do some more research, just to be sure ... and the next thing you know, your stock pick is off to the races -- without you.

All you can think is, thanks for nothing, buddy.

We've all had chance encounters like this. They can cause self-doubt, make you second-guess yourself, wreak havoc with an investment strategy.

There are two solutions to dealing with this kind of distraction: One is to become more confident in your own skills. This will occur as you continually educate yourself, which is what "The Apprenticed Investor" is all about. The more confidence you develop, the easier it is to stick to your investment plan and not let third parties bump you off track.

The other solution is simpler: Learn to recognize destructive investor personalities -- and stay as far away from them as possible.

Last week, we discussed why gains and losses are ultimately the investor's responsibility . But there are some people who can temporarily knock you off your game: These are people to avoid.

The Dirty Half-Dozen

- The Enthusiast: He's always breathless; his companies are always on the verge. "Big news is due any day now." There's always someone about to "snap these guys up." He's entranced with new management, i.e., "The new CFO was employee No. 12 at Dell (DELL:Nasdaq - news - research)!".

At one time or another, we've all been bitten by the infectious salesmanship of the enthusiast. The story always sounds great ... yet somehow, the stocks never seem to work out.

1 The Tipster: The easiest of all the archetypes to recognize, this guy always has a hot story that simply cannot wait. It's about to happen any minute -- a deal to be announced or an imminent takeover.

While the "enthusiast" is all excited about the company, what gets the tipster jazzed is the source of info. "This guy I know is (choose one) head trader at a hedge fund/runs a major wire house desk/at the FDA/on the board of directors."

Last year, biotech was hot and the tipster talked a lot about new drugs that were just about to get FDA approval (none worked out). Lately, the tipster has been big into government and military contracts; apparently, he gets to brunch with Donald Rumsfeld.

For a person who supposedly has information that -- if true, is likely illegal -- the tipster's trading record is surprisingly bad. With all of his connections and illicit info, it turns out that the tipster is little more than a rumor monger -- and one who's usually late to the party at that.

2 The Liar: Most industries have their fair share of B.S. artists. But there is a very special type of liar attracted to trading.

You know these guys; they never seem to have a losing trade. When they discuss their executions, they consistently manage to buy at the low tick of the day. When they sell, their executions invariably are the very best possible print -- and on almost every sale.

Think about how often you've managed to get the very best print of the year -- or even the day. Over the past decade, I can count on one hand the number of times I've top-ticked stocks on the way out: Iomega (IOM:NYSE - news - research), Micromuse (MUSE:Nasdaq - news - research) and Qualcomm ( QCOM:Nasdaq - news - research). Meanwhile, I've had countless sells at the day's low print.

Somehow, the liar manages to accomplish a decade worth of statistically aberrant prices each day, before lunch.

I never call these clowns out. Why show your hand? But I make a mental note who the liar is, and judge all future statements accordingly. You should do the same thing.

3 The Permabull or Permabear: Among the most dangerous and costly clowns in the circus, these guys are responsible for more destruction of wealth than any other player.

You doubtless recall the permabulls from the late 1990s. Most are little more than slick salesmen. They do not do much in the way of original research, but you can imagine the inner workings of their minds, sifting through reports looking for just the right bullet points.

The permabull uses all of the right buzzwords, his patter is polished, his manner impeccable. By the time he's done with his bullish sales pitch, you're reaching for your checkbook -- and historically, big trouble.

Some of the permabulls used to be on TV a lot. One in particular was a frequent TV guest, extolling the virtues of the Goldilocks economy and the ever-rising bull market at Nasdaq 5000. Then the bottom fell out, taking the Nasdaq down a mere 80%. He never changed his tune the entire way down.

On the flip side are the permabears, of which there a few classic examples. They've been bearish for as far back as I can remember. They may have avoided the drop from Dow 11,000 to 8,000, but they've been waiting for that drop ever since Dow 3,000.

Avoid these broken clocks like the plague.

4 The Exotician: The more obscure, the better: that's the motto of this creature.

Fascinated by exotic charts and little known indicators, the exotician changes methodologies as often as he changes his underwear.

Flitting from style to style like a butterfly, his enthusiasm for the esoteric merely masks the lack of conviction he holds for his previous theory.

Last week it was a combination Bollinger Bands and McClennan Oscillators. Before that it was Elliot Waves. This week, its MACD and Fibonnaci. Next month, it's the Kondratiev Long Wave theorem.

It's not that these techniques don't have value, but the exotician simply can't seem to stick with any one long enough to test their validity. The exotician is on a futile search for the magic elixir -- which, unfortunately, does not exist.

5 The Know-It-All: I love listening to people talk about stocks at cocktail parties. One of my favorite players is the guy who knows all the obscure details on a company: When they were formed, who sits on the board, the model numbers of new products, all sort of useless minutia. At his fingertips is an unholy checklist of data, all of which is completely irrelevant to the investment process.

This is especially true with tech companies. Their products are complex and ever-changing; the networks they sell into are even more complicated. The technical attributes of their products are way beyond the comprehension of the average investor whose VCR clock has been flashing "12:00" since 1994.

Actual language overheard at a barbecue last summer: "Wait till you see the new 2200 dynamic cross circuitry router -- it's going to kick Cisco's ( CSCO:Nasdaq - news - research) ass."

Now, I'm pretty tech savvy: I hooked up my own TiVo ( TIVO:Nasdaq - news - research), and I can swap out a hard drive or add RAM by myself. But comparing the technical attributes of high-end switching equipment, and then doing a cost benefit analysis of the technical advantages of that product line (relative to the rest of the marketplace for that equipment) is far beyond my expertise.

I'll wager it's beyond your ken also.

Be wary of these characters. They remind me of the kid in grade school who couldn't hit, throw or field, but he memorized the stats of all the players on his favorite baseball team.

Folks like that often lack an appreciation for the game. It's no different with investing.

[Apprenticed Investor: Your Fault, Dear Reader ]

In the first installment of "The Apprenticed Investor," we discussed why investors should expect to be wrong, and most importantly, having appropriate plans for what to do when you are wrong.

That column gave you two lessons disguised as one. Hidden within was a second, subtler message. It is so obvious, yet so ignored by investors: You are ultimately the only person responsible for your investments.

That sounds pretty straightforward, but for some reason it seems to be a problem in our society. Few want to take responsibility for their actions or situation, if they can avoid it.

Think I'm exaggerating? Every kid who does poorly in school gets diagnosed with ADHD. We are fat because of McDonald's ( MCD:NYSE - news - research). There are shootings because of TV violence.

In sum, it's easier to pass the buck than to admit the truth.

Bad Excuses for Poor Investments

At times, the excuse-making from investors is even worse. Over the years, I have heard every complaint imaginable for why losses occur. Inevitably, these gripes go something like this: "It's not my fault but the fault of:

-- The analyst who recommended it.

-- The banker who did the deal.

-- CNBC, which hyped it.

-- The talking head who loved it.

-- My brother-in-law, who got a hot tip on it."

I've heard people complain about their broker's bad advice, the lousy execution they got, and how a market maker or specialist hurt their trade. Other kvetches? Management stinks, insiders are dumping shares, regulators are overzealous. Margin calls did it. Or was it the president's policies or congressional gridlock or Chinese imports? Really, who can trade when the economic data are cooked, and the "Plunge Protection Team" counters your best positioning?

I've overheard people complain that they lost money because Alan Greenspan raised, lowered and/or left rates unchanged. Oh, and Eliot Spitzer, too.

Well, folks, I've got some bad news for you. None of those are the reason any of you lost money. The dirty little secret is much simpler. You lost money because you bought a stock, and that stock went down, and then you sold it. Period, end of discussion.

Buying high and selling low is a lousy investment strategy. Worse is buying high and not selling at all as (paper) losses mount. Think of Lucent ( LU:NYSE - news - research) or Sun Microsystems (SUNW :Nasdaq - news - research) or Nortel ( NT:NYSE - news - research), or the slew of stocks that went to zero. Too many people rode 'em all the way down, rather than admit a mistake and take responsibility.

You see, with responsibility comes a natural tendency toward planning. If you buy without a plan in place for when things go south --- when your original thesis turns out to be wrong -- then you are at fault.

Sorry to be the bearer of this bad news, but the sooner you start accepting that simple truth, the better off you will be.

Why? Because all of the excuses above are foreseeable events that only investors (and fools) fail to anticipate. Analysts can be wrong, TV is about ratings, insiders sell, and talking heads talk. Is that a surprise? Hey, guess what? The Fed raises and lowers rates, the FDA pulls drugs, and attorneys general prosecute.

Review some of the aforementioned complaints, and you will see how foolish they sound. Now try this one: I lost money because I made a bad investment. I lost a lot of money because I made a bad investment without a contingency plan for when things went wrong.

Here's the only excuse I would accept from an investor: Aliens from Alpha Centauri landed on earth and gave a huge technological secret to the rival of the company whose stock you own. OK, when that happens, you are excused. Short of that, everything else is your own responsibility.

Priorities and Homework

Excuses are just a sign of how lazy we all are (me too), including boredom and procrastination (guilty). If we are going to be investors, then we must do all the heavy lifting that's called work. If it were easy and painless, then everyone would be a fabulous and wealthy investor. But it's not, so you have to outwork and outhustle the next guy.

Recall that Michael Jordan didn't initially make his high school basketball team. After that, he swore he would never be outworked by anyone ever again. He went on to become the greatest player ever. There's a lesson in that.

We all know guys who can recall every baseball stat of their favorite team off the top of their heads; win-loss records, slugging percentage, ERA. Ask them about the top five holdings of their mutual funds, and they look at you as if you have two heads.

Some people spend more time investigating the purchase of a refrigerator than they do a stock or mutual fund. You have to wonder why people put more time into planning their next vacation than they do their retirement. A vacation is two weeks long; a retirement can be 20 years. There is something wrong with the math here.

The Freedom of Responsibility

Not to get all Zen on you, but once you accept this, there is a certain exhilaration in the concept. Suddenly, planning for your own retirement takes on a different hue. You become more focused, motivated and excited about learning.

Short cuts (i.e., stock tips) make you laugh. When other traders whine about their bad luck/the Fed/market makers, you can snicker to yourself at how they are fooling themselves.

As the magnitude of the awesome responsibility of taking control -- and responsibility -- sets in, it tends to sharpen the mind. It is empowering.

I think Spider-Man may have gotten it backwards: With responsibility comes great power.

[Apprenticed Investor: Expect to Be Wrong ]

In the present-day realm of investing, the near obsessive focus on stock selection has obscured the "art" of investing. There is much, much more to buying and selling stocks than mere stock picking. Not that you could tell, based upon what's in the financial media.

This new column -- "The Apprenticed Investor" -- is all about making you a better investor. Not just a better stock picker, but someone who knows how to preserve capital and manage risk.

One of the keys to successful investing is recognizing the frequency of "strikeouts" -- and having a plan in place to deal with them. This is the first lesson most new investors fail to digest.

I am rather frequently -- and on occasion, quite spectacularly -- wrong. But I expect to be. No one really knows what is going to happen in the future, so why pretend otherwise? When you anticipate being wrong, it makes it that much easier to both plan ahead and manage risk. There's little ego tied up in the position to prevent you from jettisoning it -- provided you have planned for the worst.

For the record, I do not yet consider myself a "master" -- not in the classic sense of the word: In the Middle Ages, anyone who wanted to learn a craft had to first apprentice. After many years of struggle and hard work, apprentices would toil their way up to "journeyman." Once a journeyman demonstrated a degree of expertise, he would be invited to join the guild, thereby becoming a master.

As a member of the guild, the master was expected to pass on his skills to the next generation of apprentices. This was how a craft was kept alive and growing. That's the inspiration for this new weekly feature.

Coming Up Next

Over the next few weeks, we will review the traps, pitfalls and common errors that befall all too many investors. We will disassemble the damaging myths that keep haunting individuals. My list of investing "pet peeves" will get some airtime.

We will dissect the reasons why stocks go up and down; it's actually simpler than most people realize. We will look at the debate over the "fundamental vs. technical analysis" issue. But it's not simply abstract theory: We'll go over "sell signals and stop-losses" -- a very basic yet overlooked tool. We'll look at "long-term" investing -- is it dead? Was it ever really alive? The answer will surprise you.

There are several important concepts that get almost no media coverage -- we will attack those. Managing risk will be a prime focus, including how you can trade even "fiasco" stocks -- like Enron and WorldCom -- yet not get destroyed.

The intriguing issue of investor underperformance will get some ink (pixels?). I'll show you why human beings simply aren't hardwired for the capital markets. Once you become aware of your limitations as a member of an occasionally rational but often emotional species, it will change your thought process.

We'll also spend time on the "don't" category. I'll discuss the five "investor types" you must avoid. You may be interacting with any one (or more) of these types; they are simply bad for you and for your investing. We'll go over some of the worst things investors say. These excuses lose people money -- and they don't even know it.

I also hope to convince you why you need not own the stock of your favorite company. It's a peeve I call "love the company, hate the stock." (This one freaks people out.)

We'll get to other subjects as they come up. This is an interactive media, so I'm more than willing to tackle your questions.

Finally, many investment "experts" make outrageous promises of untold riches to perspective clients. Here is my more realistic pledge to you: Spend 15 minutes per week with me on these pages, and I promise you that one year from now, you will know much more about how the markets work; you will have developed your own logical set of personal investing strategies; you will have learned disciplines that help you through all types of markets. In sum, you will have that many more arrows in your investment quiver.

And it is my hope that you will have made the transition from apprentice to journeyman investor.

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