Invest as professors do and not as they espouse and elucidate
• They might know a thing or two about finance, but most play it safe with their own money
Plenty of high-profile people are more than happy to share their views on the state of the market and give advice on the best course of action. However, much of the time what they say in public has little to no bearing on how they manage their own portfolios.
Client letters, television appearances, interviews and speeches tell you a lot about someone’s personal convictions but usually very little about the extent to which they are willing to act on them.
In 2008, Jason Zweig wrote a piece for The Intelligent Investor in which he argued that you may be better off listening to experts rather than trying to do what they do. The basis of his argument was a survey conducted by Colby Wright, then a scholar at Central Michigan University, of more than 600 finance professors at leading US universities to see how they go about investing their own money.
As it turned out, most kept things simple and aligned to theory. They did little or no stock picking and avoided options, futures and the likes.
About two-thirds of the professors had the bulk of their assets in index funds. “These academics more or less practise the basic lesson of modern portfolio theory,” said Zweig.
But that left a third who had gone astray. These professors lectured on complex theories of how markets balance risk and return, but when it came to investing ignored all that. They didn’t rely on discounted cash flow analysis or consider the capital asset pricing model. Instead they behaved like any CNBC junkie, zeroing in on stocks that had risen in price over the past six to 12 months.
Worse still, among nearly half of the professors who believed the market was efficient — meaning that whatever is knowable is already priced into stocks — nearly a quarter agreed with the statement: “When I invest my own money, my goal is to beat the market.”
In other words, having spent their career studying the stock market, these experts had come to the conclusion that it can’t be beaten — except by them.
“Professors’ perceptions of market efficiency have little, if any, influence on how they invest,” concluded Wright. “What really drives their investing behaviour is their confidence in their own abilities.”
In this, the professors were like the rest of us. Although everybody knows how hard it is to beat the market, nobody stops trying. Or, as Zweig put it: “Everybody knows how hard it is for everybody else to beat the market. So you and I are always honest about each other’s chances of success but never about our own.”
Two important bits of learning were embedded in Wright’s data, which Zweig believes still apply: “First, whenever anyone tells you that research ‘proves’ a novel method of investing is a market beater, bear in mind that the professor behind the paper is most likely an indexer who has never road tested his theory in the real world of trading costs, taxes and other expenses.
“Second, remember that even many of the people who know best can’t resist chasing hot stocks, so you have to control your behaviour in advance. Put 90% of your money in lowcost index funds and lock yourself in by adding a fixed amount every month through an electronic transfer from your bank.
“Speculate with just the remaining 10%, and use a checklist of buying criteria to make sure you never buy a stock purely because it has been going up. You don’t have to be a finance professor — in fact, maybe you shouldn’t be one — to realise that the seller may know something you don’t.”
John Maynard Keynes said: “There is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and overexacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”
If that toll is only 10% of your portfolio, it doesn’t sound like such a heavy a price to pay for having some fun with your money — and dreaming of extraordinary gains.
But if you don’t think speculating is fun, or that anything can be achieved by it, then don’t do it. It’s that simple.
As Mark Cuban says: “If you are going to trade stocks, you have to follow just one rule and remember just one thing. That rule is always have a definite knowledge advantage about the company you are trading, and always remember that every stock transaction has a sucker, and you have to know whether it’s you or the person on the other side of the trade.
“No one buys a stock from you or sells one to you knowing they are leaving money on the table. You have to keep in mind that the markets are efficient – you can argue about the extent to which they’re efficient, but the first thing you have to come to terms with is the extent to which they’re efficient.”
“It’s just inescapable that whenever you sell a stock, somebody else is buying it and whenever you buy a stock, somebody else is selling it,” says Bruce Greenwald. “And one of you is wrong. Only in Lake Wobegon can more than 50% of the investors outperform the market. So there’s an absolutely fundamental sense in which you’ve got to start off thinking that markets are efficient.
“You want to structure things so you’re on the right side of the trade and that the people on the other side of the trade are, in some sense, doing irrational things,” he says.
“When you think you’ve located a bargain you have to ask yourself: ‘Why me, God? Why have you made this available only to me?’ If God doesn’t answer, you’ve got to come up with the answer yourself; perhaps in terms of market psychology, or because you think you know something others don’t, but you must have some sort of rationale as to why this bargain has come to you as opposed to the person on the other side of the trade.”
‘YOU DON’T HAVE TO BE A PROFESSOR … TO REALISE THAT THE SELLER MAY KNOW SOMETHING YOU DON’T’