Pinoc­chio traders: They’re only ly­ing to them­selves

The Washington Post Sunday - - TECHNOLOGY & INNOVATION - Barry Ritholtz

Michael: I don’t know any­one who could get through the day with­out two or three juicy ra­tio­nal­iza­tions. They’re more im­por­tant than sex. Sam: Ah, come on. Noth­ing’s more im­por­tant than sex. Michael: Oh yeah? Ever gone a week with­out a ra­tio­nal­iza­tion?

— “The Big Chill” (1983) In my last col­umn, we dis­cussed my an­nual rite of Mea Culpa. That’s where I look back at the prior year to eval­u­ate what I got wrong and why. It is a hum­bling ex­pe­ri­ence de­signed to make me a bet­ter in­vestor, and I have been do­ing it — in pub­lic — for sev­eral years. Numer­ous read­ers have told me that this is a rar­ity in the world of fi­nance.

But ev­ery year I hear from a small seg­ment of ac­tive traders who mis­read what the dis­cus­sion is about, see­ing it as an in­vi­ta­tion to brag about their best trades. As­ton­ish­ingly, th­ese e-mail­ers have all sig­nif­i­cantly out­per­formed the mar­kets over the years, putting up fan­tas­tic re­turn num­bers. They never seem to have a los­ing trade. They sold Ap­ple at ex­actly $705 and bought gold pre­cisely at the bot­tom. Even more amaz­ingly, they got out at the mar­ket top in Oc­to­ber 2007 and bought in at the ex­act lows in March 2009.

The po­lite term for th­ese peo­ple is “fib­bers.” Per­son­ally, I say it’s ly­ing.

Math­e­mat­i­cal prob­a­bil­i­ties make th­ese claims of uni­formly spec­tac­u­lar track records ex­tremely un­likely. And what I find most in­trigu­ing is that th­ese Pinoc­chio traders (as I call them) are not really ly­ing to you or me, but, rather, to them­selves.

Lit­tle white lies are told by hu­mans all the time. In­deed, ly­ing is of­ten how we get through each day in a happy lit­tle bub­ble. We spend time and en­ergy ra­tio­nal­iz­ing our own be­hav­iors, be­liefs and de­ci­sion-mak­ing pro­cesses.

As in­vestors, we want to be­lieve we are smart, in­sight­ful and uniquely tal­ented — even though we of­ten fail to do the heavy lift­ing, put in the long hours, and make the un­com­fort­able but nec­es­sary de­ci­sions to achieve success.

But self-de­cep­tion is es­pe­cially costly when it comes to in­vest­ing. So let’s con­sider some of the lies that a lot of you may be telling your­selves and the im­pact they may have on your port­fo­lios.

Let’s con­sider some of the lies that a lot of you may be telling your­selves, and the im­pact they may have on your port­fo­lios.

You know what your in­vest­ment re­turns are. You would be sur­prised at how few peo­ple ac­tu­ally know what their re­turns are. Even fewer un­der­stand their per­for­mance rel­a­tive to a bench­mark.

Ac­cord­ing to a study of on­line in­vestors by Markus Glaser and Martin We­ber, “The cor­re­la­tion co­ef­fi­cient be­tween re­turn es­ti­mates and re­al­ized re­turns is not dis­tin­guish­able from zero.” In other words, what we think our in­vest­ment re­turns are and what they ac­tu­ally are have lit­er­ally noth­ing to do with each other.

It is not that com­pli­cated to cor­rect this. Set up a sim­ple spread­sheet us­ing Mi­crosoft Excel or Google Drive or one of the avail­able on­line tools. Keep care­ful records of your port­fo­lios, cu­mu­la­tive and YTD re­turns, and you will avoid the “per­for­mance delu­sion.” You can pre­dict the fu­ture. You may not say you be­lieve you can forecast what will hap­pen next year, but you cer­tainly be­have that way.

When­ever you try to pick mar­ket tops and bot­toms, you are mak­ing a pre­dic­tion. Guess­ing what stock is go­ing to out­per­form the mar­ket is fore­cast­ing, as is sell­ing a stock for no ap­par­ent rea­son. In­deed, nearly all cap­i­tal de­ci­sions made by most peo­ple are un­con­scious pre­dic­tions.

We’ve dis­cussed this many times, but it bears re­peat­ing: No one can con­sis­tently pre­dict the fu­ture with any de­gree of ac­cu­racy. If your in­vest­ing ap­proach re­quires that you be- come Nostradamus to suc­ceed, then you are des­tined to fail. You know how costs, fees and taxes im­pact your re­turns. Not too long ago, an ac­quain­tance was brag­ging about what a great year he was hav­ing. And truth be told, his gross re­turns were im­pres­sive.

Then I had him cal­cu­late his net re­turns. Once he fig­ured in his turnover, com­mis­sions and es­pe­cially taxes, he re­al­ized he had an enor­mous cost struc­ture that ate into his P&L. Af­ter all costs, his great gross re­turns turned into be­low-mar­ket re­turns.

I in­formed him, “My re­tired 75-year-old mom bought an S&P 500 in­dex last Jan­uary, paid an $8 com­mis­sion and for­got about it for the year. She kicked your pro­fes­sional butt.” He was not happy about that.

Per­haps we need a corol­lary rule about ac­tive trad­ing: Gross re­turns don’t count, net re­turns do. You can pick fund man­agers. Yes, we all know who the great fund man­agers of the past 20 years were, but that’s af­ter the fact. What makes you think you have the skill set to eval­u­ate the best ones of the next 10 to 20 years — their in­vest­ing ap­proach, dis­ci­pline, char­ac­ter and abil­ity to ex­press their in­vest­ing the­sis?

Only 1 per­cent of fund man­agers ac­tu­ally earn their fees: Why do you be­lieve that you can pick them out? You un­der­stand mean re­ver­sion. Ev­ery year, it seems, some fund man­ager gets the hot hand and be­comes a me­dia dar­ling. He at­tracts lots of as­sets as in­vestors chase past per­for­mance. The size of his fund bal­loons. Then the dis­ap­point­ments come.

Here’s why. Out­per­for­mance is of­ten random among the 20 per­cent who man­age to do bet­ter than their bench­mark each year. But it’s al­ways a dif­fer­ent 20 per­cent. Fol­low­ing that run of good for­tune, they typ­i­cally fol­low with a sub­par year, as their cho­sen style or sec­tor cools off — it re­verts to the mean, or av­er­age. (Math is a cruel mis­tress.) You have a plan. I am con­stantly as­ton­ished at how few peo­ple ac­tu­ally have any sort of long-term plan other than throw­ing some money into a 401(k) or IRA and hop­ing for the best. You can pick stocks. Let’s be bru­tally hon­est about this: Dis­cussing spe­cific stocks dur­ing a bull mar­ket is loads of fun. Chat­ting about new prod­ucts, man­age­ment and ex­cit­ing new tech­nolo­gies makes for great cock­tail party chat­ter.

The prob­lem is that most of you lack the spe­cific skill set to do this well. This in­cludes un­der­stand­ing val­u­a­tions, rec­og­niz­ing prob­lems early and, per­haps most of all, fol­low­ing your dis­ci­pline to limit losses when things don’t work out.

Most in­vestors are bet­ter off own­ing a set of broad in­dexes for their main re­tire­ment ac­counts. You are sav­ing enough for re­tire­ment. I’ ll spare you the lec­ture, but for most of you this is not true.

The av­er­age re­tire­ment ac­count held by 60 per­cent of Amer­i­cans is less than $25,000 (ac­cord­ing to the Em­ployee Ben­e­fit Re­search In­sti­tute). The av­er­age 401(k) is $77,300 (Fi­delity). Ac­cord­ing to EBRI, only 14 per­cent of Amer­i­can work­ers are very con­fi­dent they will have enough money to live com­fort­ably in re­tire­ment.

This has been a short list. As Mark Twain wrote: “Ev­ery­body lies — ev­ery day; ev­ery hour; awake; asleep; in his dreams; in his joy; in his mourn­ing.”

What are you ly­ing to your­self about?

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