Many investors use magical thinking to mislead themselves. Worse, brokerage firms and insurance companies reinforce this. But these “magic” strategies don’t provide the intended results. If they did, wouldn’t the best investors in the world, like Warren Buffett and Charlie Munger, use them?
They don’t because they’re magic only for the people selling them. Brokerage firms, including discount brokerage firms, sell sophisticated trading strategies to entice investors. Insurance firms sell “guarantees.” These strategies generate a lot of commissions and fees for the brokerage firms and insurance firms.
In life, there is no reward without risk. We use fundamental strategies with our clients to assure they are on track. It’s not always easy. But these strategies have the highest odds of getting our clients where they need to be.
If anyone shows you something too good to be true, it is. If you see something too good to be true, let us look at it so that we can show you what it really is.
Everyone “wants” what they can’t have. A lean, fit body with poor diet and little exercise. Quick success without risk. To get lucky in work and earn a lot of money. But everyone who achieved success did it through a lot of hard work. Readers should note that I put “wants” in quotes. If you really want something, you make the sacrifice to get it – that’s how economics works!
No pain, no gain. No risk, no reward.
Risk and reward are joined at the hip, at least in the short-term. If the market didn’t misprice securities, smart investors couldn’t profit when others over react. But we know they do.
We sometimes have new clients ask questions like, “What is your strategy for limiting the downside?” Our answer will always be the same. In two simple parts.
- Making sure our clients are taking the right level of risk (valid assessment of risk and budget to it)
- Selecting investment strategies that are fundamentally based, whose investment concept has been proven in the real world, over time and under stress.
Unfortunately for investors, the brokerage firms and insurance companies make a lot of hay convincing you that you can have return without risk. You can’t. Might be worth a revisit of this: Our System for Investing.
Below we discuss 5 key ways investors engage in magical thinking:
1. The Sophisticated Trading Strategy
“The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” – Warren Buffett
The big banks and brokerage firms, especially discount brokerage firms, have taught investors they can use sophisticated trading techniques to limit losses and make money.
The problem with any lie like this is that it contains a small truth. It is true, you can, for example, use a stock loss order to limit the loss of a stock. But then you are in cash. What do you do next? What do you buy and when? The problem with these strategies is they are first order only. Success comes through implementation of a system.
This is the biggest problem we humans face in investing – and in all decision making. Human beings are hard wired to think in the first order. Daniel Kahneman wrote a book about it called “Thinking Fast and Slow.” We’re wired to think fast (and survive against a predator). Not to think slow (and keep up with others also being deliberative).
The slow thinking is the strategy that works in the world we now live in. But it’s counterintuitive.
How do we know trading strategies don’t work?
I’ve only been looking for almost 20 years, but in that time, I still haven’t come across one. I haven’t found one successful trading strategy that I can use for clients that has an audited track record and that worked better than our Medium Risk managers, over a full market cycle. Sure, there are some hedge funds that do this to some extent, but they aren’t available to our clients. Worse, you only know about the ones that were successful because the ones that didn’t failed (causing permanent loss of capital)!
2. The ‘Guarantee’
Insurance companies are in business to make money for their shareholders. In order to do so, they provide incentives to salesmen, in the form of commissions. The commissions for index annuities are usually 10 to 13 percent. For variable annuities, 7 percent. Insurance companies want you to give them premiums and then pay you back later because they understand the time value of money.
Insurance companies make money two ways. First, they make money from underwriting. This is the difference between premiums they receive and claims they pay out. It applies to every type of insurance. Only very successful insurance companies make money underwriting, so they need another source. The second way they make money is from investment income. Nearly every insurance company makes money on investment income. Investment income is money made on premiums you pay in before they must pay out.
Remember Wimpy in Popeye? “I’ll gladly pay you Tuesday for a hamburger today.”
This is why insurance companies gladly pay you later for money today. They understand the power of compounding. We have found that many of the “guarantees” insurance companies make are essentially little more than a return of premium.
I know, because I worked at the corporate headquarters of an insurance company. I analyzed insurance companies for my employer to buy. I looked for companies that could make money underwriting.
Insurance companies essentially are wooing you to eliminate perceived volatility. But we prefer Charlie Munger’s approach:
“This great emphasis on volatility in corporate finance we regard as nonsense.” – Charlie Munger
For more great quotes on volatility, click here.
3. The Perma Bear Fund
In order to make money, you must bet on something, not against it.
This is worth a reminder. We’ve followed fund managers for almost 20 years. In that time, some have always been bearish. One is an economist turned portfolio manager at the University of Michigan who predicted the Dot Com bubble. He put his money where his mouth is, starting a hedge fund and mutual fund in 2000. He wrote clever weekly newsletters explaining why the market would react in some way or another. Because, for most of the time, he felt the market was overvalued, he used hedging strategies to reduce loses.
This strategy worked from peak on September 20 to current bottom on December 24. His fund rose 12 percent while the market was down 20 percent. Sounds smart right?
Over the last 10 years, the fund lost investors 5 percent per year. A million dollars invested 10 years ago is worth $600,000 today.
The point I am trying to make here is simple. Investors profit from investing in fundamentals. Fundamentals are value, quality and growth. High-cost attempts to hedge risk almost always result in losses. It’s why portfolio managers at First Eagle, International Value Advisors, Centerstone and Grandeur Peak generally eschew these strategies. The cost is not worth the benefit.
We’ve talked with them about it over the last 20 years. Fundamentals, and investing on something works.
Just not always in the short-term.
4. The Hot Stock Idea
Stocks are usually “hot” because they are very risky. If the stocks do well, they can tenfold. But if not, they go to zero.
We have had some inquiries lately about marijuana stocks. The case for medical marijuana appears to be strong, causing many states to legalize it. It seems likely that this will increase demand, but it is nearly impossible at this point to pick winners and losers. In cases like this, it’s hard to invest based on fundamentals and instead is more of a crapshoot.
Everyone remembers the “hot” stocks they bought that did well. But remember Enron, WorldCom and all the others that went to zero?
Picking stocks needs to be based on sound fundamentals. It’s not for amateurs or short-term performance seekers.
5. Confusing Short-Term Performance with Sound Investing
Buying a security and having it go up in the next month, three months or six months is usually just luck. Similarly, excellent securities can fall in price. The so-called value-trap happens when a stock with sound fundamentals continues to fall in price.
Don’t get me wrong, valuation is not the only fundamental. In my world, there are three: Valuation, Quality and Growth.
But investors tend to remember only what benefited them and forget the things that don’t. The choice-supportive bias is a known bias investors have. Similarly, the egocentric bias causes one to remember things as better than they were.
Believe me when I tell you, we have seen the statements and know the real returns investors have received over the long-run. It’s true, most investors, left to their own devices and biases, get about half of the return they should for the risk they are taking.
It’s our job to prevent that.