Introduction
Jeff’s audience is large but still pretty exclusive. He writes for an intelligent group of individual investors and also for colleagues in the advisory business. In their regular lives, a bit of reading and study takes them a long way toward solving life’s problems.
Something quite different happens in the investment world. The individual investor is faced with so much information that it is like a fire hose with no regulator. Most sources are paid for viewer ratings or page views. Fear sells.
A successful investor needs to put aside the scare stories and stick with the facts. It also requires perspective on international issues, economics, and public policy. For many it would make more sense to turn the job over to an expert and enjoy life. (see the great commentary from Josh Brown). “If you had five years…..”
Individual Investor Quicktip – 1/10/15
Each week, we highlight a past post from “A Dash” with particular relevance to current events. As the start of every year seems to be accompanied by some sort of trader adage, we’d like to start off by tackling heuristics.
There is a strong tendency among individual investors to rely on bits of conventional wisdom – or heuristics – as a way to explain market moves. This is problematic by definition! If your investment approach is based on common knowledge, it doesn’t provide you with any edge. This was a theme of one of the first ever posts on A Dash of Insight.
Experts in fields requiring decision-making know all of the heuristics, but they also know the underlying causal models. They know when to make exceptions. They know when to say “Things are different this time.”
In one of my worlds, high-level tournament bridge, many of the competitors are experts at stocks, options, and other derivatives. They are highly skilled at analyzing risk and reward, doing so quickly, and acting under pressure. Bridge has a large number of heuristics that help beginning players learn how to play at an adequate level, avoiding serious error. There is a point count system for evaluating hands. There are rules of play like “second hand low,” “third hand high,” lead up to weakness,” and “cover an honor with an honor.”
Blindly following these rules might help a player achieve average in a Flight C game, but that is about it. Experts understand that these rules usually work, but each case is tested to see if “this time is different.” When you see a hand in a bridge column, the expert player popped an honor second hand, or ducked as third hand, or whatever.
Perhaps readers can suggest similar concepts from other intellectual activities requiring heuristics.
The point is that knowing the basic rules of the stock market like The Presidential Cycle, Don’t Fight the Fed, Three Steps and a Stumble, or other similar slogans is only enough to make you average in the Flight C game. These are universally known market concepts that should be fully discounted by current market prices.
Timeless Guidelines
Jeff encourages you to keep a level head and approach your portfolio with attention to real risk, not guesswork about market timing. Jeff writes each post as if he were speaking directly with one of his clients. Some find that they have the time, energy, and objectivity to act successfully on their own. We know that this work helps them and we love the feedback.
Common Errors
Here is Jeff’s list of frequent investor errors:
They try to be traders.
The successful investment strategy differs markedly from trading. It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high. Most successful professionals, of course, do the opposite.
Even successful years have significant drawdowns. 15% is not unusual. The investor needs to expect this. If it feels stressful, then your asset allocation is wrong.
They think they are experts on world events.
Taking a long-term perspective is easier said than done. With everyone on TV explaining with great confidence what just happened (please check out my article on the “message of the markets”) it is easy for the average person to think he is out of step. For several weeks I have emphasized the folly of attempts at short-term market timing.
They confuse their politics with their invesments.
Regular readers know that I stress to be “politically agnostic” in my observations on current events. Rather than trade based on my personal opinions, I analyze news with the most likely outcome in mind. This is a recurring theme in many posts, but you can find a more extensive breakdown of the idea here.
They want to wait too long — until there are no problems.
This is the single most costly mistake. If there were no problems, the market would be at 20K or higher. Investing requires balancing risk and reward, not waiting for complete safety.
They fail to see what is working.
Our single best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield. Doug Short notes the decline in volatility, calling it “Siesta Time.” This is music to the ears of those selling calls against their dividend stock positions for a yield of 8-10% with greater safety than pure stock ownership.
They do not manage risk effectively.
It is far better to manage your risk, specifically considering the role of bonds and the risk of bond mutual funds. As I emphasized, “You need to choose the right level of risk!”Right now, it is the most important question for investors. There is plenty of “headline risk” that may not really translate into lower stock prices. Instead of reacting to news, the long-term investor should emphasize broad themes.
They try to go “all in.”
If you are completely out of the market, you are not alone. Consider buying dividend stocks and selling calls against them. This strategy has been working great both for our clients and for many readers. (Thanks for the email responses!) This will work in a sideways market. You can also buy some stock in the sectors with the best P/E ratios.
On Market Timing
The successful investment strategy differs markedly from trading. It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high. Most successful professionals, of course, do the opposite.
This is easier said than done. With everyone on TV explaining with great confidence what just happened (please check out my article on the “message of the markets”) it is easy for the average person to think he is out of step. For several weeks I have emphasized the folly of attempts at short-term market timing.
There is no magic moment. Resolving market worries is a process, not an event.
I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look. You can contrast this with the many pundits who claim miracles of market timing.
The market action in the last two weeks has once again illustrated market moves based on unpredictable factors. Who would have guessed on Tuesday afternoon that the market would be 2% higher on the week?
Our single best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield. This week provided great opportunities to set new positions early in the week and sell calls against existing holdings late in the week, just as we suggested last week. Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership. Take what the market is offering!
The Wall of Worry
For investment accounts I have been buying on dips in stocks that we like. I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look. You can contrast this with the many pundits who claim miracles of market timing.
The single most difficult thing for me to explain is that investors should often embrace opportunity just as traders are trying to do some fancy footwork. Investors should not be trying to guess the next market move. Instead, take what the market is giving you. You should not be a “buy and hold” investor, but instead engage in active management. Think about risk control rather than market timing.
To highlight the continuing discrepancy between headlines and the economic fundamentals, let us look to Dr. Ed. He compares various alternative investments to stocks, using the trailing earnings. This chart summarized a point that was widely observed in the past week.
The earnings yield from stocks, when compared to corporate bond yields, is at a 50-year spread. This suggests extreme skepticism about corporate earnings. Another way to view this is that it is the greatest fear since the mid-70’s. If the two lines simply met, the S&P 500 would have to rally by 27%. This is conservative, since you can see that the bonds usually trade at a higher yield. If you used forward earnings or Treauries, the so-called Fed model, you would get an even larger discrepancy.
The biggest mistake that individual investors make is bad timing by following headlines. Using data is a way to avoid that.
Long-term investors who ignore this warning can follow “Plan B.” You can imitate our enhanced yield program. Buy good dividend stocks and sell short-term calls. I am targeting 8-9% returns on this approach, and achieving it over the course of a market cycle. You can, too. With the increase in volatility, there are many good opportunities.
Conclusion
Disclosure: We sincerely hope that you can apply these fundamental principles to improve the performance of your personal investments. As frequent readers will recognize, Jeff works these fundamentals into all his writing on A Dash. This is because these are exactly the same foundations on which Jeff has built his own investment management business. For more information, feel free to contact us at any time.