Kimmunications

Don't second guess

Ignoring the temptation to second guess investment decisions improves results. Here is an example.

 

The stock-picking newsletter, Closed-End Country Fund Report, stopped issuing new recommendations in mid-2004. But because the editor said he might resume publishing at some point in the future, Hulbert's Financial Digest left its last picks active in their database. For those of you unfamiliar with Hulbert's, it is a service of Dow Jones that has tracked newsletter performance since the mid-1970s.

 

A funny thing happened. The dormant newsletter's picks have gained 139% since it stopped publishing, it was one of the top performers of 2006 and it has the best five year performance among all newsletters tracked by Hulbert.

 

There are important lessons here for individual investors. Amateurs and professionals alike are affected by fear and greed. When you decide to change course, in mid-stream, it is rarely a logical decision. More likely you are being driven by fear or greed. Fear and greed make terrible portfolio managers.

 

Mark Hulbert, the found of Hulbert's Financial Digest (and a previous guest on my radio show) does an exercise to prove this point. Each year, he takes the picks of newsletter writers at the beginning of the year and figures out the return if they had stuck with those picks rather than fine-tuning throughout the year. In every year, the newsletter writers would have done better by going with their original game plan.

 

In 2006, for example, the average newsletter portfolio gained 11.35%. Had they stuck with their picks from the beginning of the year, their results would have been 12.15%. When you factor in the tax consequences of the transactions, the results would have been even more favorable if they had gone with their original plan.

 

Similar exercises have been done for mutual fund managers and individual investors with similar results. Time and time again, study after study says fear and greed cause us to buy high and sell low. We become convinced that we could do better elsewhere and we get the exact opposite result.

 

An article by Mark Hulbert on MarketWatch recognizes the difficulty we all face:

 

None of these results denies that doing nothing can be psychologically difficult. Holding a stock that is falling takes courage, just as it can seem irresistible to jump on a stock that has already risen.

 

If it was easy, we would all make a lot more money and they would have to take very few coaching calls at Chronim Advisors. I don't think anyone, especially me, is suggesting you completely ignore your portfolio. That can be equally bad. But you have to strike a middle ground.

 

But what these results do suggest is that we should place a large burden of proof on making a change in our portfolios. Unless the arguments in favor of such a change are particularly compelling, we probably should simply do nothing.

 

The most important thing you can do as an investor is to be consistent. In other words, you must make investment decisions when you are sane - when you have not put any money at risk - and stick with them when you become clinically insane - which is the moment you invest a dollar in a security. From that point on, you are not competent to make logical decisions.

 

The way to circumvent that is to make all the decisions up front and never on the fly. Now you might be thinking to yourself, but what if new information becomes available that I didn't have in the first place?

 

Remember, 99% of what you hear is noise, not signal. Pros may be able to distinguish between noise and signal but you can't. The probabilities will work in your favor if you can teach yourself to ignore it.

 

Throughout the history of financial markets, the investors that have done best are those that can manage their portfolio, and their emotions, with unflinching discipline. If you listen to noise, change course mid-stream, and constantly second guess your investment decisions, you will probably not be very successful as an investor.

 

But the good news is this is a learned skill. If managing your portfolio well is a priority for you - and who can afford for it not to be given our need to fund a thirty year retirement - moving from a fly by the seat of your pants mentality to a disciplined approach will make a big difference.

 

SOURCE: (Direct quotes are highlighted)

 

1. Mark Hulbert, "The Value of Doing Nothing"; MarketWatch.com; 19 Jan 2007

http://snipurl.com/mktw_nothing

 

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Principle-Driven Portfolio Management

Nick Murray is one of my favorite financial writers. He is an author, speaker and advisor to investment advisors. While I disagree vehemently with the diversified portfolio approach he advocates, I cannot help but agree with most of his views on how to "think about" portfolio management.

 

He publishes a column each month in Financial Advisor magazine, which is unfortunately, not published on their web site. That also means, in order to share any of it with you, I must re-type it or scan it and run it through OCR. I thought the article, "Portfolio Management As Belief System" was so right on target, that I have done that.

 

The subtitle is "Principles, not prognostication, produce superior returns." I could not agree more. The Snider Investment method™ is, as it turns out, a principle-driven approach to portfolio management, not one based on prognostication. Here is an excerpt from the column:

 

Investors should not be seeking the maximum return possible anywhere in the universe, but rather the best return available with the least stress. In this construct, if Investor A gets a 9.5% lifetime return and thereby achieves his goals with the expenditure of little or no time and energy, while Investor B gets 10.7% working on his portfolio nearly every day, Investor A is held to have outperformed by a significant (if not precisely measurable) margin.

 

(This hypothetical comparison is made only to illustrate the idea of a quality-of-life component in real returns. You will not have failed to note that, in actual practice, the above juxtaposition of outcomes could probably not happen, everything else being equal, because the guy "managing" his portfolio every day would have made so many more market-driven portfolio switches that he'd have drilled his return into the ground.

 

The principle-driven portfolio management belief system thus begins with the dictum that "performance" is not a financial goal, and that the only rational basis for the construction and management of a long-term portfolio is the long-term financial goals of its owners. Thus questions like "When will the Fed stop raising rates?" and "What will the S&P 500 earn this year?" are subordinate, by several orders of magnitude, to the questions that really matter: (1)"Who is the money for?" (2)"What is the money for?", and (3)"When will this money be needed?" Or, if you prefer: the portfolio doesn't follow the market; it follows the human needs of the investor household/family.

 

My way of expressing this same belief is "Focus on outcomes rather than numbers." The idea is exactly the same. Obsession with performance is a disease inflicting most investors. A principled, rational approach makes more sense but the medicine is difficult to swallow for most. Here is another excerpt:

 

The third principle in this system states that the dominant determinant of real-life long-term return isn't what the portfolio does; it's what the investor does. That is, investor behavior dwarfs investment performance in determining the actual return that investors get.

 

[...]

 

Of necessity, since most financial input ordinary people receive is from journalism, they are constantly being brainwashed by a selection-and-timing culture. The primacy of asset allocation may be the immutable truth, but it isn't "news", and therefore journalism can't cover it. The truth is not merely different from the news, it is antithetical to it. The news is the disease; the truth-telling principled advisor is, for most investors, the cure ... assuming, of course, that they want to be cured.

 

Again, I have a different way of stating the same principle: "Investors are their own worst enemy." Investors are irrational. Investors emotions cause them to react irrationally - to do the opposite of what they should be doing - to view things as important that aren't and to view things very important as not.

 

Principle-driven portfolio management requires discipline. It also required, as Nick Murray states elsewhere in his article, for you to remain lashed to the mast of your principles in the face of storms of pounding fury. That is hard, for anyone. It is even harder to get others to stay lashed to the mast with you. And yet, we must.

 

So what do you think? Does this idea make sense to you or do you think it is all wet? Let us know. Leave your thoughts and comments below.

 

SOURCE:

 

Nick Murray. "Principle Driven Portfolio Management: Principles, Not Prognostication Produce Superior Returns," Financial Advisor, May 2006; p45, 46 <No on-line version available>

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Investment Advice From Mark Cuban

I love Mark Cuban. I didn't want to like him. When he first bought the Dallas Mavericks I thought "Ugh!" Here is some young punk who got lucky, made a billion dollars in the Internet bubble that he probably doesn't deserve, and has bought the Mavericks to show everyone that he can.

 

Then I heard him speak. He was phenomenal. No airs. No bull. Just straight from the hip. I realized in that 90 minutes that, while he may have been in the right place at the right time, there was serious business acumen behind the bad boy image.

 

I left that program with a tremendous amount of admiration. That admiration has only grown as I have watched him over the years. As businesspeople, we share many of the same values. Truth-telling, putting the customers best interest ahead of your own, being accessible, and having fun with it.

 

Everyone wants to know what you have to say about the stock market when you are a billionaire. Mark Cuban gives us his investment advice for 2006, which is, not coincidentally, right in line with my own. Here are a few choice excerpts:

 

Every year at this time, everyone and anyone who has a vested interest in selling stocks comes out and talks about how great a year its going to be in the stock market.  Of course its all nonsense and bullshit. NO ONE knows what the market is going to do. Not timers. Not technical charts. Not economists, Not brokerage Heads of Research, Not stock pickers. No one.

 

[ … ]

 

According to an ad for one family of mutual funds, there are 17,000 mutual funds on the market for purchase.  How amazing is that ? How in the world can there be 17,000 fund managers that are worth a damn ? There cant be. How many are good ? How many suck ? How many of the funds will close every year taking your money with them ? Are you completely confident in the fund that is taking money from your paycheck every 2 weeks ?

 

Then of course there are the brokerages. I swear that there are few things that turn my stomach on TV more than watching commercials for brokerages. The guy who gives the toast at the wedding, Paul McCartney, the guy from Law & Order, all trying to con people into thinking that any of their stockbrokers can take you to a financial promised land.

 

[ … ]

 

Simple, avoid risk.

 

Risk is what Wall Street lies about every day. Risk is what they try to sweep under the covers knowing that we all are addicted to the dream of financial freedom. Risk is the poison that is masked by the commercials.

 

[ … ]

 

You can however make the personal decision to avoid risk. Avoiding risk allows you to sleep at night. Avoiding risk allows you to have more at the end of the year than when you started.

 

Lots of people spent a lot of money on commissions this year. If you put your money in the bank, in a CD or in treasuries, you not only slept better than them, there is a very, very good chance you kicked their ass in total return. Your interest compounded, they probably paid interest on their investments.

 

I get emails every day asking me where people should invest. I tell them all the same thing, and I will say it here. Put your money in interest earning investments.

 

Amen Mark! What he is saying is you should avoid risk and put your money in something that provides a consistent payment or paycheck. You know I agree although I know a place where I can get significantly better interest than treasuries with only slightly more risk. The full text of Cuban's post is on his blog, Blog Maverick, and is worth the read.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

The Differences Between Ostriches and Owls

I’ve been thinking about the animals we associate with the stock market – the most obvious of which are bulls and bears. There is some question as to where the terms bulls and bears first came from.

 

Many historians believe the terms came from the way the two animals fight. A bull tosses its horns upward to gore its opponent. A bear slashes downward with its sharp claws. But I am thinking of much more mundane creatures than fighting bulls and bears. In fact, I have been thinking about stock market birds – ostriches and owls.

 

Investors who invest in the traditional way remind me of ostriches - they stick their head in the sand and hope it all works out. I don't want to be an ostrich. I don't want you to be an ostrich. I want you to be an owl. Here is what I think are the differences between ostriches and owls:

 

Imagine you have two young birds – one an ostrich and the other an owl. Both have to be taught how to invest. Neither knew instinctively what to do when they were young.

 

The ostrich looked around to see what everyone else was doing and felt most comfortable doing the same thing. He looked to the same sources as everyone else for information.

 

His advisors saw a great opportunity here and taught him early on that he should rely on them for advice – they were “the experts.” After all, this was all too complicated for his little ostrich brain to understand.

Once he had accepted this belief system, his advisors were able to sell the ostrich ridiculously bad investment, charge absurd fees and commissions, and answer any questions with nonspeak worthy of a politician. The ostrich, believing from a young age that he was incapable of understanding, just rubber stamped anything his advisors told him.

 

Owl though, got a much better education. Owl was brought up to be self-reliant. He was told that he should be accountable for his own financial well-being and the way to do that was to get a good financial education and be willing to apply it throughout his life. “There was nothing to be afraid of”, his friends and family said. “This isn’t rocket science. It is mostly common sense. Anyone can learn if they were willing to make the effort.”

 

Over time, the ostrich learned from his advisors that his focus should be on portfolio growth. That is how you will know an ostrich - he will be talking about things like asset allocation, stock picking and market timing. Ostriches focus on maximizing return and the question they ask themselves every night before they go to bed is, “how did my portfolio do today?”

 

The owl learned that so long as he could generate a paycheck from his portfolio that he didn’t have to work for or worry about, he would be financially free. For owl, work, and when to stop working, would be a choice. You will know an owl because he talks about financial engineering –using all the latest knowledge and research to create new and better ways of investing his money so that it creates the steady paycheck he seeks. Owls focus on managing risk and the question that drives them is “what if I live to be 120?”

 

Ostriches and owls come from totally different points of view, based on their upbringing and belief system. Ostriches are eternal optimists. They say to one another, “Remember, stocks always go up in the long run.” Owls respond with, “Yes, but in the long run we’re all dead.” Owls are more realists. They don’t spend time thinking about what they would like to happen but rather on all the things that could possibly happen that they should plan for – for example, “What if what I want to happen, doesn’t?” or “What if the worst thing that could happen, did?”

 

Because ostriches are eternal optimists (and it makes the most money for their advisors), they invest by betting. They bet on the future direction of stock prices in the same way someone else might bet on Cactus Jack in the 6th at Churchill Downs. Listen closely and you’ll hear them. “I’d like to put ten thousand dollars on Cisco to win and I want Google, Taser and Baidu in the Trifecta.” Like all gamblers, this means their portfolios are very volatile – most of the time they are losing but every once in awhile they win big, which keeps them convinced there is a huge payday just around the corner.. Just as the handicapper spends his days poring over the racing form, stock market gamblers pore over news, newsletters, stock charts and data. Heck, there is even a 24 hour gambling channel now. It is called CNBC – the Can’t Not Bet Channel.

 

Owls are different - much more relaxed. They don’t care which direction the market moves because they don’t bet on stocks. Owls have figured out a much better game. They know statistically that the gamblers lose the vast majority of the time. So rather than gambling on stocks, they just bet against the gamblers. It’s the closest thing to a sure bet there is – bet against the bettor, hedge away the risk of the one time in ten that the gambler actually wins and you have a nice steady stream of income that is independent of the market’s direction. So instead of poring over stock charts, you will find the owls enjoying their families, spending time with their grandchildren, playing golf, or hanging out with their buddies in Bora Bora.

 

The ostrich’s best friend is named Luck. He has another guy he likes to hang with called Hope. Ostriches biggest vices are fear and greed. Because Luck and Hope are so unreliable, the ostrich often feels like he is on an island, and the future holds mostly fear and uncertainty. Thinking about whether or not he will ever be able to retire is a source of great anxiety. He often thinks to himself, “Where are Hope and Luck? They are never around when I need them!”

 

The owl’s best friend is a very smart fellow called Probability and another useful chap named Intellect. Probability and Intellect never fail the owl and because they are so trustworthy, owl has trained himself to rely on them whenever he finds himself confronted by the evil fear and greed. With friends like Probability and Intellect at his side, the owl sees the future as a source of joy and can’t wait to see what tomorrow will bring.

 

One day, Money Mustang was standing nearby watching the ostrich go about his investing. “Are you a sheep?” he called out to the ostrich. “Of course not. Everyone can see I’m an ostrich,” he replied. “Humph! Looks like a sheep to me,” thought Money Mustang.

 

Then Money Mustang came upon the owl. He watched the owl taking care of his investing. The mustang noticed the owl was very different from the sheep/ostrich he had encountered earlier. “Are you a Snider Method Investor?” asked the pony. “Why yes I am,” said the owl delighted to find someone who understood him. “I am just leaving for Bora Bora for a month. Care to join me?”

 

If you would like to view a chart that I posted that summarizes the differences between owls and ostriches, it is in the previous post. If you would like to comment on my little parable, leave your thoughts below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Ostriches and Owls

Investors who invest in the traditional way strike me as ostriches. They stick their head in the sand and hope it all works out.

I don't want to be an ostrich. I don't want you to be an ostrich. I want you to be an owl. Here is a chart outlining what I think are the differences in the two approaches:

So what do you think? Are you an owl or an ostrich? Leave your comments below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

"Pick Winning Stocks! You Can Time the Market Like a Pro!"

Guess what? This is the dirty little secret of Wall Street.

 

The financial services industry make their money by selling you the impossible - a pipe dream - the ability to consistently predict the unpredictable.

 

Just today, the following advertisement arrived in my inbox, courtesy of Barron's:

 

Not only will The Money Show be in a brand-new location, it will feature a brand-new focus as well: stock selection and real estate investing for income & growth.

 

Since when are these new? Hasn't Warren Buffett very recently warned investors away from both stock picking and real estate?

 

Selecting which stocks are right for your portfolio can be a daunting and time-consuming task.

 

Don't you mean an impossible task?

 

Adding real estate to the mix, especially now in the face of rising interest rates, can be even more confusing.

 

As if stock picking wasn't foolish enough, you also want us to try to time interest rates, something our most learned and esteemed economists are unable to do?

 

Experts in both arenas will help you narrow down the plethora of possibilities and provide you with timely and actionable advice on how to incorporate both into your portfolio.

 

Experts? You mean bell-ringers, candy men, cheap jacks, dealers, drummers, hawkers, hucksters, medicine men, merchants, outcriers, pitchmen, pushers, and peddlars, don't you?

 

Last week, I posted an investment scenario and listed six mutually exclusive alternatives for investing your money. I asked which you would pick at different ages.

 

Just to remind you, the scenario was that you had accumulated $100K in retirement funds. We have a crystal ball that tells us twenty years from today, the S&P 500 will be either 20% higher or lower than it is today but it doesn't tell us which way it will go, only that the odds are 50/50. No other outcomes are possible.

 

The choices were:

 

A. Buy and hold a market basket of stocks and hope that it goes up 20% instead of down 20%

B. Try to time the market - get in when it is going up and out when it is going down

C. Try to pick stocks using historical data, company fundamentals, technical analysis, sector analysis or some other stock-picking methodology

D. Put your money in bonds which will return on average about 5% but have a small risk of loss

E. Put your money in a principal protected cash equivalent like CDs paying 2%

F. Put your money in an investment that will lose significant value if the market declines but will generate a consistent cash flow of approximately $1000 per month over the ten year period.

 

I asked which of these investments you would choose at age 35 and at age 55, if you had to pick only one and were locked in for the entire twenty year period.

 

In comments left in response to my post on the "buy and hope strategy", some people seemed to have missed the point. Whether the scenario unfolds over twenty years (less likely but still very possible) or five years (more likely), doesn't matter.

 

Dead money is a sin. And that is what you have for as long as your portfolio remains underwater in a capital appreciation investment strategy foisted on you by an industry that makes a lot of money from your naïveté.

 

So let's not focus on the number of years. It's irrelevant. It's the general concept I want you to understand. Also, as I did in the first scenario analysis, let's increase the starting number to $1 million instead of $100K, just to make it more realistic.

 

With that being said, let's dispatch choices 2 and 3:

 

Market timing and or stock picking - the evidence is pretty overwhelming here that neither of these two things do anything but lose you money. And yet, consciously or unconsciously, it is what most people do.

 

I have written on both pretty extensively on this blog, and pound on both relentlessly on my radio show. But for the uninitiated, here is a recap:

 

This is what you are trying to time or pick stocks in. This is the return of the U.S. stock market, by year, going back to 1873.

 

 

According to 2004 congressional testimony, the average managed mutual fund returns 2.5% to 3% less than the market and 80% of managed funds under-perform the market return in any given year. These guys get paid millions of dollars a year and they can't do it.

 

According to the database maintained by Hulbert's Financial Digest, the risk adjusted return of the average newsletter writer is less than half that of the market itself. They have every financial incentive in the world to out-perform the market - wouldn't you agree? They can't do it.

 

In a first-of-its-kind study of the trading records of 78,000 households who pick their own stocks done by Brad Barber and Terry Odean, the results were exactly what you would expect. Again, the stock pickers were performing worse than the market itself. We can't do it.

 

According to the Quantitative Analysis of Investor Behavior which has been done every year for over 20 years by Dalbar, a Boston research firm, the average stock mutual fund investor has had an average return of only 2.5% annualized over the last nineteen years - a period in which inflation has risen annually at the rate of 3.1% and the S&P 500 by 12.2%!

 

Look at the chart above. Imagine when those bars are going up, your portfolio isn't going up as much. And imagine when those bars are going down, your portfolio is going down more! The evidence is overwhelming. That is exactly what is happening to the vast majority of people who try to pick their own stocks or hire people to do it for them.

 

So exactly who is making the money here? Because it surely isn't you! Not if you invest by trying to predict the future.

 

If you are going to have to one day live off your portfolio, with little or no assistance from pension or government programs, you need to make as much as you can, as consistently as you can, and avoid losses like the plague.

 

Stock picking and market timing create the exact opposite result.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

If You Torture the Data Long Enough, it Will Confess to Anything

Is it possible to time the market?

DALLAS, TX - I was teaching a SYGMATM Workshop last weekend, during the course of which, I began explaining some of the assumptions which underlie the SYGMA Method. One of those assumptions is that market timing and stock picking don't work.

"This is based on the data", I told them. "I have not seen or read of a verified case of someone who has been able to time the market successfully, and beat the market's returns on a risk- adjusted basis over long periods of time", I said. "There are an infinite number of documented cases of people who failed - and lost a lot of investor's money in the process."

Market timing is attempting to predict the future direction of the market, typically through the use of technical indicators or economic data, and to buy and sell accordingly.

Many investors, especially academics, believe it is impossible to time the market. Other investors, notably active traders and those who make their living selling actively managed financial products believe strongly in market timing. So, whether market timing is possible is really a matter of some debate.

During the break, one of the students came up to me and said, "I know you follow Mark Hulbert."

Well, that is not exactly true. Mark Hulbert has been producing the well-respected Hulbert's Financial Digest since 1980. His newsletter tracks the performance of other newsletters, which is generally pretty dismal.

I don't follow Hulbert because I don't subscribe to newsletters or believe in the stock picking or market- timing abilities of the writers. But it is fair to say that I use the data from Hulbert's database, which is widely quoted, to support my assertion that no one can time the market or beat the market by picking stocks.

In fact, Hulbert's data says that in any given year, 80% of newsletter writers have performance that is worse than the market and the one's that outperform vary from year to year. Just because you beat the market one year doesn't give you any better chance of beating it the next.

In other words, there is none of what academics call persistence. Their results are simply a matter of chance, not some special skill at divining the future. This finding is consistent with studies of brokerage analysts, mutual fund managers, and individual investors. So, no, I don't follow Hulbert, but I know his data pretty well.

"He has shown newsletter writers who were able to time the market", my student said.

"Not over long periods of time", I said. "It's not possible."

"Yes. Over twenty years", he said.

I told him I didn't think so and asked him to show me the Hulbert data he was referring to. And he did.

My student sent me a copy of the April 2004 Financial Digest and asked for my comments. Well, here they are.

This issue purports to show five newsletters which were able to beat the market over the last twenty years. In spite of the fact this was only five newsletters out of the 500 portfolios his web site says he covers, I was of course interested and began reading further.

Turns out the five examples he has cited were not cases where the buy and sell recommendations of the newsletter writer actually beat the market. These were hypothetical portfolios created using a method called back-testing.

Backtesting is a technique that has many critics, including me. It's a hypothetical analysis of how an investment strategy would have done if you'd used it over a certain period of years.

Less politely put, "it's a theory on something that worked in the past that, by the time they get assets in it, doesn't work anymore," says Don Phillips, president of Morningstar Inc., the mutual fund research service.

And, as a rule, it's a technique that sends regulators into a cold sweat. "Historical data is easily manipulated," says Barry Barbash, director of the investment management division of the Securities and Exchange Commission. "It's only [used] when it's good, and there is a possibility for it to be cherry-picked or misused."

What HFD has done is to substitute the hypothetical purchase of the Wilshire 5000 index for each stock pick that the writer actually made. When the writer recommends a sell, HFD substitutes 90 day T-Bills for cash.

So in this hypothetical portfolio, the only two choices are the Wilshire 5000 and 90 day T-Bills. The idea here is that by eliminating the stock picks and substituting an index, any gains or losses are limited to the writer's market-timing ability rather than good stock picking.

Just for the record, if you had followed the stock picks the writer's actually recommended, you would have done much worse than the market itself. Using Hulbert's own example, following the advice given by the Cabbot Market Letter would have gotten you an 8.8% annualized return over the twenty year period, while the market's return was over 12%.

But by using this hypothetical portfolio substituting the Wilshire 5000 for Cabbot's stock picks, the hypothetical portfolio would have returned 13.3% - better than the market returns.

The fallacy in the logic should be pretty obvious. This is a shining example of the old saying, "If you torture the data long enough, it will confess to anything!"

The conclusion that these writers could have beaten the market if they had wanted to - but didn't - is preposterous on its face. A little bit of logic reveals that the conclusion is the result of two common flaws of logic that plague back-tested models: they are known as "back-testing brilliance" and "data mining".

These refer to errors in logic that occur by throwing a computer at a set of data. Eventually, you will find a pattern that fits the hypothesis you are trying to prove, but that does not make it valid as a predictor of future success.

Some of the best known examples of data mining are the Hemline Index and the idea that the future direction of the stock market is predicted by whether the NFC or AFC wins the Super Bowl.

It is easy to conclude that because historical data shows a correlation between the length of the hemlines on ladies skirts and the stock markets, that future hemline length will predict future stock market direction, but it just isn't the case. It is an example of finding the survivor within a set of rules that could possibly work. This is also called data fitting and it is merely a coincidence.

Lest you be too amazed at how big a coincidence is, let me give you an example from Nassim Taleb's excellent book, Fooled By Randomness. If you meet someone randomly, there is a 1 in 365 chance that you share the same birthday. If you put twenty-three people in a room, the chances that someone in that room will share a birthday suddenly becomes 50%.

In other words, our perception of coincidences is that they are rare, but in reality, they are easy to turn up, especially when you begin fitting a set of rules to historical data.

According to Dean LeBaron, "What passes for investment research is usually back-testing: if I know now what I should have known then, how good the results would be." Is it any surprise that looking at historical data always produces wonderful results, but that application of the same concept in real time almost always fails?

Case in point is Value Line. Many people point to Value Line's stock picking methodology as evidence stock picking can be done successfully. When back-tested, Value Line produces results that consistently beat the market by a wide margin - even on a risk adjusted basis.

And yet, when applied in real-time by the fund manager's at Value Line's own mutual funds, their results have been exactly what we would expect. Over ten years, Value Line funds which follow their own stock picking scheme have had a return of 11.1% while the market averaged 12.9%. Over a fifteen year period, the discrepancy was even bigger.

With regard to the hypothetical portfolios in Hulbert's Financial Digest, I would submit that Mr. Hulbert, who I must confess I hold in pretty high regard for his generally forthright analyses, has fallen pray to the cognitive biases that afflict all of us if we are not careful.

To those of you who still believe that stock picking and market timing can be done: show me a complete track record with real money that stands up to careful scrutiny and then - and only then - will I be impressed.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.