Mike Kueber's Blog

July 19, 2012

Should I buy stocks or do my gambling in Vegas?

Filed under: Investing — Mike Kueber @ 2:21 pm
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The roller-coaster ride provided by the stock market since the turn of the century has scared off a lot of potential investors.  Lots of my friends consider the market to be too risky, so they prepare for retirement by parking their savings in places that will almost certainly return less value (albeit only slightly less) than they started with.  So much for the “power of compounding,” which was the universal mantra at the end of the 20th century. 

The market naysayers often compare the stock market to gambling, and I have a friend who says he prefers to get his gambling fix by going to Vegas instead of playing the market.  He says Vegas gives better odds.  Is that true?

The major difference between Vegas and the stock market is that Vegas returns less than the amount bet.  If $100 is bet, Vegas will return only $90 or so and keep the difference as a commission, rake, vig, or juice.  By contrast, the stock market will, over time, return about 10% a year more than it takes in, less a relatively small amount for broker’s fees.  Thus, your chance of winning in the stock market appear to be much better than in Vegas.  But that conclusion may be premature because there is a double-edged sword in the stock trading that is more likely to cut you than protect you. 

While gambling in Vegas is essentially a game of chance, stock-market prices are driven by knowledge and information, and unfortunately those of us in the hinterlands have little of either.  When we are buying a stock based on our knowledge and information, someone else with more knowledge and information is selling that stock to us.  The same symmetry applies when we are selling a stock. 

Based on this information imbalance, I suspect that casual stock traders probably have as much chance of winning in the market as they would in Vegas.  But there is a winning strategy for the market and that is “buy and hold.”  People who employ this strategy (especially with index mutual funds) will likely have a positive return while minimizing broker’s fees and eliminating the need to battle wits with someone who is much better armed, figuratively speaking.

March 5, 2011

Sunday book review #18 – The Little Book of Behavioral Investing by James Montier

The Little Book of Behavioral Investing is directed toward those investors whose investments underperform the market – i.e., just about everyone.  The author, James Montier, believes that investors are unsuccessful, not because they aren’t as smart as Warren Buffett, but because their decision-making process is prone to be based on emotion instead of reason.  Montier even quotes Buffett to support this proposition:

  • Success in investing doesn’t correlate with IQ once you’re above the level of 100.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing.”

Initially, I thought The Little Book would have little applicability to me because I am a firm adherent to Buffett’s buy-and-hold philosophy.  Montier warns of studies, however, that show virtually all investors concede that emotional behavior significantly affects investing decisions, but they also believe they are the exception to the rule. 

To persuade his readers that they aren’t an exception to the rule, Montier begins his book with a three-part brain teaser:

  1. A bat and a ball cost $1.10 in total.  The bat costs a dollar more than the ball.  How much does the ball cost?
  2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
  3. In a lake there is a patch of lily pads.  Every day the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

This test (Cognitive Reflection Task – CRT) is designed to reveal whether an individual’s brain operates with a lot of emotional thinking or logical reasoning.  Montier uses two characters from Star Trek to contrast this difference, with Dr. McCoy (Bones) epitomizing human emotion and Spock epitomizing dispassionate logic.  McCoy’s is an emotional approach to decision making (effortless, with mental shortcuts), whereas Spock’s is a more logical way of processing information (slow, step-by-step).  (All of which sounds a lot like my previous posting on intuition.)

According to psychologists, individuals tend to act like McCoy when (a) a problem is ill structured and complex, (b) information is incomplete, ambiguous, and changing, (c) the goals are ill-defined, shifting, or competing, (d) the stress is high, because either time constraints or high stakes are involved, or (e) decisions rely on interaction with others.  Montier points out that one of these factors applies to virtually all of our important decisions. 

Montier suggests that even if you correctly answered all three questions on the CRT test, you might still have “general vulnerability to a whole plethora of behavioral biases, such as loss aversion, conservatism, and impatience.  In addition to these biases, everyone has a problem with over-confidence, over-optimism (chapter three), and confirmatory bias (chapter eight).   

Only 17% of respondents correctly answered all three questions; whereas 33% got all three wrong.  I quickly answered the first question and studied the second and third more closely.  Not surprisingly, I got the first wrong and the other two correct.  The first answer is five cents, the second is five minutes, and the third is forty-seven days. 

I love brain teasers like the CRT and there are several others in the book.  The most difficult is in Chapter Eight, and it is intended to show that we are all subject to a “confirmatory bias”:

  • Let’s imagine you have four playing cards laid out in front of you.  Each one has a letter on one side and a number on the other.  The four face-up symbols are E, 4, K, and 7.  I’m going to tell you that if a card has an E, then it should have a 4 on the reverse.  Which cards would you like to turn over to see if I am telling you the truth?”

 This teaser, which 95% of the people fail, shows that we tend to look for information that confirms our existing beliefs and we avoid disconfirming evidence. Most people answer E and 4.  The E is correct because if the face-down is not a 4, you will have learned that I lied.  However, turning over the 4 proves nothing, regardless of what the face-down symbol is.  The same is true of the K.  But you should turn over the 7 because if the face-down is an E, you will have learned that I lied.   Sometimes the best way to test a hypothesis is to look for all information that disagrees with it – “a process known as falsification.”  This is a particularly glaring weakness of mine.  I often look for a good explanation of something that I believe in and then don’t bother to look or study the contrary arguments.

Some of the various behavioral defects discussed in The Little Book include:

  • The empathy gap.  The “empathy gap” means that a person says or does one thing during calm and a different thing during the heat of the moment.  Because decision-making is usually better during calm, the author suggests that decisions be made during calm and then use discipline to ensure that you don’t change your mind during the heat of the moment.
  • Courage deficit.  The “courage deficit” describes the inability to act when the big bad market is terrifying.  As an example, Montier mentions the bottoming of the stock market in March 2009, at which time he presciently wrote, “Buy when it’s cheap – if not then, when?”  He brags, “Of course valuation isn’t a fail-safe reason for buying equities – cheap stocks can always get cheaper – but in March I was convinced that they offered a great buying opportunity for long-term investors.”  That sounds like Monday Morning Quarterbacking, which Montier lambastes later in the book.  With all of the Buffett quotes in this book, I am surprised that he didn’t use one of Buffett’s best in this chapter – “When others are fearful, be brave; when others are brave, be fearful.”
  • Over-optimism.  Montier describes over-optimism as one of the cognitive-ability-resistant biases.  To counter this, we must discipline ourselves to think critically and become more skeptical. 
  • Over-confidence.  This is another cognitive-ability-resistant bias that especially afflicts experts, who are even more over-confident than the rest of us.  Stop listening to them.
  • Forecasting.  Is almost always wrong.  Use it to help prepare, but don’t rely on it.
  • Information overload.  Humans are susceptible to information overload because, unlike computers, we cannot efficiently process limitless information.  At some point, the additional marginal information weakens our ability to make the correct, timely decision.
  • The good story.  There is a temptation to ignore facts when they conflict with a good story.  Value stocks usually have bad stories; IPOs usually have good stories.
  • Dealing with bubbles.  Normal people have an advantage over pros in dealing with bubbles because normal people don’t have to compete against artificial benchmarks.
  • Monday Morning Quarterbacking.  Investors are disposed to think, in hindsight, that everything that happened was obvious and predictable.
  • ADHD.  Many investors are afflicted with attention-deficit, hyperactivity disorder (ADHD).  They feel like they always should be doing something.  By way of contrast, Warren Buffett suggests the analogy of a baseball hitter without an umpire.  That batter can wait all day until he gets a fat pitch to swing at.  That’s what an investor should do.
  • Lemmings.  Instead of being a lemming, be a contrarian.
  • Status-quo bias.  There is a tendency to avoid buying or selling – like a deer caught in headlights.

Montier concludes by warning that we can’t control the outcome, but we can improve our chances by controlling our decision-making process.  Excellent advice; excellent book.

November 2, 2010

Intestinal fortitude

Filed under: Finances,Investing — Mike Kueber @ 5:04 pm
Tags: , , ,

My brother Kelly visited me from North Dakota a couple of weeks ago.  It was the first time he had to Texas since 9/11/01.  On that day, I remember him calling down from upstairs to say there was something important happening on TV.  During a previous trip to San Antonio, Selena was murdered (3/31/95).  Fortunately, nothing traumatic happened during this trip, but Kelly did tell me about something traumatic that happened more than a year ago – the stock market crashed and his 401k became a 201k. 

Although I am an avid investor and follow the market daily, I am lucky to have a cool disposition toward its ups & downs; Kelly, not so much.  For most of his working life, Kelly worked as an accountant in Fargo, ND for a small chain of motels.  This chain not only didn’t provide employees with a pension, they didn’t even offer a 401k.  For long-term security, employees were left to their own devices except for mandatory social security.  About five years ago, Kelly went to work for Cirrus, an airplane manufacturer in Grand Forks, ND.  Although the company didn’t have a pension (very few companies do nowadays), it did have a 401k.

Kelly’s initial 401k strategy was solid, in my opinion.  Even though he was nearing 50 years old, he invested bullishly in the stock market.  Unluckily, his timing couldn’t have been worse.  In 2005, the market had been inflating for several years because of the boom in house prices (caused by the subprime mortgage fiasco), so Kelly was buying over-valued stock.  Then in 2008, as the housing market collapsed, the stock market crashed.  The crash caused Kelly and millions of other market newcomers to abandon the stock market.  As newcomers to the market, they thought that they had learned their lesson relatively cheaply, and that lesson was that the stock market is gambling at best and rigged gambling at worst.  In either event, it is something to stay away from.       

We’ve all heard the old saying about “buying low and selling high.”  And obviously, people who sold out near the bottom of the market in March of 2009 did the opposite – i.e., they bought high, sold low, and missed the big gains for the past 18 months.  But I appreciate how hard it is to stick to the time-tested fundamentals of investing, such as dollar-cost averaging, periodically adjusting your portfolio, and the most important – buy and hold.  In fact, disciplined as I am, I didn’t have the courage last year to re-allocate my stock portfolio to 40% international when its share dropped to barely 35%.  Instead, I rationalized that maybe I should have allocated only 35% to International from the beginning.  So what happened?  International has completely recovered to 40%, and I would have made a lot more money if I had re-allocated.

I had a similar failing in picking NFL games the past few weeks.  My initial strategy was to go with the Vegas line unless the line was close and I had a strong feeling that Vegas was wrong.  That strategy worked OK at the beginning of the year, but there were a lot of upsets, and I wasn’t in the top tier of players.  Because I lacked discipline (this was supposed to be fun), I decided to pick more upsets.  So what happened?  As some sports-gambling books have suggested, the Vegas line gets more solid as the year progresses.  In the last three weeks, the Vegas line would have earned one second-place finish and one third-place finish in the Hill’s & Dale’s pool.  My prognostications, laced as they were with upsets, have moved me toward the bottom of my pool.

The moral of this story is to apply solid fundamentals to your strategy, whether in investing or gambling, and don’t let short-term results distort that strategy.  I think that’s what they used to call intestinal fortitude.

September 4, 2010

An open letter to Glenn Beck re: the stock market

Dear Glenn Beck:

 I was recently listening to you being interviewed by Chris Wallace on a Sunday talk show following your big Saturday event in D.C.  During the interview, you smugly reminded Chris of your prescient prediction on the collapse of the stock market in late 2008 and early 2009.  I might say that even a blind squirrel occasionally finds an acorn, but that would unkind and unfair.  It is fair, however, to say that your prediction was a disservice to your country and your patriotic listeners.

You seem to think of the stock market as a betting place like Las Vegas – instead of betting on games, you bet on whether business is going to get better or worse.  But that is a fundamental misconception.  The stock market represents the ownership of American business, and that ownership entitles us to participate in future profits from the business.  This concept of ownership applies to both public and private companies, but ownership in public companies is much more liquid – i.e., easy to buy in or sell out. 

Liquidity is a major attraction of public stocks, but it can be a drawback, too, when prices fluctuate dramatically based on speculation about short-term earnings.  Unfortunately, speculators base their investment decisions, not on the long-term prospects for profits, but rather on the profits for the next few quarters. 

In 2008-2009, you told your listeners that the world economy was, essentially, going to hell, and therefore they should sell their ownership interest in business and place their cash in the safest place they could find.  In making this warning, you were suggesting that your listeners should act like a speculator instead of following Warren Buffett’s advice of “buy and hold.”    

Although your advice was focused on the stock market, I assume the same advice would apply to someone who had private ownership of a business.  It may not be as easy to sell private assets, but if you are jettisoning Buffett’s buy-and-hold philosophy, there is no reason for small proprietors to ride out the storm. 

Another issue with your advice – where can you safely place your money if the world economy is going to hell?  Your advice reminds me of John Denver, who was criticized for working toward energy independence while hedging his bet by installing several fully-stocked, industrial-sized fuel tanks in his back yard.  Don’t you realize that by living in fear of the future, you are exacerbating the problems that currently confront us? 

You probably aren’t old enough to remember this, but in my youth there were people who were building bomb shelters because of their fear that Russia was going to bomb us into oblivion.  These people wanted to be among the few who remained breathing the morning after.  Well, if Armageddon hits the world economy, let it be said that the Becksters followed the advice that Beck learned from his granddad:

“The people who survived the Great Depression were the ones who had money to buy when everybody else was selling.”

Some questions to ponder:

  • Do you want to plan your finances so that you will survive a financial meltdown?
  • If you put your money on the sidelines, will you be rooting (like Rush Limbaugh) for America to fail so that you can buy low later? 
  • What will happen to the American economy if everyone acts like you and decides to cash-out and go to the sidelines? 
  • Won’t the collapse of big businesses spread to small businesses and to families? 

I think your suggestion to abandon the American stock market was one of the least patriotic things you could do.