The Seduction of Above Average

I think over confidence is a major issue amongst investors, both professional and amateur.

Why there's an assumption that index is the only way to invest and anything outside of it might have an element of seduction to it, as if one was fooling themselves to think they could succeed?

It's far more important to understand the different options out there, get educated on the different mechanisms to build wealth, their pros and cons (all of them has pros and cons) and make an informed, rational decision on what risks one is willing to accept to implement their decision, with the level of time and effort associated with it.

Speaking for myself, I must do something different than indexing because indexing doesn't meet my goals, which is having a portfolio that produces a perpetual growing stream of income, which grows about 7% per year, every year, including during recessions and crisis. The index can't provide me that, so I build a portfolio with my own stocks, following my criteria rationally at any scenario, at all times. Not every company from the index pays dividend. Many companies of the index doesn't meet my quality criteria. Many companies of the index are overvalued. And many companies that I want to partner with are not part of the index. For all these reasons, the index doesn't work for me. Once I know what my requirements are, I just need to define what to buy (quality approach) and when to buy (valuation approach).

This is for my main portfolios. The other portfolio (RESP) is focused on growth, and for that I want to maximize total return. The index also doesn't work for me because it limits me at market returns. I rather have the choice to choose only growing companies, that are expanding very rapidly. I rather take quality and valuation into account, factors that are not considered by the index. And companies that are not in the index because they are smaller.

But specifically to your question, yes I feel confident that the effort justifies the results, starting by the clarification that success at investing has nothing to do with intelligence:

"Success in investing doesn't correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing. In ‘97-8, people weren’t rational. People got caught up with what other people were doing. Don’t get caught up with what other people are doing. Being a contrarian isn’t the key, but being a crowd follower isn’t either. You need to detach yourself emotionally. You need to think about what is going on around you. Being in Omaha helps me in that regard. When I was in NYC, I had 50 people whispering in my ear before noon. It’s hard sometimes, like when the Internet craze hit. Nobody likes to see their neighbor doing stupid things and getting rich. It was like Cinderella’s ball, I think I’ll just have one more dance, it’s not midnight yet. Sounds simple – but it is hard to leave the party. The problem with stocks is they don’t have clocks. You don’t know when it will be midnight so you can leave the party. My partner Charlie Munger and Tony Nicely at Geico are always rational. 160 IQs can say stupid things that sound good. People do silly things, whether they have 120 IQ or 160. You can always improve your rational thought. Rationality is the only thing that helps you. One thing that could help would be to write down the reason you are buying a stock before your purchase. Write down “I am buying Microsoft @ $300B because…” Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational." - Warren Buffett, BRK Student Visit, 2007

So is the seduction factor the lack of temperament that most investors have? Is it the approach to only look at price, instead of quality and valuation of the underlying business? How an investor emotionally reacts in a bear market is a different risk entirely. If someone loses money by selling them, that is their own emotional risk. That action does not change the actual risk characteristic of the blue-chip company itself.

An idividual investor can do much better by investing only in businesses that meet their objectives. They can choose the level of risk, since not all stocks carry the same risks. They can choose valuation, and only buy when a business is attractivelly priced, instead of buying at any price. They have control on their portfolio, by selling the businesses that no longer meet their objectives, by lacking earnings growth or being very overvalued. Can't do or control any of that with an index. But temperament is required, which is a soft-skill unrelated to intelligence because it involves detaching emotionally from your life savings and future funds for your well being - something that is difficult (but not impossible) to do. I rather focus on what it takes to succeed at picking stocks (if indexing is not an option). A lot of the key points to succeed (temperament) are also the same as if one indexes.

The other point that also justifies why anyone can succeed and not be simply seduced to it? Consistency. Which aligns with temperament:

As long as you are consistent on how you value business, your degree of inaccuracy, if it’s replicated through consistency, will lead to a great model for a relative valuations. So if your valuation model is not sophisticated, does not take into account six dozen variables, well, as long as you’re applying it the same way to every company and you are looking at a lot of different companies, you will have a useful model for relative valuation which can lead to very superior investment returns." - Charlie Munger, Vice Chairman, Berkshire Hathaway

Your article is about someone that thinks that are well equipped to be a great active manager. It's also important to clarify that an individual investor has more chances to succeed than a professional active manager. No wonder professionals barely beat the market. In no way that implies that the little guy cannot succeed, because we don't have the same mandates, requirements and pressure to show short term performance than they do, nor we need to buy just the liquid stocks that they do, nor we have to buy when everybody does or sell when everybody does. So I disagree with the statement that "You are now playing against the cream of the cream of the crop. It’s like a college football player that enters the NFL". The professional money manager can’t even win their own game! Why should you want to play it at all? If you follow their rules, you will lose - since you will end up as much a slave to Mr. Market as the professionals are. The small investor doesn't compete with anyone if they are simply tagging along the operating performance of the businesses that they choose to partner with.

Lastly, the efforts to pick stocks are lower than you (and the indexing industry) portraits. It's not zero (like indexing), but it doesn't have to take quality time away:

Seth Klarman summarized it best:

"Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information."

I think investors would be much better off if all the effort they put into predicting macro events and situations that they can't control were instead focused on the actual business that they were investing on, and learn that discipline, not intelligence, is what allows them to succeed, by not letting greed make them overpay or over-allocate and by not letting fear make them missing opportunities when good businesses are fairly priced. Companies report results only 4 times a year, results should be compared yearly, the daily quotes are just distractions. I firmly believe that anyone can learn how to succeed and not be simply seduced that they can, since it mostly involves a mindset change.



Rod

CheapScotch wrote: ↑ https://ofdollarsanddata.com/the-seduct ... e-average/



Just want to make it clear up front that I am not starting this thread to for the purposes of debating stock picking vs. indexing. I understand there are a lot of intelligent people in this forum who spend quite a bit of time studying personal finance and investing topics. Just want to ask: how confident do you feel that your efforts justify the potential rewards? Do you think, in any way, that you are being "seduced", as the author of the article implies?

As Rod said, this article has unfortunately presented a false dichotomy as not everyone has the same aims. I for one am very happy with the stable income that my portfolio provides, I might have lost some gains from not indexing but I gained a lot of peace of mind knowing that I have predictable income no matter the situation.

That's the reason why we have people dabbling in cryptocurrency, to gain some leverage.

My portfolio mostly consists of ZLB and ZLU, along with the odd stock pick here and there to make me feel like one of the cool kids.

I have an old man portfolio, which fits very comfortably with my old man willingness to assume risk.

Ultimately your portfolio should be tailored around your willingness and ability to assume different levels of risk, and problems often arise when those are not fully known or acknowledged.

Gungnir wrote: ↑ As Rod said, this article has unfortunately presented a false dichotomy as not everyone has the same aims. I for one am very happy with the stable income that my portfolio provides, I might have lost some gains from not indexing but I gained a lot of peace of mind knowing that I have predictable income no matter the situation.

I don't think the author was referring to a person like you, since it seems you are not trying to beat the market. But you point is taken; it was a short article and the author needed to simplify things.

treva84 wrote: ↑ I think over confidence is a major issue amongst investors, both professional and amateur.

I agree with this insofar as many prospective investors will be seduced into thinking they are "above average" investors because they seem themselves as more intelligent, more disciplined, more patient,..... whatever quality they think they have to put them ahead of the pack. This gives them the confidence to believe in themselves and try to beat the market. I am not saying that they are all destined to fail, but if they are going to spend time trying to separate the "good stocks" from the "bad stocks", they should also be spending time learning about psychology and the cognitive biases which investors are susceptible to.

CheapScotch wrote: ↑ I agree with this insofar as many prospective investors will be seduced into thinking they are "above average" investors because they seem themselves as more intelligent, more disciplined, more patient,..... whatever quality they think they have to put them ahead of the pack. This gives them the confidence to believe in themselves and try to beat the market. I am not saying that they are all destined to fail, but if they are going to spend time trying to separate the "good stocks" from the "bad stocks", they should also be spending time learning about psychology and the cognitive biases which investors are susceptible to.

Yup, couldn't agree more. Behavioural finance is very applicable to anyone who ever does anything with money.

alanbrenton wrote: ↑ That's the reason why we have people dabbling in cryptocurrency, to gain some leverage.

I see speculation in Crypto as much closer to certain forms of gambling which have an element of skill (e.g. poker, sports/horse race betting) than long term investing. But the way I see it, people are seduced to dabble in Crypto for 2 separate reasons:

1. There are people who buy Crypto because they are "true believers" that Crypto is the future of money. They will compare Crypto to gold or other precious metals with natural scarcity, or take an anarchist point of view that Crypto will liberate the masses from the oppression of central banks and their fiat currency, corrupt large financial institutions, etc. Makes me think about how diehard Socialists/Commies believed that common ownership of the means of production would liberate the proletariat.

These people are seduced into believing they have some special insight or wisdom about how the future will turn out. They see themselves as the fortunate few who are the first to understand the potential of Crypto at present, and by buying into it now they will be richly rewarded in the future once the unenlightened masses catch up with them.

2. There are people who speculate in Crypto simply because they think they can make a buck off of it right now, regardless of where it will go in the future. Not unlike other kinds of currency speculators out there.

I will give these people credit insofar as they are more realistic than the first group above; they understand how incredibly difficult it is to predict the future. But I would still argue that they are being seduced by the prospect of easy money speculating in Crypto. As a new phenomena, there is quite a bit more risk compared to other forms of speculation, and they are competing against other highly motivated and intelligent speculators.

Alll you need to do is cut losses short. Go 50/50 on investing, and make money!

Sadly most people don't (read rfd lol), "believe", and end up way under water (see cannabis thread)

Its not hard, but most don't do it. Cut losses, buy above a moving average (or buy a quick plunge, cut losses very short and take profits when presented), SELL when it turns down. no inteligence required. If you cant do that, invest in an index and forget about it

I believe that most professional investors seriously don’t know how to invest lol..

The biggest problem is not reacting fast enough to changing trends

wolfs004 wrote: ↑ I believe that most professional investors seriously don’t know how to invest lol..

The biggest problem is not reacting fast enough to changing trends

I totally agree with you.

I was reading recently about "cognitive entrenchment" - where you find something that works and you stick with it. The ideas that work and give you success then become entrenched in the brain. You then fail to consider new ideas and fail to anticipate and respond to change. When the game changes (and because markets are so dynamic in investing it always will change) you are then stuck in your old ways and then you get left behind.

It happens in multiple domains (not just investing) - for example there's a saying that "science advances one funeral at a time". I think its another form of anchoring which is something we all suffer from.

treva84 wrote: ↑ I totally agree with you.

I was reading recently about "cognitive entrenchment" - where you find something that works and you stick with it. The ideas that work and give you success then become entrenched in the brain. You then fail to consider new ideas and fail to anticipate and respond to change. When the game changes (and because markets are so dynamic in investing it always will change) you are then stuck in your old ways and then you get left behind.

It happens in multiple domains (not just investing) - for example there's a saying that "science advances one funeral at a time". I think its another form of anchoring which is something we all suffer from.

Pretty much this.

2000s was a commodity bubble so every Pm that got rich off energy got killed the last 5 years
I could go on and on...

In many cases They end up being so broadly diversified anyways not really taking any real bets that they end up matching the index anyways

zoro69 wrote: ↑ Its not hard, but most don't do it. Cut losses, buy above a moving average (or buy a quick plunge, cut losses very short and take profits when presented), SELL when it turns down. no intelligence required. If you cant do that, invest in an index and forget about it

If if was that easy, we would all be billionaires living on our own private islands, being waited on by an army of servants to take care of our every whim ....... we would not be posting articles on RFD discussing investment strategies.

CheapScotch wrote: ↑ If if was that easy, we would all be billionaires living on our own private islands, being waited on by an army of servants to take care of our every whim ....... we would not be posting articles on RFD discussing investment strategies.

It is that easy...most do not do it. Buy a stock, if it doesn't move in the right direction sell. Most people hold on when it goes agaisnt them, then sell quickly when it moves in their direction. Reverse that,, you wil do much better

wolfs004 wrote: ↑ I believe that most professional investors seriously don’t know how to invest lol..

The biggest problem is not reacting fast enough to changing trends

Reminds me of another article recently posted by the same author (Nick Maggiulli)

https://ofdollarsanddata.com/the-red-qu ... investing/

But this isn’t just a reality for hedge funds and traders, individual retail investors have to deal with the Red Queen as well. Consider how much investing has changed over the last century. In the 1950s your competition was mostly fellow households, but now you have funds, foreigners, and institutions to contend with too. As Nate Geraci illustrated in this chart, who owns the equity market has changed:

What impact will this have on retail investors? Does it present new risks? If so, what kinds? I don’t know the answer to these questions, but I do know that any complex, adaptive system like the stock market will continue to evolve based on the decisions made by its many participants. This is why investing will never be easy. Because if it was, then other investors would arbitrage any such easy return streams until it wasn’t easy anymore. This explains why “buy the dip” will continue to work in this relentless bull market…until it doesn’t. Or why gaining more information is advantageous until everyone else has that information as well. Back and forth. Back and forth. Yet the Red Queen never tires.

Even Benjamin Graham admitted in the 1970s that his method of picking stocks was no longer effective; imagine what he would think about the challenges facing investors today.

zoro69 wrote: ↑ It is that easy...most do not do it

So when are you going to invite us all to your private island?

CheapScotch wrote: ↑ So when are you going to invite us all to your private island?

No island, however i am up significantly in my cannabis account over the last year, while stocks are all down. Because I sell quickly rather then hold and lose (and lose and lose these days lol).