Our built-in behaviors, which are unconscious, make us choose investments that will lag. The key is to do what we can to defeat these tendencies. • The more research we do, the more we convince ourselves of our rightness, and therefore the more overconfident (and wrong) we become. Fortunately, there are easy ways we can let the market — rather than our opinions — tell us what to buy and sell.
Figure 1. As investors, we can leave behavioral biases aside and use sound principles to guide us to long-term outperformance.
So far in this series, we’ve seen three investor tendencies, all of which can be explained by what finance experts call “behavioral biases”:
- Individual investors tend to sell funds that have underperformed the market in the past three years, buying funds that have performed better. But the funds that are purchased do worse in the next three years than the funds that were sold.
- Financial institutions with highly compensated specialists exhibit a similar behavior. The institutions routinely terminate outside money managers who’ve lagged a benchmark for as few as 1, 2, or 3 years. But the managers that the institutions hire as replacements fail to outperform the fired managers over the following 3 years.
- Academic researchers have shown that securities have a “reversal” tendency. The strategies that performed well in the past 2 and 3 years go on in the following 2 to 3 years to underperform the strategies that were previously the laggards. Our minds are not built to expect this trend reversal.
All three of the behavioral biases listed above — and many more — are exactly the reasons why stock exchanges have continued to exist and profit from investors’ trading activity for more than 400 years. I showed evidence in my one-page Muscular Portfolios summary that the stocks investors buy tend to rise 5.7% in the next 12 months. But the stocks that the same people previously sold soared 9.0%! Someone is taking the other side of these trades, of course. The professional market makers profit, while most people’s portfolios lag the market.
We are all hard-wired to zig when we should zag. The stock market is a funhouse mirror, which may look normal but the view is actually distorted. A mind is a terrible thing to use to select securities.
The good news is that there is a simple way to prevent our behavioral biases from leading us into poor trading decisions. There are dozens of complex trading styles, from buying “options on futures” to selling “naked puts.” But an important and simple trading style that’s growing in popularity among informed investors is called mechanical investing. See Figure 2.
Figure 2. Although there are dozens of trading styles, most individuals who participate in the market use “active investing” or “passive investing.” As a growing alternative, “mechanical investing” sidesteps our behavioral biases by providing a computerized formula to follow, which outperforms trading decisions that are based on opinions. Illustration by Pieter Tandjung.
If you happen to have a successful system that trades complex instruments, good for you! Perhaps you trade currency pairs, or you buy and sell gold bars, or you use one of the many other trading styles.
But watch out! Unless you have a very strong, objective mechanism that measures your gains and losses, your mind may be deceiving you into thinking your method beats the market, when it doesn’t. For example, an exhaustive study by the European Central Bank found that more than 70% of retail currency traders actually lose money.
Most individual investors, of course, don’t use their retirement accounts for complex strategies. The great majority of 401(k)-type retirement accounts don’t even allow the purchase of individual stocks. Savers are usually limited to a specified list of funds. The majority of investors, therefore, use one of three simple trading styles:
- Active investing involves frequent trades that are based on an individual’s or an adviser’s research and opinions. As we’ve seen, our human mind is built to bet on the wrong horse when we’re faced with this kind of financial decision.
- Passive investing is partly an academic response to the recognized failure of active investing to outperform market indexes. A passive investor divides a portfolio into percentages, with each slice of the pie containing a fixed amount of stocks, bonds, and real-estate investment trusts. The percentages never change. This has been shown to expose investors to losses in the 40% to 50% range, which most individuals don’t tolerate well.
- Mechanical investing resolves these problems, providing a computerized formula that individuals can follow without their opinions mucking up the decisions. It’s well known that computers beat the world champions in chess, Go, and even the television trivia game Jeopardy! Selecting which assets are the most likely to go up in the coming month is yet another area of human activity where a machine makes better decisions than the human mind.
There are many ways to take advantage of mechanical investing. For example, the advisory firm Gotham Asset Management uses a technique based on Joel Greenblatt’s 2006 work, The Little Book That Beats the Market. For a fee, Gotham offered Formula Investing accounts to wealthy clients from 2009 through 2012. Precisely following the method resulted in a gain of 84.1%, while the S&P 500’s total gain was only 62.7%. But account holders were allowed to pick which stocks in the formula to hold and which to omit. The people who overrode the computer’s choices gained just 59.4%.
I myself run my own website, which rates low-cost index funds using a formula that is fully disclosed in the book Muscular Portfolios — absolutely free of charge with no need for registration. More and more public services like this will surely arise, as individual investors turn toward the new science of mechanical investing, away from the stress of active investing and the crashing of passive investing.
To be sure, there’s no magic bullet. As I showed in my Feb. 26, 2019, column, every formula that beats the S&P 500 over complete bear-bull market cycles badly underperforms the benchmark for multiple periods that may be 1, 2, or 3 years long.
For investing to work for you, picking an investing style and sticking with it — even during the inevitable periods of underperformance — is the key to your money growing at market-like rates during your lifetime.
Good investing to you!
With great knowledge comes great responsibility.
Send story ideas to MaxGaines “at” BrianLivingston.com