Smart Advice for the HuffPost Investor: Investment Pornography -- Are You A Victim?

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"Investment pornography" is generally attributed to the respected financial journalist Jane Bryant Quinn. She defined it in the following quote:

You know the stories: The Top Ten Mutual Funds to Buy Now, How to Double Your Money This Year, personality profiles that read like fan magazines. Stock-touting pieces that praise any path to profits. We've all done these stories, in one form or another. It's investment pornography -- soft core, not hard core, but pornography all the same.

I define it as any effort to convince investors that there is a reliable way to "beat the markets."

Many investors fall prey to investment pornography. They believe they have found the path to investment success. Upon examination, their strongly held beliefs are more likely to lead to financial disaster than to investment success.

I deal with these issues in this week's column.

Thanks for your continuing excellent comments and encouragement. I always look forward to your questions.

Question: Can I beat the markets by buying low and selling high?

Answer: It would be great if you could. One study showed that someone with the ability to be in Treasury Bills during bad times in the market and in stocks during good times over a 52-year period would have seen her $1000 investment increase to a whopping $5.36 billion!

Do you know anyone who achieved these returns? Have you even read about any one who did?

Here is the bottom line: There is no evidence that anyone has the ability to predict highs and lows in the market. If they did, there would be a lot of billionaires out there who made their money market timing. They don't exist.

Question: Can technical analysis programs help me time the market?

Answer: While the research is not entirely free from dissent, the overwhelming weight of authority is that these programs enrich those who sell them, at the expense of investors to whom they are sold.

In order for technical analysis to work, you would need to ignore the following:

• Markets are random and efficient;
• The pattern detected in the analysis most likely cannot be exploited for profit because it has been disseminated to investors who subscribe to the program; and
• Transaction costs involved in implementing the recommendations of the program will substantially reduce or eliminate profits.

There is overwhelming academic evidence that each of these statements is true. It is for this reason Burton Malkiel noted, in A Random Walk Down Wall Street, that "technical analysis is anathema to the academic world."

Warren Buffet dismissed technical analysis, stating: "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer."

Nevertheless, the quest for trying to find patterns in an effort to beat the markets still has many adherents. Most of them will lose money.

Ask yourself this question: If you had a program that successfully predicted the price movement of stocks, would you sell it to other investors? Why not keep the proprietary information to yourself, eliminate the possibility that the markets will react to it, and trade with your own funds?

Question: Can I be assured of beating the markets by buying Berkshire Hathaway stock?

Answer: No. For the five year period from October 1, 2002 through September 30, 2007, the total return of Berkshire Hathaway A stock was 59.72%. The total return of the S & P 500 index during that period was 104.07%.

The correct "market" for comparison purposes is the index that has a comparable risk, as measured by standard deviation, for Berkshire Hathaway stock. This would be an emerging markets value index.

For the 20 year period from 1986 through 2006, this index had an annualized standard deviation of 23.20% which is very close to the 24% annualized standard deviation of Berkshire Hathaway stock. The index had an annualized return of 20.03%. Berkshire Hathaway stock had an annualized return of 21%. Investors in both the index and Berkshire Hathaway stock took similar risks and achieved similar returns.

A portfolio consisting solely of Berkshire Hathaway stock would be far too risky for most investors. In addition, the concentration of assets in one stock would expose investors to a high degree of "idiosyncratic risk"-- the risk of loss due to the unique circumstances of a specific stock. This risk can be eliminated by diversifying your portfolio.

Since you can achieve the same expected return by purchasing an index of emerging market value stocks and eliminate idiosyncratic risk, why would you put all of your eggs in the Berkshire Hathaway basket?

Question: Why do you want to beat the markets?

Answer: I can understand the quest for more money, but at what risk?

Capturing market returns, which is easy to do, will give you returns approximately 300% greater than those achieved by the average equity investor. It will also place you in the top 5% of all professionally managed money over the long term.

Is it really worth it to be in the top 4% or 3% of professionally managed money, when you consider the very real possibility that your efforts will most likely cause you to underperform the markets?

The present system is not working for investors. The rules of the game are set up for brokers and advisors who will happily take your money and entice you with the prospect of "market beating" returns.

There will always be plenty of takers. You should not be among them.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[Camel54]

Dan:

My wife has a 403(b) from a previous job that she has left in the care of the manager for that outfit because taking it out, even moving it to her new 403(b), would have meant over $500 in fines she was not told about when she joined the fund. However, we just received a statement and in the first quarter of this year that 403(b) has lost nearly $1000--close to a tenth of its full value. Her allocation is not aggressive, in fact its on the low side of moderate. We're freaking out a little, though. Do we leave it there and risk losing more? Half of it? Three-quarters? All of it? Or do we pull it out, deal with an additional $500 loss and put it into our savings account, which is now at least earning 3.5% as opposed to losing 10%?

We don't have a lot of money and we're being killed by gas and milk prices. We can't risk losing what little retirement savings we've accrued so far. Your advice is always appreciated.

[larry278]

If a deal sounds like its too good to be true-it isn't true. Don't walk away from it; run away from it. You can steal a lot more money with a pen &/or a computer than with a gun & white color criminals often don't do hard time. A number of the 'new' gimicks are too good to be true. While it's not comfortable to sleep on a mattress filled gold, it could be safer than holding paper for a while. We're getting to the point where it's speculating to buy & hold paper that's guarenteed with the full faith & credit of the US government.

[mightbesane]

OK. I get it. Index funds almost always beat managed funds. But hey, can't a guy have a little fun every now and then? It didn't take a rocket scientist to figure out that funds heavy into energy would thrive when Bush blew up the Middle East a few years ago and that precious metals always soar when the I-word hits the fan.

And can't we trade in stocks on line just a little bit? For the rush? I've got less that 2% of my portfolio in my trading account and it's a hoot. And I'm beating the indexes, too...making money in this lousy market, besides.

Can I go out and play, Daddy? Please?

[Mutex]

Dan,

Perhaps you don't dispense pornography but you do show more than a little leg.

You state: "I can understand the quest for more money, but at what risk?"

I couldn't have said it better. EVEN index funds have risk and when the Fed starts engaging in actions not seen since the Great Depression that risk is not only increased but increased substantially.

Those people still advocating that the markets and capitalism are infallible 'in the long run' are in extreme denial. Experts, such as yourself, are only right until you aren't and that day may be approaching must faster than you are even willing to consider.

The stock market offers no guarantees...even in index funds. To advise people otherwise is to mislead them. The risk/reward ratio is always there and in times such as this the risk side of the equation is greater than at any other time in the history of capitalism.

For those who think we will have, at most, a brief recession and that the demise of Bear Stearns signified the bottom I ask a simple question...

When has there ever been just one cockroach?

We may be on the verge of exposing the entire nest.

[ReasonIsMyReligion]

Investment porn vs. porn-porn.

In one you pay per jerk.

[burque]

Dan,

I couldn't agree more with your indexing advice. A few questions for your consideration:

1. You recommend (and disclose that you also sell) DFA funds that you say consistently outperform index funds, but Warren Buffett has not. While that statement gives me pause, I'll just take it at face value for now. Who besides DFA do you regard as historically beating index funds (over 10 years or more)?

2. Would consistently buying Vanguard sector ETFs (financial, energy, etc.) over time be as effective as indexing? If so, does any sort of purchase based on sector rotation/regression to the mean make sense, i.e. if consumer discretionary ETF underperforms the market for three years, would it make more sense to drip my contributions in that sector versus an Energy ETF posting 3 years of high returns?
Has any sector outperformed the overall index over a meaningful length of time?

3. I'm self-employed and looking into an HSA but I can only find ones with unreasonable stewardship fees. Vanguard doesn't do them yet. Any low cost suggestions? Any reason an HSA isn't a good idea?

[worldtraveller]

1- I agree people should not try and TRADE. My experience suggests that only 1/4 of 1 percent of people that try and make a career out of proprietary trading are very successful at it.

2- Buffets comment is great. The problem is not Technical analysis per se but that people will interpret what they want to see when they look at it. Kind of like a Rorschach test. Opinions will dictate what you see and when you don't like what you see one way you will expand to a different viewpoint until you see what you want.

Now maybe splitting hairs but

1- Markets are not efficient and even academic (that word raises an eyebrow to begin with) studies disprove it. Markets exist on behavior essentially being fear and greed and neither are efficient.

2- more importantly markets take a random walk is completely incorrect and a simple volatility based specification test based on variance estimators proves this. Accepting random walk would also suggest that a closed end Black-Scholes model would accurately allow one to price complex financial returns and no one believes that it does, without significant modification for fat tail distributions which random walk would suggest those 5 standard deviation moves (that statistically can almost never occur, but occur with rather surprising frequency) can not happen.

Otherwise.. good post :-)

[Unrepentantliberal]

Dan. I Just wish I'd of known about your sensible ideas twenty years ago when I started putting money into my 403-b. I would have even more in there than I do now with much less risk and worry along the way. Young investors: Listen to this man! Don't get seduced by the 'financial porno.'

[TrollDiddy]

Dan, LOVE your column, really. I did well stock-picking for three years but got absolutely walloped in the past nine months (owning Starbucks, Bank of America...there's more, but I don't want to embarass myself further), so now I'm converted to your views and have switched almost entirely to low-cost, passively managed Vanguard index funds.

Now, I'm ALMOST converted. I still have a trader account and have accumulated a substantial position in a stock called PVX. It's an energy trust from Canada that pays like 12% dividends and the price barely moves. What I'm getting at is this: are you completely, 100% against owning any stocks? Surely, a wise investor like you wouldn't be totally against owning stable, slow, boring, dividend paying stocks. It's almost like having a supercharged savings account or CD.

[ReasonIsMyReligion]

TD,

Your comment reminds me of a phenomenon taught in Behavioral Decision Theory called "Availability Bias": One tends to believe more that which is heard more, regardless of relative truth.

Lightning deaths makes the news more than "didn't-buckle-up" deaths. (Not to mention which one you have greater control over.) And losing day-traders don't boast. etc.

Dan nails it -- it's all about proper return for actual -- not perceived -- risk.

[Henry]

I listened to a U.S. Senator (on cspan) state that there is concensus amongst several economists who think that the derivative driven Hedgies have driven the price of oil up $30 beyond where the market forces would support it! Efficient Market has alway bewildered me. 8000 funds managing $8 trillion in market cap, and you or I have a "chance"?