Monday, October 27, 2014

You shouldn't pick your own stocks, a discussion - Part 1

It was about a year ago that I found out that finance blogs were a thing that existed.  It should have been obvious, given that I've read blogs since I was in high school when everyone (including me) kept them.  Facebook didn't exist yet, so if you wanted to baffle your friends by vaguely alluding to inner turmoil by way of posted text, you did it on your blog.

"Today was... interesting.  It made me wonder about people and stuff."
I forgot that blogs existed when I was in University.  Of course, I also forgot that a few other things existed like regular sleep schedules and homework-free evenings.

And sunlight.
The popularity of blogs was reaching a high point when I graduated from university.  Even then, I assumed that the only topic appropriate for a blog had to relate to you or your family.  Finance doesn't fit very well into that mold.

"The babies screamed more than usual today which coincided nicely with a frenzied day on the stock market.  All of the major indexes rose, just like Olivia's fever."

I love to read about finance.  I'll usually skim over the a few finance articles from the Google Finance news feed on a pretty much daily basis.  I rip through finance books like a finance-crazed hyena.  To refresh my energies for work, I scribble notes on finance in a notebook during my lunch hours.  I love to read about finance.

I decided to write a finance blog in part because a friend of mine at work suggested that I do it.

"You can be just like those other finance blogs and give tips about budgeting and getting out of debt!" she told me.
Or how to make a gorgeous centerpiece out of unused credit card application forms.

I discovered finance blogs and I tried to make up for lost time.
 Power Reading: Intensity 10

Rather than being fabulously inspired as I had hoped I would be, I was instead forced to confront an uncomfortable reality.

I was reading a variety of finance blogs and vehemently disagreeing with more people than I ever thought possible.  

Budget tips?  MY way of budgeting is better!  
Investment advice?  That would never work! 
Debt management tactics?  I'm already a stupendous debt manager; I don't need any tips!
Portfolio/Net Worth updates?  I loathe you for having more than I do.

Do not even get me started on stocks.  See, I'm a firm proponent of picking my own stocks to buy.  I don't have a money manager and I don't follow anyone's stock picks.  My money lives in the stocks that I individually select and buy.

And in my zillion bank accounts.
Some people have a problem with this "stock picking" approach.  They feel that the average person cannot dedicate the time required to fully understand their portfolio without making those efforts a full-time job.

I disagree completely with these people.

The problem is that these people with these opinions have done extensive work to prove why their point of view is valid.  For example: here, here, and here

I read articles like the ones above, espousing the workaholic method of stock selection.  I spend the whole time that I am reading the articles wholeheartedly disagreeing with their content and then I finish reading them and immediately dismiss all of the ideas presented.

For example, I disagree completely with the idea that you shouldn't pick your own stocks to invest in, or that you should dedicate an hour a week for EACH stock that you own.

"I've memorized the company motto and read the minutes of the executive retreat.  Only 29 minutes until I can be bored by a different company's weekly corporate records."
I currently dedicate about 10 minutes a day to skimming finance articles, which may or may not have anything to do with stocks I actually own.  On average, I dedicate 0 minutes per week reviewing each stock holding.  I really see no reason to change my ways; I firmly believe that if I obsessed over each stock that I own for an hour each week (I own 19 different stocks at the time of writing, so that would be 19 hours per week), then I would make some terrible investment decisions.

"The COO changed his hair style?!?  SELL EVERYTHING!!!"

I'm either the most knowledgeable investor ever to walk the Earth, or I have need of some serious introspection.  

Need introspection... who, me?
Science comes to the rescue.  It says that I'm probably suffering from a slew of cognitive biases.

It's a convenient way to say that none of this is my fault; it's all my brain's fault.

I may be suffering from the effects of Confirmation Bias.

"Confirmation bias (also called confirmatory bias or myside bias) is the tendency of people to favor information that confirms their beliefs or hypotheses.  People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. People also tend to interpret ambiguous evidence as supporting their existing position."
"You're not agreeing with me?  No..."


The confirmation bias could have led me down a path of Attitude Polarization.

"Attitude polarization, also known as belief polarization, is a phenomenon in which a disagreement becomes more extreme as the different parties consider evidence on the issue. It is one of the effects of confirmation bias: the tendency of people to search for and interpret evidence selectively, to reinforce their current beliefs or attitudes. When people encounter ambiguous evidence, this bias can potentially result in each of them interpreting it as in support of their existing attitudes, widening rather than narrowing the disagreement between them."
"Look, this chart even shows how right I am."
"Actually, that chart shows that I'm right."


Is it possible to mitigate the effects of my innate cognitive biases?  It is, by deliberately searching out controversial material and then approaching it with open curiosity.

I can do open curiosity.

Here goes.  Let's assume that the workaholic high intensity investor crowd is right.  I shouldn't invest in anything if I'm not willing to put in the incredibly demanding hours of research.  I, the lazy investor, would need to find someone smarter and more dedicated to invest my money for me.  

Fortunately, there are lots of people who are willing to invest my money for me.  
Take mutual funds, for example.  These are the first investment mechanism that I ever learned about, from the book 'The Wealthy Barber' (which I reviewed, here).

Mutual funds--where an investor buys a small percentage of a large basket of shares, managed by a computer or a money manager--are persistently recommended by financial writers.

It's presented as a nice dream.  You, the scared investor, hand your money over to friendly people who dedicate hours and days and months to make sure every penny of your money works its little butt off to grow and multiply.

"Unless you puke, faint or die, keep going!"
In concept, it's fantastic.

I'm cool with delegation.

In practise, it's ineffective and expensive.  The reason is mathematics.  Of all of the traders in the world, roughly half of them will "beat the market" that is, make gains that exceed the gains of all the other stocks.  The other half will not.

All of the mutual fund managers, whether they make your money beat the market or not, will collect their management fee at the end of the year.  These fees can range from moderate 3% to... I don't know that there's a limit.  I guess that fees could go as high as people are willing to pay.

What does that give the investor?  Let's be nice and assume that they get the mutual fund manager with average performance.  This source estimates that the stock market, averaged from 1900, has returned an annual 10.4% per year.

So what happens?

Year 1:
Starting amount: $100.00
Amount at the end of year 1: $110.40
Deduct 3% management fee from end of year amount: $107.09

Let's suppose instead that the investor was a clever person and managed to follow the average market increase.  It is mathematically possible for every person to have average returns.

Year 1:
Starting amount: $100.00
Amount at the end of year 1: $110.40

That doesn't look like much, but it makes a big difference overall.

Following the average yearly return of the market over 30 years, our hypothetical investor's $100 investment could have grown to either $640 or $9,746, depending on the percentage that their mutual fund charged.  Also known as "a big difference overall".  (Message me if you really want to see my calculation spreadsheet.)
But here I go again, putting the high intensity investor's position in a bad light again.  My chart, above, assumes that a regular person can match the performance of a highly educated professional investor!

Let's investigate my assumption.  The following two quotes are from the same source website, MarketWatch.

"Some research I’ve recently come upon clinches it: Fewer than 1% of mutual fund managers persistently beat the market based on superior market-timing or stock-picking skills. --Source"

"And how many of those “best [individual investor] traders” beat the market after expenses? 10%? 20%? Actually, Barber told me, it’s closer to 1%. --Source"

1% of individual traders and 1% of money managers are beating the market.  Kind of seems like professional investors are regular people.

...who should stay away from my money.

I can't do this.  Being open-minded about mutual funds is just too hard for me to wrap my poor brain around.  

"Wait, come back brain!  I'm sorry I tried to be open minded about mutual funds!"
"Leave me alone!"

Fortunately, there is a second option that high intensity investors think is appropriate for normal people who don't read financial reports for fun.

The second option is to buy an index fund, either through a financial manager or as an Exchange Traded Fund (ETFs).

In the spirit of broadening my horizons and making myself a better person, I needed to investigate this approach with open curiosity.  I reluctantly dipped my toe into the unfamiliar waters of the Exchange Traded Funds ocean.  

One small step for a woman, one microscopically insignificant hop for investors everywhere.
I mean that only in the broadest terms, of course. What I actually did was Google "dividend exchange traded fund Canada".

Results popped up, and I read the headings.

I selected a webpage and...

To be continued.

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