Before we look at what works, we need to eliminate what doesn’t work. Once you cut out all the things that don’t “work” (remember our objective measurement of “success”), then the things that can work become very limited.
The first and foremost thing to remember is that your strategy cannot be what everyone else is doing. If you’re doing what the average person is doing, then your long term average returns will be no different than average. This is true in investing as well as in life.
There are 2 kinds of “average person”, neither of which is much better than the other.
- The average mom-and-pop investor who buys and holds forever, because “Warren Buffett said to believe in America”
- The average professional trader, investor, hedge funder, etc, who can’t even beat buy and hold in the long run.
It’s painfully obvious why you don’t want to invest using a strategy like the average mom-and-pop investor. “Buy and hold” = “buy and hope”. If you get lucky and are born into a golden era, then you will do well. If you get unlucky and are born into a bad era, then you do poorly.
Here is an inflation-adjusted monthly chart for the S&P 500 from December 1927 – October 2018
As you can see, the stock market went nowhere from the following periods on an inflation-adjusted basis:
- 1929 – 1955 (26 years)
- 1968 – 1987 (21 years)
- 2000-2014 (14 years)
Of course, real returns would be higher, because the S&P 500 index excludes dividends. Including dividends, real returns would have been higher.
But the point is simple. Buy and hold = buy and hope. How well buy and hold works for you pretty much depends on when you enter the market and when you were born. E.g. If you enter the workforce, raise a family, and start investing in 1968, well tough luck. The stock market went nowhere for more than a decade.
The average professional is no better. These professionals include traders, investors, bankers, hedge funders, etc.
Professionals mostly underperform in bull markets and they hopefully outperform in bear markets. Unfortunately, “outperforming” in a bear market merely means losing less money than the index. So in reality, hedge funds underperform in bull markets and lose less money in bear markets. Not a great combination.
According to data from HFR, hedge funds as a class have underperformed in 10 out of the past 12 years. The random probability of this is very low. Hence, this underperformance is probably not a fluke. There’s a specific reason why the average professional in the finance industry consistently underperforms.
*Sometimes people underperform for a stretch of time because their strategy doesn’t suit a certain market environment. That’s not a problem. Every strategy has its more suitable market environment and less suitable environment. For example, some strategies perform better in bull markets while other strategies perform better in bear markets. There is no one-size-fits-all strategy that works equally well in all environments. However, if a strategy works poorly in both bull markets and bear markets (i.e. IN EVERY ENVIRONMENT), then there is something seriously wrong with it. This is exactly the problem that the average professional trader and hedge fund manager faces. Their strategies underperform in bull markets and don’t do much better in bear markets.
Hedge funds that focus on U.S. equities returned half of the S&P 500’s annual returns from 2009-2017, even though they charge lofty management and performance fees. Traders at banks are no better, which is why Wall Street firms have been consistently letting go of human traders over the past 10 years.
There is no other industry in the world in which the average nonprofessional is better than the average professional.
- In the tech industry: the average professional programmer is better than the average person who is not a programmer.
- In the plumbing industry: the average professional plumber is better than the average person who is not a plumber.
- In the medical industry: the average doctor is more knowledgeable than the average person who isn’t a medical practitioner.
But for some reason, in the financial industry, the average professional often underperforms the “shmuck” who buys and holds.
How can this be?
For starters, a generation of hedge funds and professional investors/traders have been scarred for life by the Great Financial Crisis, even more than 9 years after it ended. This is called “recency bias”. Today, you’re hailed as an “expert” on Wall Street if you constantly emphasize the risks that “might” make the stock market crash, regardless of how low-probability these risks are. But if you mention that good times ahead, the common reaction is that you’re either a salesman or comically aloof of risks. As a result, hedge funds and professional traders/investors have been consistently underweight equities during this bull market. The following chart clearly demonstrates that hedge funds were more aggressive before 2008 and more defensive after 2008.
But more importantly, many standard trading strategies that are taught to traders and investors just don’t work very well in the stock market. If you use standard trading strategies like traditional technical analysis, you probably won’t be much better off than those who just buy and hold for the long term.
If you’re a professional trader who underperforms buy and hold, does this mean that you should give up on your career? No! It just means that you need to make some simple mindset adjustments that will get you on track to consistently beating your peers. A lot of what you’ve been taught is wrong. Once you unlearn the wrong things, you can start to learn the right things.
Here’s a radical truth. Technical analysis on its own DOESN’T WORK.
Technical Analysis on its own is just reading the tea leaves. Here’s the data to prove it. You need to combine technical analysis with fundamental analysis in order to beat buy and hold.
But even though our backtest proves that technical analysis on its own doesn’t work, traders still LOVE staring at charts. Why? Because most people don’t know how to read data. They see what they want to see on charts and subconsciously ignore the cases they don’t want to see. The human brain is visual: it prefers charts over data because reading data is more difficult.
Another big reason why the average professional underperforms is that he is always so focused on the “trees” that he loses sight of the “forest”. The average professional panics and “worries” about every little thing. A 5% decline is called a “crash”, and a 3% rally is called “stocks SOARED today”. It’s 5% and 3%. No wonder these guys have trouble sleeping at night.
If you want to be successful, focus on the bigger picture. Don’t lose sight of the forest for the trees. For example, I focus on avoiding big corrections and bear markets. I don’t try to avoid small corrections because for every one that you successfully avoid, you end up getting 2 false alarms and buy back your stocks at a higher price. So on balance, avoiding small corrections isn’t really worth it. It doesn’t do you any good.
Although I don’t agree with everything that Warren Buffett does, he is still a good example of long term thinking.
Did you know that Warren Buffett only looks at the stock market’s price once a day? I look at it twice a day: once in the morning and once at night. I don’t bother staring at the price every hour or every few minutes. That’s just madness. Your mind will be an emotional roller coaster that moves with the stock market’s hour-to-hour and minute-to-minute changes.
This is also why Warren Buffett chose to live in Omaha instead of NYC. He wants clear thinking. When everyone else in NYC panics over each 10% move, Buffett doesn’t care. He focuses on the forest, whereas most of these professionals focus on the trees.
The problem with trying to avoid all the small pullbacks in the stock market is that the rallies you miss > the pullbacks you avoid. When you add up the # of small declines that short term strategies successfully avoid and the # of rallies that short term strategies missed, they end up doing worse than buy and hold. Here’s an example.
This is the classic mentality of a trader. But when you step back and look at the forest, you realize “what on earth is this guy doing. Busy work for nothing. He bought and sold at the same price!”
Here’s a more recent example.
This is a case whereby some professional sells and buys back even higher, EVEN AFTER the stock market makes a correction that he supposedly “successfully” predicted.
The world is changing – it always changes. We live in a post-algo world, where a lot of each day’s volume on the stock exchange comes from algo programs.
As a result…
- The stock market’s short term price action has changed. The stock market can have larger daily swings than it used to have, which means that this hurts short term trading strategies.
- The stock market’s medium term and long term haven’t changed. They are still driven by the same factors (fundamentals), because algos don’t hold their positions for multi-months of multi-years. Algos hold positions for a few seconds, minutes, hours, or even days. So while algos have a big impact on the short term, they don’t cause bull markets or bear markets.
What algos do is SPEED UP the stock market’s short term movements because machines are faster than humans. For example, let’s assume that in the past, the stock market took 30 days to fall -10%, in a rather steady fashion. But thanks to algos, these days the stock market will consolidate within a -3% range for 25 days, and then crash -7% on the final 5 days. You can see how the short term price action has changed, but the medium term is no different. Still -10% in 30 days.
Here’s a very simple way of looking at the impact of algos. Here are all the days in which the stock market fell -3% or more in 1 day, from 1927 – present
It’s common for the stock market to fall -3% or more in a single day during bear markets, after the market has crashed more than 30%. That’s because bear markets are characterized by panic selling. However, it’s uncommon for the stock market to fall more than -3% during bull markets!
Look at the above chart and examine the bull market years. You can see that big -3% days are more and more common after 1995. What happened after 1995? The rise of the internet, computers, and algos.
Short term trading in the stock market is hard because the stock market’s short term price action is always changing. Meanwhile, the stock market’s medium term and long term don’t change that much. That’s why you should focus on medium term and long term trading. Here is another look at why trading the short term is so hard.
This is what happens when you trade the S&P 500 using a 5 day moving average trend following model. Notice how the model does exceptionally well up to 2000, after which its returns are terrible. The stock market’s short term price action has become more choppy. Meanwhile, a long term moving average like the 200 dma is just as useful as it was in the past. Short term choppiness has increased, while long term choppiness is mostly the same.
It’s worth mentioning that much of the “mystique” behind hedge funds and professional traders is a byproduct of a BYGONE ERA.
Before the 2000’s, hedge funds and traders on Wall Street consistently beat buy and hold. What changed?
A lot of people don’t seem to get this, but in the past, professionals didn’t make most of their profits from betting on the stock market’s direction. They made money from what was essentially arbitrage: buying at one price and turning around to sell it to someone else a second later for a better price. You can see this in Michael Steindhardt’s book No Bull. He talks about buying something for $13 and selling it for $14 in a matter of minutes. Such easy profits relies on information asymmetry and a slow flow of information. In other words, it relies on a lack of transparency in the market.
This edge has almost completely disappeared, thanks to the advent of the internet and mass communications. We live in the age of transparency. The internet has brought about the democracy of information. The traditional investment industry relies on a lack of transparency to make profits (i.e. market inefficiencies). Shed light on that inefficiency, and the market is the way it is today: the average professional can’t even beat buy and hold over the long run.