Sunday, February 28, 2010

4 investment "lessons" from the WSJ

A column from the WSJ Sunday was reprinted in my local paper - the News and Observer. The title of the column is "Even the smart guys don't always get it right" by Scott Patterson.

Patterson wrote a book called "The Quants: How a New Breed of Math Whiz Conquered Wall Street and Nearly Destroyed It". I haven't read the book, but based on Patterson's column, I don't think I'll waste my time.

Patterson offers four lessons for individual investors from Wall Street "quants". Each one of these "lessons" is basically a lesson for wealth destruction. It is actually quite amazing how one guy could offer so much bad advice in one article. In fact, I don't think he makes a single intelligent suggestion. Anyhow, let me explain why each one of these nuggets of wisdom is pure idiocy.

1. Forget the old lessons - don't index and forget buy and hold. Individuals need to become more active in managing their portfolios.
Study after study has shown that the only element of investing that the individual can reliably control is costs. Therefore individual investors should invest in broad, well diversified index funds. Furthermore numerous studies have shown that "active management" - especially by individuals is a sure fire way of destroying wealth. Trading costs will eat you alive.

2. Active management doesn't mean role the dice more often
No, says the "expert" in the piece, it means looking for trouble and ducking for cover sooner rather than later. Great advice, if you have a crystal ball. Otherwise, you'll just end up trading too much. The problem with ducking for cover sooner is that there is no way you know what is going to happen later until it has happened.

3. Sell a stock at the first sign of trouble
Again, how do you know whether the "trouble" is a bump in the road, or a major meltdown. You don't. But selling at the first sign of trouble guarantees you'll make the right call about 50% of the time. But you'll eat the transaction costs 100% of the time.

4 Invest only in the cheapest stocks
Brilliant! Why didn't I think of that? Oh yes, and use the P/E ratio as your stock selection tool. Nothing will go wrong there.
First of all, cheap stocks are often (in fact nearly always) cheap for a reason. They are low growth and high risk. It is the same reason why some houses are cheap compared to others - they have problems. While there is some evidence of a "value effect" - that is low P/E stocks out perform high P/E stocks in the long run, this strategy only makes sense at the portfolio level, and many debate whether it is really a true anomaly and not just compensation for extra risk.

Finally the article says "in general be more vigilant". This is about as useful as telling a basketball player to "try to be taller".

Overall, this article is the stupidest thing I have read all week.