Wednesday, November 12, 2003

*Stock Market Experts*

"Scheisters and Idiots"

Which one are you?

The behavior of any market is just the result of some extremely complex equation with a zillion and one variables, each one changing with every passing second, each one influenced by numerous other, constantly changing variables. If we were bright enough, we could just plug the numbers in and, voila! Brokers go the way of the dodo. Back here in the real world, however, the closest that Wall Street PhDs and B-school gurus have gotten is statistics. Numbers. Math. Probabilities. Data series and trend lines, means and medians, standard deviations and confidence intervals. First thing I learned in stats class is that the past doesn't predict the future, so this isn't exactly the holy grail either, but it can at least tell you where the market has been and then quantify the probability of it going where you want it to go ceterus paribus. If you believe that tomorrow will bring no earth-shatteringly fundamental change over yesterday, you can put the various probabilities into Excel and let it tell you the allocation which has the highest probability of giving you the highest return. Log onto eTrade and execute for 10 bucks.

Something's wrong here. Too good to be true. If it's so simple, why doesn't everybody do this? Because, in the long-term, it will give you only the AVERAGE market return -- and who wants to settle for average? No, no, we need to "beat the market" if we're going to have the condo in the Keys before we're 40.

People use all sorts of methods to figure out how to beat the market. Some read the paper for company names in the headlines. Some watch the ticker under the mistaken premise that you can predict the future by looking at the past. Some use arcane and nebulous economic theories (and I mean that in the not-applicable-in-the-real-world sense of the word) to pick which sector, product, CEO, or time of the month they want to throw their money at. Some have a 'trusted friend' advisor or mutual fund manager (aka broker aka scheister) who somehow just knows . Then there are the endlessly droning talking heads on **insert name of banal news-entertainment channel here**. Certainly they must be experts or else they wouldn't be on said banal channel. Others pay $19.95 for a book of 'secrets' by the likes of reverend Tony Robbins. The slightly smarter ones give up and throw darts.

Some will fall into the worst trap: the more expensive the advice, the better it must be. To heck with eTrade; you've got to spend money to make money, right? As every Wall Street ad says, the key to retiring a millionaire at 40 is to build a long term relationship with a pricey broker. Don't worry, it's not the thousands in fees he bleeds out of your account each month which motivate him. It's that love he feels for you, evidenced by the 3-martini lunch he treats you to once a month. He spares no expense in building that relationship so you will buy the fairy tales of financial gems he offers only to you, his best friend. Unfortunately, every minute he spends valuing you as a person is a minute he's not spending studying the markets. Think about it: 160 hours in your average work-month. 200 clients in your average broker's black book. Not much time left to uncover all those gems-to-be?

And that's OK, because however much time he spends, and whatever (legal) method he uses, math will eventually catch up with him. Anyone who consistently beats the market (long or short term), is a statistical outlier, and by definition we can't all be outliers. You can shoot for the Buffetian 25% long-term rate, but without a lotta luck and a little inside info, you won't likely be remembered as the sage of anything. And don't think that your Rolexed broker or those mutual fund managers who have recently stumbled into the limelight are immune to the laws of stats either. Not that they care -- since their commission is earned upfront, they win either way. When one of their portfolios goes south, they just sell it and mask the loss by folding the money into a better-performing portfolio. By definition, this means selling low and buying high. It also means buying into something which is statistically due for a drop (in order to return to long-term market average). In the mean time, your 401k is worth half what you put into it, and he's earned enough commissions to ski Vail next Christmas. If he messes up enough times, he may be pressured into early retirement, but he certainly isn't asked to refund the millions he's earned in commissions.

Give up the quest, stop paying for his BMWs and just buy the index. Memorize these letters: S P Y. The market grows at a long-term average rate of 11%. Inflation runs at a long-term average rate of 4%. So if, as I said earlier, you're willing to assume that tomorrow will be more or less like yesterday and the trend line will continue, you can settle in and earn your 7% long-term real rate of return, which is just going to have to be good enough.

Like everyone else who reads this, you probably are convinced that you (and your broker) are among the bold, the few, the statistical outliers. Reminds me of the old saying "the lotto is a tax on stupid people."