Ten facts of investing life worth learning

A writer’s aphorisms gleaned from years of financial writing.

Motley Fool writer Morgan Housel recently came up with an impressive list of 122 investing aphorisms that distill the wisdom he has gleaned from years of writing about markets and the financial industry. Most are either insights into human psychology or historical facts and figures.  Almost all of them, in my humble opinion, are good advice.

In fact, there was really only one I didn’t like:

Finance would be better if it was taught by the psychology and history departments at universities.

As someone who teaches finance, I might sound a little self-serving for saying that academic finance has valuable things to teach students. But if you look at Housel’s list of aphorisms, many of them come from research done by finance professors! And many of the others have recently been confirmed by academic research. Just to illustrate the point, I picked out 10 of my favourites from the list.

As Erik Falkenstein says: “In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”

This is called the Grossman-Stiglitz paradox. Obviously if all investors try to beat the market, a lot of effort will be wasted. But if none of them try to beat the market, the market won’t be a useful aggregator of information. The solution is to have true experts dig up new knowledge and make money doing it, while everyone else invests in index funds and exchange-traded funds and just goes along for the ride. (Also see the excellent piece by my Bloomberg View colleague Matt Levine on this topic.)

Investor Nick Murray once said, “Timing the market is a fool’s game, whereas time in the market is your greatest natural advantage.” Remember this the next time you’re compelled to cash out.

Definitely. In fact, a growing body of research is finding that chasing returns is a killer for many investors.

According to J.P. Morgan, 40% of stocks have suffered “catastrophic losses” since 1980, meaning they fell at least 70% and never recovered.

If you understand the math of the random walk– the idea that stocks move in unpredictable ways — this won’t be very surprising!

According to Vanguard, 72% of mutual funds benchmarked to the S&P 500 underperformed the index over a 20-year period ending in 2010. The phrase “professional investor” is a loose one.

This is absolutely crucial for investors to know. Actually, finance profs have been yelling about this for decades. For example, see this 1995 paper by Princeton economist Burton Malkiel.

Our memories of financial history seem to extend about a decade back. “Time heals all wounds,” the saying goes. It also erases many important lessons.

This is the subject of a recent line of research by University of California, Berkeley, professors Ulrike Malmendier and Stefan Nagel (among others), who find that Depression babies expect more depressions, and people who grew up during the 1970s expect more inflation.

The most boring companies – toothpaste, food, bolts – can make some of the best long-term investments. The most innovative, some of the worst.

Very true, and finance researchers have noticed the outperformance of value stocks over glamor stocks for decades!

A broad index of U.S. stocks increased 2,000-fold between 1928 and 2013, but lost at least 20% of its value 20 times during that period. People would be less scared of volatility if they knew how common it was.

Any investor who has a basic grasp of the idea of randomness and the behaviour of random processes will be much better equipped to understand the finance world than someone who naively thinks in purely deterministic terms. In fact, the more informationally efficient financial markets are, the more unpredictable their movements will be!

According to University of Oregon economist Tim Duy, “As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”

This is great advice. But it’s also a reason not to invest in stocks in Japan, where population is shrinking and productivity has stagnated. Seen in the context of economic fundamentals, it might not be so surprising that the Japanese stock market has been in more or less secular decline for more than two decades.

Several academic studies have shown that those who trade the most earn the lowest returns. Remember Pascal’s wisdom: “All man’s miseries derive from not being able to sit in a quiet room alone.”

Overtrading is indeed a big killer of individual stock returns. As finance researchers Brad Barber and Terry Odean put it in a landmark 2000 paper, “trading is hazardous to your wealth.”

The single best three-year period to own stocks was during the Great Depression. Not far behind was the three-year period starting in 2009, when the economy struggled in utter ruin. The biggest returns begin when most people think the biggest losses are inevitable.

Long-run predictability is one of the most interesting facts discovered by finance researchers in the last few decades, and it’s what earned Yale economist Bob Shiller his 2013 Nobel. You can indeed make a little extra money by buying stocks when they are cheap and selling when they are expensive. Just remember not to take this strategy to extremes!

Housel’s compilation of aphorisms is a good list. Check it out. And remember, finance academics are hard at work discovering interesting and useful facts about investing, trading and asset markets.

©2014 Bloomberg View



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