Jack Bogle and the Bogleheads

Bogle's Folly

Back in 1946 Ben Graham, doyen of value investors, opined thus:

"Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did."

It was to take another thirty years before Graham’s "great deal of sense" was heeded when Jack Bogle set up the Vanguard Fund tracking the S&P500. Bogle’s contention was that by keeping costs down, avoiding unnecessary transactions and avoiding the behavioural biases associated with active trading an index tracker would outperform the majority of active funds over time.

Unsurprisingly the fund industry labelled Vanguard as “Bogle’s Folly” and "UnAmerican". Funny guys . Who's laughing now?

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Exotic ETFs Are Toxic ETFs

Beware of Enticing Charms

Just as the exotic charms of Cleopatra confounded Julius Caesar, the foreign wiles of Delilah did for Samson and the mystique of Heather Mills’ fake leg ensnared Paul McCartney, so the mysterious allure of the exotic ETF is undermining the original purpose of these investment vehicles. As usual the investment industry has worked its magic and turned a really useful investment tool into a method for speculating in snake oil.

From single country funds with markets no bigger than the market capitalisation of a newly downsized investment bank to Ultra Short ETFs that ensure you have a whole new set of ways to lose money these things are dangerous for private investors. However attractive they may look, beneath the surface they’re toxic waste, not investment gold.

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Loss Aversion Affects Tiger Woods, Too

Behavioral Biases (3): Loss Aversion

Loss aversion, the tendency for people to be more risk adverse when protecting a gain than when chasing a loss, is a pervasive psychological bias. Indeed, it appears not even Tiger Woods is immune:

“Although the very best golfers are slightly less biased than their peers, even the best golfers—including Tiger Woods—exhibit loss aversion. This is a costly mistake. If any one of the top 20 golfers in 2008 was able to overcome this bias, his expected annual tournament earnings would have increased by $1.2 million dollars (a 22% increase).”

Put simply golfers play better when attempting to avoid dropping a shot than when trying to gain one, when they consistently leave their shots short. Yet this doesn’t make any sense – “bogey”/loss” and “birdie”/“gain” are purely relative concepts – all that should matter is the overall score or portfolio value.

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Akerlof’s Lemons: Risk Asymmetry Dangers for Investors

The Failure of Markets

Ever since Adam Smith identified the raw stuff of market economics and David Ricardo explained the concept of comparative advantage genuine new ideas in economics have been as rare as a vegetable in a child’s dinner. However, market economics doesn't always work – as Hardin showed, in The Tragedy of the Commons, where resources are shared then market economics breaks down – which may be a disaster when the common resource is the air we breathe.

In 1970 George Akerlof came up with another mechanism to disturb the most rampant of free-marketeers, demonstrating that there are times when markets fail even when there are both willing buyers and sellers. His work suggests that similar problems may dog investors as they try to make an honest turn on the markets through small cap stocks or mutual funds.

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It’s OK To Lose Money

Markets Go Down, Often

It’s hard to believe that markets spend nearly as much of their time going down as up. Obsessing over market or portfolio highs seems to be an international investor pastime, as though some permanently high valuation plateau is the ideal state. It’s not, of course, if you’re intending to buy in the near future.

Losing money investing in shares is a perfectly fine state of affairs as long as you’re not alone. However, if you're losing regularly when everyone else is gaining then you may need to take a long, hard look at what you’re doing and then go and do something different. Probably for the best if it doesn’t involve investing money, though.

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B.F. Skinner’s Stockmarket Slot Machines

Win Big, Win Rarely, Win Never

Psychologists have long trailed in the wake of retailers and gaming companies when it comes to understanding the triggers that make people spend money. Slot machines, for instance, rely on the effect of variable interval operant conditioning to increase their takings.

Or, to put it in English, they pay out only rarely but when they do they pay out big. Turns out this makes people gamble more. Those investors who like to run small portfolios and look for big returns should take note.

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Debt Matters

Borrow Wisely

If anyone was in any doubt about how much debt matters to individual stockmarket investors and their preferred investments, the events of the last few years should surely have convinced them otherwise. Debt is one of the most critical factors investors need to consider in making their investments, and it’s not just a matter of the corporate borrowings of companies but also of personal loans – from mortgages through to credit card payments.

The problem is that when times get tough for companies, and they have trouble refinancing their borrowings, this generally foreshadows private investors having the same difficulties. Get this wrong and you find yourself with increasing debt, decreasing income, sliding investments, relationship difficulties and under extreme psychological pressure to do exactly the wrong thing. None us should be in any doubt – debt matters.

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Momentum Trading Madness

Jungle Survival Strategies

When we used to skulk about in the rainforest as undernourished and over-predated apes, evolution figured out that a good strategy for survival was to assume that any trend was likely to continue, once it had established momentum. Of course this occasionally went wrong when the volcano god got an attack of indigestion but generally tomorrow was likely to be pretty much the same as today, the antelopes were always at the waterhole at the same time and wandering into the sabre-toothed tiger’s lair was never a good idea.

Unfortunately to make money safely on the stockmarket you’ve got to assume exactly the opposite of momentum: that what worked yesterday won’t work tomorrow and that the tiger's never where you think it is. Which is not the way our ape-evolved minds prefer to work.

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Don’t Lose Money in the Stupid Corner

The Dunning-Kruger Effect

Justin Kruger and David Dunning have conducted some excellent research into incompetence, providing invaluable pointers for investors who don’t want to waste their lives following up dead-end leads and engaging in pointless debates. What they discovered is not just that the incompetent are, well, incompetent but that they’re so bloody stupid that don’t know that they’re completely useless.

In fact, sometimes they’re so dumb they can’t even tell when someone else is more knowledgeable than them. Think Forrest Gump debating quantum mechanics with Albert Einstein. Only one winner there, in Forrest’s eyes.

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Hindsight Bias

Behavioural Biases (2): Hindsight Bias

The CIA reports that hindsight biases are:

attributable to the nature of human mental processes, not just to self-interest and lack of objectivity, and that they are, therefore, exceedingly difficult to overcome.

And, after some years searching for weapons of mass destruction in the wrong country, as the North Koreans have demonstrated by actually exploding nuclear weapons, the CIA really ought to know about this.

In fact, if you replace “exceedingly difficult” with “impossible” you’ve basically got the point – hindsight bias, the tendency to believe that events that have already occurred were more predictable than they were before they took place, is endemic and a built-in part of the human psyche. It’s one of a multitude of factors that leads to investor overconfidence and underperformance.

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Capitalism Evolving: Be a Cockroach, Not a Dinosaur

Not Dying, Adapting

Many of the world’s most ardent free market economists would have us believe that the current wave of government intervention in markets heralds the end of capitalism. It’s not, because capitalism isn’t something you can kill, it simply adapts itself to the prevailing reality and carries on, regardless of economists and their ideas.

The proper metaphor for capitalism is evolution – which is ironic because Adam Smith’s invisible hand was one of the inspirations for Charles Darwin’s intellectual breakthrough, the theory of natural selection – a rare case of science imitating economics. Evolution, the process of life adapting to the complex changes in the natural world, is mimicked by capitalism, the process of markets adapting to complex changes in the financial world.

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