A short introduction to the history of human stupidity

This is the title of a book written in 1932 by a fellow named Walter Pitkin. Mr. Pitkin had a wealth of material to work with. The copy I have on my bookshelf is 574 pages in length, all 8 point type. Some "short" introduction!

I am reminded of the wisdom this book contains whenever I get a comment like this one which came in this morning:

Anonymous said...

good luck Mr. eternal bull!

you missed the biggest bear market in our lifetime because:

1. you are a perma-bull
2. it is unpatriotic of you to be bearish
3.you're afraid to go bear as that would make you less of an American
4. all of the above?

3/30/2009 09:24:00 AM

I generally don't publish comments like this one, but it happens to provide me with a teachable moment.

The goal of any investor or trader must be to outperform the "buy and hold" strategy by a big enough margin to justify the time and expense put into the effort.

Should this objective bias an investor or trader into favoring the bull or bear side of the market?

I think it should! Why? It is a historical fact that the U.S. stock market has outperformed every asset class (bonds, real estate, cash, commodities) over the past 200 years. It is also a fact that the market spends more calendar time going up than going down.

Let's frame these facts in another way. Suppose you had to make a choice at the start of each year whether to be fully invested in the stock market or instead fully invested in cash. What would your best choice be? The answer is simple - each and every year you would choose to be fully invested in stocks! If you make any other choice you would almost certainly do worse than the buy and hold strategy.

A lot of people delude themselves with the thought that they can consistently and successfully predict the advent of bull and bear markets. But to beat the market in this way an investor has to make two good decisions in a row - he must "sell high" near the top of a bull market and "buy low" near the bottom of a bear market. If he gets even one of these decisions wrong he will do worse than buy and hold.

Suppose that our hypothetical market timer gets things right 70% of the time - the probablility that he successfully buys low or sells high is 0.70. This is a pretty high level of skill. What are the odds that he will make two consecutive correct decisions? Probability theory tells us the answer is 0.70 x 0.70 = 0.49 - only 49%. So half the time our skilled market timer makes at least one incorrect decision and consequently does worse than buy and hold! In the long run his results will only match buy and hold - not a very high return on the skills which produce his 70% accuracy rate for single decisions !

The moral of this story is simple. If you want to beat buy and hold, it almost never pays to predict a bear market unless your skill level gives you at least an 80% or higher chance of getting it right, and also an 80% or higher chance of getting in near the bottom of the bear market. Any less skill than this won't help you.

Our anonymous commenter probably didn't sell near the top of the bull market. But even if he did, I can assure you that he will remain bearish throughout the next bull market - the time when buy and hold prospers. And I can also assure you that the attitudes exhibited in his message are those of an investor who does worse than buy and hold over time spans of 5 years or more.