Monday, March 30, 2009

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'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.


JF said...

Some new research has suggested that stocks haven't actually outpermformed bonds enough to be worthy of their risk versus bonds. I don't have the links readily available, but it's been out there in several pieces recently.

The buy and hold strategy is ridiculous, given that it's based on faulty math -- see Mandelbrot's work on this topic.

However, stocks are much more exquisite tradign vehicle than bonds.

All this aside, I enjoy reading your analysis.

Carl Futia said...

Yes, studies like the one you cite about the long run returns in the stock market are frequently seen near the bottom of bear markets.

Anonymous said...

Excellent commentary to lend insight to those who dont read history.
Disicpline in money management is so key for ongoing credits to any traders success......while the "system and it's tweaking" keeps our nose to the grindstone and away from the shoulda, coulda wouldas in trading.

Your stewardship in teaching others to trade is a genuine sign of a altruistic character!
You are a rare person.

Bless you,


Anonymous said...

I agree with Carl regarding outperformance of stocks over the last 200 years and Buy and Hold strategy, in general, works. To the first poster, who cites Madelbrot (and slew of others who are writing about stock underperformance wrt bonds), it all depends on the time frame one takes in to consideration. Stocks outperformed over 200 years, but underperformed in last 20 or so years.

A trivia: Financials have outperformed spx by 3000bps over last 10 days, but underperformed over last 10 years by several 1000bps. If you apply your thesis, would you be buying financials and shorting overall market here? That answer will answer the jokers who are calling for continued underperformance of equities.

Tim- said...


I have a question on your simple probability example. You are using theoretical probability where as in reality the previous result doesn't effect the future probability.

In theory the probability of picking tops and bottoms consecutively will always diminish if the trader has anything less than 100% accuracy, but like a coin flip, regardless of previous result, you always have a 50% probability to get heads on any given flip. So the trader always has a 70% chance of buying or selling at the correct time.

Also, you don't say anything about how quickly the trader identifies he's wrong. I could be a really bad trader with only a 1/3 chance of buying the market correctly. but if I quickly identify my mistake and correctly sell the market i now have a 2/3 chance of being correct.

Balsamo said...


It is a fact that the dow Jones was 380 in 1929 and 776 in 1982...
What kind of return is that ?????
Didn't real estate do better during this period ???

All those theory about stocks being the best investments are flawed by what's will be remembered as the biggest bull market of all time (1982-2000!)...
Most of the historical returns was made during those years...Ans it's this bull market that is being
adjusted right now...

historically the 1990 could appear as crasy the 1922-29 periods was...Who knows ?

All we know is that there are secular bull markets and bear market. Both can last longer that originally thought...And YES, THERE ARE LOST GENERATIONS as far as stocks are concerned...

Carl Futia said...


I have but one question. What was the correct investment choice in 1982 ?

Unknown said...

Sorry Mr. Futia but Your logic is a bit incorrect.
You Do Not necessaryly need to Find the Top for a Short and a Bottom for a Short cover.

It is Enough to have only One decision correct with a predefined
Profit level.
It is Not a Must to be 80%
correct to beat the buy and hold
way of investing, having a system / knowledge with 80% accuracy of trade decisions
might beat the buy and hold handsomly if other little trade management points taken into account.


Balsamo said...

To buy...
But there some signals that doesn't exist today, not yet...
Valuation : PE stood at 7.3
Inflation : was high but the trend was improving (FED rates were heading south)

Today, valuation is still relatively high, and FED Rates can only head north.

ALL THE PAST BEAR MARKET ended with a PE between 6 and 12 ! ALL OF THEM...

But that doesn't mean that the market cannot bounce...
Just watch a chart of the 1965-1982 periods: it's a roller coaster, but in my definition it is still a secular bear market (considering buy and hold)... The fact is that PE was 23.3 in 1965 (SP500) and 7.3 in 1982...

Anonymous said...


Very good analysis! In the long run, it pays be to be a perma-bull instead of a perma bear.

Ideally, you want to time the market but very few people have the internal flexibility and open mindedness to change with the market.

Balsamo said...

Well Anonymous,

It all depends on your year of birth...or the year you started investing...and the year you retire...

All the people who bought stocks in the 1923-1929 perdiods, if they bought and hold...were still losing money 20 years later...And that is if they were brave enough not to sell in between...

And the fact is most people buy when the market is high, and sell low...

Conclusion : it's not wise to be permabull nor permabear...

JF said...

It's very easy to include the start of the best bull market in stocks ever as a starting point: 1982. However, if stocks go just a bit lower and bonds higher, even this cherry picking would prove wrong.

I think the point still is: stocks are a better trading vehicle.

Buy and hold is a moronic strategy for both stocks and bonds. Their risk metrics constantly change depending on the circumstances. Treasuries right now are way too risky to be long right now. Stocks are less risky by far.

And to the person who doesn't like Mandelbrot, try studying the prices of financial markets and then compare Brownian motion to them. You will find a serious disparity. Denying reality can only lead to serious problems.

Anonymous said...

The past 10 years have taught us that both perma-bull and perma-bear idealogues are wrong.

Naso said...

Balsamo has excellent points. Carl why did you stop posting your Lindsay analysis? You use to be good at it and you even predicted the market decline way in advance. What I don't understand is why did you stop the updates and started a totally different style. Your new style has been being in a bullish camp since the bear market began.
All my best.

Anonymous said...

To Balsamo: That is exactly the point Carl is pointing out. Why do you think public buys at the top? Coz WSJ has rally caps all over the news, books like Dow to 36000, Everybody is drinking fine wine which comes to public attention. Why do you think Public sells at the bottom? Coz Mr. Roubini brings his target down another 50% when the market is already down 60%, Time has a cover showing consumer rowing a boat towards the edge of niagara falls and of course, the genius come out and show data with "if you bought in 2007, you lost your underwear" and "if you bought in 2000, you lost your kids underwear as well" kind of analysis.

200 year history shows trend to be up. of course nothing goes in straight line in ANY direction - if you cant spot the turning points with very high degree of certainty, it is better to just Buy and Hold. Now, it is an excellent time to just buy and hold. And hold for minimum 40 years (assuming an individual is in 30's and has saved up some money).


Anonymous said...

Walter Pitkin was 19 years old when he wrote that book ... what could he have known about humanity at such an early age?

Carl Futia said...

Dear 2:42 pm:

You are misinformed. Pitkin was 54 years old when he wrote that book. Here is the Wikipedia blurb on him:

Walter Boughton Pitkin (Born February 6, 1878 in Ypsilanti, Michigan. Died January 25, 1953 in Palo Alto, California) was an American lecturer in philosophy and psychology at Columbia University (1905-09), and professor in the Columbia University School of Journalism (1912-43).[1] He has written some self help books like Life Begins at 40 (New York, Whittlesey house, McGraw-Hill, 1932) and The Pychology of Happiness. His A Short Introduction to the History of Human Stupidity was translated into fifteen languages. Pitkin was a member of the New Realism school in philosophy, writing on its relation to biology.

Di said...

I hate people who start bull & bear fights. Their noise only distracts you from changes in the trends.