Embracing heresy

So very like Spinoza himself, who locked himself up with Aristotle and Maimonides before coming out with his great works, Baruch has been consulting ancient texts; in this case, the books of Peter Lynch, especially the all time classic One up on Wall Street. Lynch of course was and is famous for his advice to his readers to invest directly in single stocks, to “buy and hold”, in the parlance. This is now a heretical doctrine, but Baruch thinks its time has come. Or rather, come again.

So let’s say it: I think the best thing for moderate net worth retail investors to consider right now is to take their retirement account back into their own hands. I think people should start to do some research with the aim of buying 3 to 5 single stocks, maybe just as an experiment. And if the experience is good, they can do it, and they gain expertise, they should make single stocks a big chunk, say 1/3 or more, of their retirement account in the next 10 years.

Not many people in the econoblogosphere and beyond will tell you that this is a good thing to do, not least because in many cases it is them and their ilk you have been outsourcing it to all these years.* Even those who don’t have an axe to grind  will likely be mildly horrified by such advice. Take Felix; a couple months ago he wrote:

we don’t want . . . a world where most companies are owned by a small group of global plutocrats, living off the labor of the rest of us. Much better that as many Americans as possible share in the prosperity of the country as a whole by being able to invest in the stock market.

Right on, Felix! And of course, the best way of guaranteeing this is surely by having Americans (why only Americans?) invest directly in stocks!

Well actually no. Felix hurries to reassure us in his very next line

I’m not saying that individual investors should go out and start picking individual stocks.

Felix is clearly aware where his train of thought is leading, and is keen to retain his position as a prominent econo-blogger who is taken seriously. Telling people to pick individual stocks, however, is clearly the path to ridicule.

For a more concrete list of conventional wisdom on the main reasons not to own stocks look no further than this post by James Altucher, which is misconceived on so many levels it is hard to know where to start, but makes up for this by at least being entertaining.

Let us pity the mid size retail investor — the ones with enough capital that it matters, but not enough to get access to pre IPO Facebook stock.  They are the battery hens of the financial service industry, on the receiving end of the least bespoke and the most exploitative service available. These guys get a lot of advice, much of it worthless, and all of it conflicting; they are the key demographic for most of the for-money blogs, newsmedia, and the Old Man newsletters (as Josh at TRB puts it so well). If you are one of this accursed, confounded and confused group, a forgiveable reaction is to put your fate in the hands of a retail broker at e.g. Merrill Lynch or UBS. Knowing your luck, you’ll end up in a range of very reasonable sounding knock-in/knock out structured products you barely understand. They’ll have you picking up the nickels in front of the steamrollers that catch up with us every 5 to 10 years, charging a hidden 2% load for the privilege of eventually blowing you up.

The gift of Peter Lynch, if you play your cards right, if you make the right mental breakthroughs, is that you can leave all the babble behind. With practice and dedication, and a supreme act of will, you can tune it out and make it irrelevant. The main reason very few people will urge you to do this is that there is not a lot of money in it for them and you may stop reading their blog. Taking charge of one’s own investment future, if you can, is simply much more rational than handing it over to the mishmash of conflicting incentives that is the financial services industry. It’s not unthinkable; it’s the logical thing to do!

It is not true that individual investors are always going to lose when they enter a stockmarket dominated by sophisticated insitutional investors like, well, like me. I have a huge disadvantage stopping me from doing the right thing; timeframe. I have a boss breathing down my neck to whom I have to justify my bigger trades as well as my weekly, monthly, quarterly and annual returns. I have a liquidity constraint. Some of the most interesting ideas can’t make it in my fund if there is not enough daily volume to take a meaningful position. I cannot “dollar cost average”. My investors like to invest more at the top of the market, and panic at the bottoms. I have to be largely fully invested at all times, and I have to spread my genius over a diversified portfolio of 30-80 stocks. I have to avoid market strife and drawdowns. I cannot embrace declines in the way that I should. I have to watch every twitch of the market. I have to worry about things like the VIX.

You don’t! Really. You can really be a long term investor and you won’t ever have to know what the VIX is. You can make it easy for yourself. Buying stocks is lucrative, and quite often even fun. Believe it or not, in the dim and distant past, normal people used to do it all the time! What really put the kibosh on it was the 1999 bubble and the lost decade for stocks. Before that, “buy and hold” was not as it is now considered a filthy and dangerous practice, like trying to indecently molest a cheetah. Rather it was the key way to create value in retirement accounts over time and a hobby for investment clubs across the developed world.

Peter Lynch’s 3 great insights are these: i) everyone knows about something, ii) only buy what you know. and iii) you absolutely have do the work. This means above all don’t buy hype or listen to stock tips in areas you are unfamiliar with. Don’t buy “cloud” stocks unless you are a software engineer. Only buy the latest genetic sequencing concept stock if you are geneticist or terribly interested in genetics. If you are a dentist, you actually have a edge over me when it comes to the long term trends in the dental implant business. If you are a plumber , you will know about, I don’t know, new types of pipe or something; or suppliers who have improved their pipes and are winning back market share. In his books, Peter Lynch talks about how much he loved retail. He famously used to grill his kids and his wife on what they were buying, and would visit shopping malls with them to get ideas. That got him into huge gains in stocks like Hanes, the owners of L’Eggs, and The Body Shop.

Instead of buying sexy stocks, penny stocks, or the “next big thing”, he urged, we should buy boring and safe. Even better, stocks which are faintly disgusting, like waste management stocks, gravel pits, or rat breeders. Stocks with an excess of “K”s in their names, like Safety Kleen, stocks which were ignored by Wall Street analysts, were the ones he wanted to buy. Baruch has found this to be true in his career, too. His greatest winners have been stocks where there was no analyst coverage (at least in English), which no-one had heard of.

Lynch is also very clear that it isn’t enough to just think of cool trends before going off to buy the stocks exposed to them. That is just the start of the process. To do this properly, and make money, there is also a lot of work involved, looking at balance sheets, finding out about valuation, making sure the PE divided by the EPS growth rate is not over 1, for instance. It demands a level of financial literacy that a lot of people don’t believe you are capable of. You’ll probably have to look at 15 stocks and probably more to find 3 you will like. This will take time. If you can’t spare it, don’t start. But if you are one of those people, like me, who take a month of cogitating and comparing peformance statistics before buying a new car, or can rattle of the RBIs (whatever that is) of 10 baseball players, you may have the mental resources, enough of an inner nerd, to have a go.

His books also make clear that a degree of “bottom” is also strictly necessary to do this properly. You need the independence of mind to dismiss fallacious arguments from impeccable sources; the courage to continue to invest, month over month, year over year, even after reading a John Maudlin newsletter; and the mindset that welcomes a big market selloff as the opportunity to buy some stocks really cheaply.

Your timeframe should be that of a Buffet. Not Steve Cohen’s, or mine. If you invest the same way as people like me you are doing it wrong. People like me will take you out to the woodshed and you will get, as my Oregonian friends charmingly put it, “stump broke”. In this Altucher is right. I turn over my portfolio well over 3x in a year. You should do less than 50%, probably 20%-30% is optimal. I think of a stock position in terms of weeks and months; you need to think in years. I check my portfolio obsessively every 5 minutes or so, and field calls about my core bets 2-3 times a day. You should check your stock prices once a week (or every month, if you can), and give each stock a check-up every six months or so. I might be out of a job in 12 months, and for me that is the long term. For your overall portfolio you need to think in units of 10 years (more on this later, I hope).

Of all the strange things I am urging people to do, this bit is maybe the hardest and where you are most likely to come unstuck. The entire financial media and most of the blogosphere is about this news cycle, who is doing well now, who is buying who, what the charts are saying, which sectors are hot and which are not. This is where the act of will comes in, the filtering, the wilful ignoring of most the facts, of the charts, and the blogs swirling around you. It is hard to make the mental breakthrough that in the long run the gross margin of Safety Kleen is more important to your portfolio than whether Greece defaults or not. And that if in fact Greece defaults and China rolls over and the world appears be at an end that people will still need to mop up grease spots or whatever it is that Safety Kleen does, and all that has happened is you now have a bargain price to buy more Safety Kleen with part of this month’s paycheck.

Above all, the key to success in investing is about taking responsibility for your investments. If things go wrong with your stock, it is not Bernanke’s fault. It is not your broker’s fault. It is not the fault of the guy who gave you the idea on his blog, or as part of his trading system, or the supposedly smart hedge fund manager who you read about who had it in his portfolio. It is yours. You did it. When you internalise this great truth, you will set yourself free. You will realise that you have as much right to an opinion as anyone else about something you have researched and thought hard about. And you will see that working hard to see a truth that others have ignored, putting skin in the game, and reaping the benefit of being right, is one of the great pleasures of life.

Right now we’re in a period of huge wealth creation in the most populous parts of the world, economies are more open and globalised than ever before, and we are blessed with stock valuations below the average of the last few decades. We had one of the worst crises ever and we came through it. Even Felix and Altucher are keen to point out just how much they like stocks as an asset class here. However, short term, things look a bit peaky and a decline may be imminent. The typical summer seasonality, and the approaching end of QE, are probably not going to help. If you’re not invested, this should be music to your ears. If you are, I shouldn’t worry. Overall though, I think now’s probably a good time to start investigating some stocks to buy in the next 3 to 6 months or so.

* this is also the case for Baruch, who should urge you to put all your money in certain sector funds, managed by him, but who won’t because really it is not a sensible proposition (although at least some won’t hurt you).

29 responses to “Embracing heresy

  1. nakedlong

    great article, but I feel it is a bit of a stretch to have an average american put all the time necessary to invest in certain stocks. I’m really having trouble seeing a couple, both of whom could be working 40+ hrs a week and may have never even taken accounting 101, learning about balance sheets and income statements and picking quality stocks to invest in. People won’t even exercise 1hr 3 days a week. They’re not going to sit down and seriously research 15+ companies.

    • Well naked, it’s lucky I am not writing for Americans. I think most people from other countries realise that if you don’t put effort into something, you are likely to get substandard results.

      Seriously, pleading laziness is one of the more objectionable reasons for not doing something. Planning for retirement is one of the most important obligations of a responsible adult. Do you think it is impossible for an educated person who has been to university to understand basic acocunting concepts like cash, debt, and margins? I think it is possible. I also think a basic financial literacy amongst a population is important, to avoid mass participation in crises like Iceland’s, Ireland’s, and the two bubbles in your country in my professional career so far.

      You are right in a sense; not everyone is going to do this, and many are not going to be able to do this, for whatever reason. But what I am saying is that if you want to do it, and put the effort in, and do it the right way, researching and investing in single stocks successfully is very possible, and something you can consider as a potentially superior alternative to your current choice set.

      And anyway,where did I write that this was going to be free and easy? As Spinoza put it himself: “all things excellent are as difficult as they are rare.”

      • nakedlong

        “not writing for americans” what does that mean? “I think most people from other countries realise that if you don’t put effort into something, you are likely to get substandard results.” again, what are you saying? I can’t speak for most other countries, but having lived in italy no one talked stocks and 401k. The government is their retirement. Maybe you’re not looking through the eyes of the moderate net worth individuals you’re referring to. You’re sounding exactly like someone whose career is in the markets. “People this is so easy. Make your own portfolio. You won’t be irrational. No more buying at peaks and selling at bottoms. If your stock collapses it’s ok you have a longer time frame. It’ll come back. They always do. I’ve spent years in this industry. You can easily do the same a couple hours a day.”

        People specialize in certain areas for their careers. Financial advisors are supposed to be experts in their industry, but they make the same irrational moves that a retail investor would do. Maybe the entire industry should be adjusted rather than people taking their entire retirement in their own hands. I’m not trying to defend an industry so it keeps more money, but in America, social security isn’t much of a backstop if your stocks turn out to be horrible.

      • Well, naked, actually i write mostly for myself, not for Americans. However if they happen to read this, that is fine too.

        You fell into my clever rhetorical trap!! I knew that if I pretended to be rude about Americans, you would start defending them and contradict your previous position that they are generally too lazy, stupid and impatient to be able to look after their own finances. In fact we both know that is rubbish, they are as capable of looking after themselves and making the right choices as anyone else. In fact they start with a natural advantage, as their home market is deeper and broader than any and slightly less skewed against smaller investors than many, especially the Italians’.

        By the way, very few of the Italians I know are under any illusions about the “government being their retirement”; they are avid savers, much more than your lot. They just like to buy bonds. If you saw their stockmarket you would understand why.

        I am interested in your suggestions as to how you think the industry should be adjusted; me I just try and play the cards I am dealt, according to the rules of the game, and having observed the game for a while I think you are right, everyone, professionals as well as amateurs can be terrible investors. In no way am I saying this is “easy”. But professionals are forced to play in ways that make it harder to win; they have to beat benchmarks, they have to own the right types of asets and make the right type of noises, and keep their Sharpe ratios up, etc, while amateurs can play the game according to whatever rules they want — they can make it easIER for themselves. And they don’t have to pay management fees and a 5% load for the privilege.

  2. shorthope

    I hate it when investment advisors say that it is the investor’s fault if an investment turns sour rather than the advisor. If the advisor absolve’s himself from blame for what does he earn an advisory fee?

  3. Concentration is under-rated. Retail investors have an advantage over even the big shops in being able to invest over a 3-5 year horizon. It is not hard to beat the market over that time period if you can stomach the shorter term reversals in unpopular issues. There aren’t many, but there are always a few healthy, growing companies that are unpopular because their market is unpopular. But from watching how many friends and family do their own investing, I’d have to say most people don’t have the self-confidence in their own analysis to stick it out or reel in the biggest gains.

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  5. Rob Sequyle

    Good advice, but I’m not sure Safety-Kleen is the best example to use. In order to maintain the unbelievable record of quarterly earnings gains that got the attention of people like Peter Lynch, it appears the good folks at Safety-Kleen inflated earnings. Probably started small in the 1980s, but by 1999-2000 they were goosing earnings by 83% in order to stay on Peter Lynch’s pick list. The music stopped in 20o0, Safety-Kleen went bankrupt and its executives were charged with securities fraud. http://www.sec.gov/litigation/complaints/comp17891.htm

    • Hmm you may be right about that one. Lynch also had a distressing prediliction for investing in Fannie Mae and Freddie mac back in the late 80s and early 90s. That doesn’t look so good these days. But still, Holding someone to a 20 year investment horizon should seem unreasonable to even the most ardent buy and holder. I think we can forgive him.

      As The Byrds say to everything there is a season. Who knows, in 20 years’ time we may look at all the people buying AAPL today and say, “what a bunch of schmucks”.

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  7. dunkelblau

    Mean reversion bets have worked pretty well for me, of course in aggregate and with ample patience. I stay away from marquee names, anything that any analyst covers. Big players like you always leave crumbs that aren’t worth your time, and to me these can be huge opportunities. Nothing wrong with pink sheet penny stocks if you know how to pick apart financial statements; otherwise quite hazardous as this area is rife with adverse selection. People who enjoy puzzles and murder mysteries can glean some entertainment from this kind of work, and they may earn a decent hourly rate for their effort. No need for any special training or college course; the basic ingredients are available at most local libraries. My advice would be to avoid leverage and keep a high savings rate in order to fund your ideas. It’s a double-win– not only are you accustomed to spending less but what you do spend actually brings returns better than most garage sales.

  8. If you want to pay someone just to blame them why bother investing at all? From my experience in the futures market when a client follows my advice he’s got no idea why he’s buying other then the reason i provide and when i tell him to cover he spits out something about high oil prices, Kadaffi or pick something from the newsroll and decides to stick with it. If he wants to find something or someone to blame for his loss i got no problem with being the target as long as he pays.

    Great article indeed especially about internalizing the responsibility. People are more conscious about money then their looks, but with all the fuss about competition and multimillion rewards for professionals Altucher’s view seems to appeal to too many. The thing is they haven’t got the chance or the experience if you wish of “reaping the benefit of being right”.

  9. So people who say “buy a broad, low-cost index fund” are trying to sell me low-cost index funds?

    And people who point out that 90% of professional investors fail to beat the index are… what? Lying? Underestimating how much better individual investors are than professionals?

    • Typically, yes. Or have a vested interest, be it financial or psychological, in the belief that it is impossible to make good money picking stocks.

      And who is talking about “beating the index” anyway? Compounding a nice 10-12% a year, over the investment cycle, is the goal. Beating an index is a canard of the professional, exactly the type of mindset an amateur punter doesn’t have to share.

      • If you cannot beat the index — and most of us cannot — then you might as well just buy the index. Which can be done at very low cost; VTI (for instance) has an expense ratio of 0.06%. If you want global exposure, VT has an expense ratio of 0.25%.

        Do you think most individuals can outperform those by asking their teenagers where they shop or whatever?

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  11. Richard Tull

    Love the contrarian approach in reconsidering buy and hold. It did, though, prompt me to dig back into your blog to uncover a post you wrote in March 2010 (if you wrote more frequently I’d be less likely to remember specific posts). And I quote:

    [Cramer] wants to “educate” the public…so individuals can go up against the “big boy” institutional investors and hedgies and “have a chance”. Fat chance, I say. Even if it is full of excellent advice, 20 minutes of TV a day isn’t going to help Joe Schmoe have much of a look-in trading against me in stocks I know really, really well.

    Now I know you’ll counter by referencing your final paragraph where you favorably mention investment clubs, parse trading from investing for the long term, which I’ll concede. But your view of a year ago bespeaks a – shall we say skepticism – regarding the ability of individual investors, which perhaps you’ve reconsidered.

    BTW, that post from Altucher really is mental.

    • Well, Richard, you do well to note my caveats in the 2010 post you refer to. You will also note in this post above that I warn people about playing the game in the same way I do. Cramer’s investment style in his TV show is more like mine than it is like Peter Lynch’s, therefore it is not a great idea to base your home investment strategy on Jim Cramer’s “Lightening Round” for instance. That said, I think for retail guys to get an overall flavour of markets, taking risks, and how other investors think, Cramer’s TV show isn’t bad. They can watch, but probably have to ignore, large chunks of it.

      I think overall though I have reconsidered some things since March last year. One is that I think the overall market may be a bit more benign, and less full of rude shocks, than I felt it was last year. On that basis it may be a less lethal backdrop for the mums and dads to start practicing on. And frankly back then I had not just been re-reading Peter Lynch, which I remember was one of the key texts that made me the investor I am today. The lessons there are also excellent for professionals as well.

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  13. Numbers like “90% of professional investors fail to beat the index” get thrown around a lot, but even John Bogle doesn’t make this sort of claim. Actively managed mutual funds with high fees, short time horizons, and no tax planning may fall behind at this rate, but no one is recommending such funds here. Managers of such funds generally don’t get paid to outperform the index after taxes and fees over 10 years (they’re lucky to last 3 and most investors don’t notice how large the taxes + fees bite is), and so they don’t focus their efforts on this mission that would be in the best interest of their investors. Instead baruch is recommending low costs, long horizons, and low turnover (hence tax deferral). Implemented with a decent degree of intelligence and care, this strategy has expected returns pretty close to the index. With excess luck, ability, and diligence, it could do quite a bit better.

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  15. Love this post and it’s one plan to keep. I’m an amateur investor who has been doing this for about 2 years, and this basically my view articulated better than I could have said it. I have very much adopted the Lynch style of using my inherent advantages of longer time horizon, ability to invest anywhere especially small companies, and no boss or clients breathing down my neck each quarter. I’m self-directing a small portion of my portfolio while I learn and test myself, and if it continues to go well I will probably be investing larger portion of my assets. It does take hard work, but I really enjoy the intellectual challenge and the rewards of independence. It also takes discipline, but a big part of investment discipline is gaining fluency and confidence in your own analysis. I think the generations-old story of Mr. Market absolutely rings true. Unfortunately for the pro, it is hard to stray too far from what Mr. Market is doing because there is the career risk of underperformance. For the amateur, the trick is gaining enough knowledge and experience so that you can not only ignore Mr. Market, but take advantage of his manic-depressive mood swings.

    I suppose the hard work necessary to do invest well should keep most people from doing it themselves. But my adult life has consistent of two huge speculative bubbles that have left me with nothing but contempt for the skill and motives of the financial services industry. I believe there is a better way and I’m willing to work for it.

    • For the record, I did not write the previous comment under a pseudonym. B

  16. Dean Wormer

    I have a nice little swing trade strategy of late that buys stong stocks on the dip, and sells them after a week or two when they revert to their trend following some basic RSI, stochastics and vol. Not terribly complicated and when I get more confident likley could do it for 2-3 hours per day and fish the rest of the time and make 20-30% per year, no leverage. Can you show me the error of my ways

    • No I can’t show you the error of your ways. The error of your ways will become clear to you in time, without any intervention on my part.

      Being shown the error of my ways happens to me all the time.

  17. Dean Wormer

    I am even an American!

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  19. Baruch, Bento

    I’m confused

    what’s a discussion of gambling (aka share trading) doing on a site supposedly devoted to the great philosopher himself?

    sincerely yours

    Bendict aka Francis

    • We ran out of things to say about Spinoza, basically. Then we started talking about markets and technology, both of which would have interested Spinoza, who in his time was a commodities trader and specialist in high tech high performance (then) optics.