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Thursday, 26 April 2012

Your Self-Inflicted 6% Trading Tax

How Not To Make Money

Making a turn from the markets is hard, we all know that.  Unfortunately we tend to make it a lot harder for ourselves than we need to, and if we don’t then the investment industry is always there to lend a helping hand.  For an extortionate fee, of course.

We’ve already looked at the gross amount of money we conspire to lose each year – something in the region of $160 billion a year in the US alone (see: The 160 Billion Dollar Bezzle).  Now a UK writer has looked at what this means for us as individuals.  The answer is, very roughly, a cost of 6% a year.  Which, when the average return from the stockmarket is probably no more than 5%, makes for a not very good way of making money.

Monkey With A Pin

I don’t imagine that most readers here would naturally gravitate to reading a free ebook by an author with no previous experience of writing about finance, focused on the UK’s peculiar investment landscape.  Normally I’d agree but, in Monkey With A Pin, Pete Comley has written something rather interesting, and I suspect the findings translate across to most other markets.  However, I’m going to leave out the UK specifics and recommendations, so UK readers will need to get their own copy and do their own proper analysis.

Comley starts with the fairly undisputed fact that 85% of fund managers fail to beat the market each year.  It turns out that that’s about the last unvarnished “fact” he finds.  As we’ve seen before, all too often the ideas we take as eternal truths turn to be accidental hangovers from bygone ages. 

Dividends Have It

Most stockmarket growth in the last century was generated not by capital returns – which were more or less flat, adjusted for inflation – but from reinvesting dividends (see: Dividends Keep You Anchored).  Notably the only period this wasn’t true for was the 1990’s when market returns, which averaged between 4% and 5% otherwise, took off on a rip and scaled the heady heights of 13%.  

Quite why we don’t know, Comley suspects it was the removal of the gold peg allowing unlimited printing of money.  Maybe so, maybe not: certainly Andrew Haldane has shown that banking profits went skywards from about 1985 onwards, and that this correlates with their willingness to take on ever more excess gearing, which led in turn to the banking crisis in 2008 (see: It's Not Different This Time).  Whatever the reason, the data is clear, but the on-going psychological effects are less so.

Beta Minus

Looking at the average investor’s return, which is biased by our overoptimistic need to buy high and sell low, Comley’s estimate comes in at between minus one or two percent.  That is, investor “skill” generally reduces returns by one or two percent.  The Dalbar study, for instance, shows that the average return for an investor over the last 20 years was a 5% pa loss including charges (see: Overconfidence and Overoptimism).  Roughly fund investors appear to lose 2.2% a year, stock investors about 1.3% per year.  Those costs add up as well: they depend critically on your investment size, and the bid-offer spreads, but the Dalbar figure is roughly 3.8%.

There are also data problems - survivorship bias means that indexes keep going up, even if the starting constituents don’t (see: Survivorship Bias in Magical Mutual Funds).  This has a net impact on the returns quoted which Comley estimates at around 1%.  Take all of these factors into account and you start each year needing to make 6%, after inflation is taken into account, in order to just breakeven.  This is in an environment where the equity-risk premium is somewhere between 4% and 6% (see: Do Stocks Outperform (in the Long Run)?).  Woe is us.

All of which suggests that an average investor should expect to make between -2% and 0% per year through stockmarket investing, a return that might kindly be described as “disappointing”.  We shouldn’t be surprised: the zero sum game we play dictates that far more than 50% of private investors will be below average, an effect of trading against vastly better informed and equipped professional investment groups. The marketing campaigns encouraging people to trade for themselves are the equivalent of encouraging 1st graders to try their hand at professional football and then disowning the results: anywhere else and it wouldn’t just be discouraged, it would be outlawed, and the marketeers banged up in jail for long periods.

Cash Returns

Although none of the above is new information, the treatment in Monkey With A Pin is unusually clear about the effects.  However, Comley also turns his attention to the quoted returns on cash, presumably on the basis that everything else he’s been told turned out to be, at best, a pale shadow of the truth. 

Here again he finds that the low quoted returns on cash, after inflation, are an illusion caused by equating “cash” with “Treasuries”.  Actual interest rates achievable, in the UK at least, have been higher, leading to a significant and growing underestimate of the return on cash.  In fact he suggests that cash beat equities for most of the last decade and that this, the exceptional 1990’s excepted, isn’t unusual. 

This means that investors should view industry claims that cash is always a bad investment compared to stocks with scepticism: cash is far from the worst investment you can make, even over the long-term.  Losing small amounts of money to inflation is far, far better than losing large amounts investing in overhyped stocks.

A Bad Anchor

A couple of behavioral reasons are adduced for the fact that this abysmal situation has been allowed to continue for so long.  Firstly, the excessive returns generated in the 1990’s has caused both professionals and traders, who learned their skills in that period, to anchor on the “fact” that you can get extremely good returns simply by investing in stocks.  We’re stuck in a mode of belief about an idea that died around the turn of the century.  Everyone’s hanging around awaiting the imminent return of the good times, but it’s not going to happen.

Secondly, the fact that returns are so poor has probably been hidden by inflation.  This is simple money illusion at work: if your returns are 20% you’re still losing ground if inflation is at 21%, but you’re probably happy about the fact (see: Money Illusion).  We focus on nominal returns, not real ones.

Loss Aversion

In addition the book makes the intriguing suggestion that the trade off between cash and equities triggers our loss aversion tendency.  Cash is often a guaranteed losing investment when inflation is taken into account.  Shares, on the other hand, aren’t a certain loss.  The odds are against us, but loss aversion dictates that people will often prefer to take the gamble of a possible large loss, but a possible large gain, over a certain loss (see: Loss Aversion Affects Tiger Woods, Too).

The rather brutal subtext is that skill is less important than charges and if you’re to have any chance of success in investment at all you need to plan to overcome your behavioral biases.  This, of course, is exactly the advice most sensible advocates advocate.  If you wait until you need to make a decision to figure out what the decision should be it’s too late. Which is where Pete Comley addresses the practical implications of all this, you all visit his website if you want to find out what they are, and I gracefully bow out.

The Future

Let’s end with a sobering quote from the book, as if you needed further sobering, commenting on the latest  Long-Term Asset Return Study by Deutsche Bank estimating the return on the US stockmarket in the next decade at 0.6%:
“I’m sure you’d like to think investment returns will be greater than 0.6% over the next decade. After all, historically the[y] have been 5%, haven’t they? But remember, they were just over 1% pa over the whole of the last decade and the world debt crisis has not even started to be fixed yet.”
O happy days.

Website: Monkey With A Pin

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6 comments:

  1. Survivorship bias doesn't really apply to reputable indices: either a stock exits because it's not satisfying the index criteria anymore and is accounted for as a sale at the market price, or disappears via a corporate action whose cash flow can be observed and accounted for, or is delisted, this is the trickiest case but you can also account for that. Index implementers pay the index providers to get that right, and get very upset if they get unreplicable indices, so it's generally done.

    You are more likely to find it in academic or marketing studies, where the incentives/manpower are much weaker.

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  2. Also, on the statement that highish stock returns are not gonna happen ever again: will you compensate your readers who invest all their savings in selling long term out of the money index call options, because you're telling them it's a certain way to riches, if your prediction turns incorrect?

    I'm a bit surprised that you, of all people, are getting into the business of making predictions. Has some guy from zero hedge hacked your account?

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  3. Hi cig

    I'm a bit surprised that you, of all people, are getting into the business of making predictions. Has some guy from zero hedge hacked your account?

    Ouch! I didn't say "ever", though, all I'm saying is that the exceptionally returns generated in the 1990's are highly unlikely to recur soon. As predictions go I don't think it's up there with urging people to go long/short/mad with the latest and greatest stock or sector.

    On survivorship bias that's right: the problem is normally with the databases that track the indexes, which often are impacted by it. I think I read somewhere that this problem is reducing over time as well. What does matter to indexes is selection bias.

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  4. Well it seems to me your wording has too much certainty. A bull market is certainly not a given, but is it really "highly unlikely"?

    For example, if we look at the prediction implied by the SPX option prices, assuming I didn't get my back of the spreadsheet calculations wrong, we get gross annualised returns probabilities from now to December 2014:

    - 1/3 chance of > 5%
    - 1/5 chance of > 9%

    Of course matching numbers to unquantified prose is perhaps a bit disingenuous on my part ;-), but I feel that those numbers are incompatible with your statement, that is if you're right, the options market is mispriced, while I think it's broadly fair value.

    (The methodology used is to look at the ratio premium/interval for the series of adjacent call spreads, which is effectively an approximation of a binary bet on which side of the strike you will end up at expiration time. The gross returns are without dividends, which underestimates, and without inflation, which overestimates, but given that inflation and SP500 dividends are sort of nominally close these days, the real return numbers should be in the same vicinity. I used this date as the furthest expiration quoted, if you got options priced further away, I'd expect broadly similar values.)

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  5. Hi cig

    I wasn’t saying a bull market was impossible but I was arguing that anyone investing in the expectation of an early resumption of the 13% per year growth of the 1990’s – equivalent to quadrupling your money over the decade – is likely to be disappointed. Historically times of high debt and increasing interest rates – and rates surely must rise in the next decade – mean lower equity market returns. If the author quoted above is right, and has his book lays out, if investors can’t keep their costs well below 6% that’s likely to lead to disappointing returns. If you can keep from overtrading then shares will probably be the best place for your money.

    So while I can see your point about expressing this view with “excessive certainty” I didn’t intend to imply that everyone should sell their shares and head for the hills! Quite the opposite, in fact.

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  6. OK 13% for ten years is really at the high end of the spectrum, and I can agree that it's not very likely. Thankfully by now there should be few players with expectations at those levels. And of course I agree high costs are never a good idea.

    On rates, I disagree that they "must" rise within a decade. There are various very credible scenarios for the status quo or them going further down for another decade or two, or more (you can build a model where zero is the perpetual equilibrium). Of course I'm not saying it's certain, just one of the credible paths. If you have a strong argument to the contrary, please post! And in this case too your belief is actionable: you can lock in handsome returns by making direct rates bets, which would have a high chance of being more profitable than a proxy rates bet via an equity bias.

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