Ed Mamula.com

Oh, so that’s what a 40% drawdown in one week feels like.  The Cable Gilder went a dismal 1 for 5 in last week’s trading, and gave back all of it’s gains for the month of February.  Certain specific features of the drawdown make it especially painful.  I was looking for evidence that I should not trade on holiday Mondays.  I could find nothing in the backtest of the system to suggest that I should not trade last Monday, so I kept the system active, and promptly went 0 for 2 and lost 20% of my equity.  I was also undecided on whether or not to trade on Thursday, since it was an EIA Petroleum inventory data day, again due to the shortened holiday week. 

In my study of the charts last weekend, I concluded that the “Wednesday” phenomenon that I see in the backtest is probably due to triple swaps every Wednesday and NOT due to the EIA petroleum inventory release.  With that knowledge, I kept the system active on Thursday and went 0 for 2 again…again both were relatively large losses, and the last loss was an EXACT hit on a reaction low.  Put another way, if the market had retraced just one pip less, I would have been looking at a monthly profit for February in excess of 20%  Instead, I have a monthly loss of 3.9% and a paltry year to date return of 4.3%  To say that leverage is a double-edged sword is a cute understatement!

 So, despite still being up over 80% over the course of the last 5 months, I feel like crap….and NOW, cue prospect theory!  I’m currently reading “More Than You Know” by Michael Mauboussin.  This book is really thought provoking, and has re-introduced prospect theory to me.  The key learning being that a loss hurts about 2 to 2.5 times as much as a gain feels good.  With that in mind, it’s back to the drawing board for me in a sense;  I’m going to play with my position sizing algorithm such that I’m unlikely to FEEL LIKE A LOSER even when I’m winning.  There are lots of nerdly thoughts running in my head right now, but none of them are forming a coherent course of action just yet.  I’ll see what develops. 

In the meantime, the Cable Glider will be idle until Thursday, so I have a bit more time to see if I come up with any beneficial revisions to the bet sizing algorithm.  On another bright note, I re-coded the Cable Glider with Metatrader 4, which gives me more flexibility when I’m looking for forex brokers in the future. 

Time and again, investors are fed statistics on how few actively managed mutual funds outperform the S&P 500 index (or some other relevant benchmark).  A casual glance around the ‘Net this evening revealed to me that 80% of actively managed funds do not beat the S&P 500 index.  This bit of knowledge is usually followed by all of the benefits of owning index funds, such as low costs, “good” long term returns, a strategy that is easy to automate and guarantees average returns, etc.  The message is that it is so hard to beat the average that we should simply buy the index, and strive to be average.  This type of advice is never given in other areas.  “Jimmy, it’s tough to get straight A’s, so do as little work as possible and be happy with a C- average”.

Let me be the first to say just how easy it is to actively manage your own account and do WORSE than average.  It’s so quick and easy to set up an online trading account and start buying things left and right without any real strategy.  The trader who does this sure better hope the market really is random!  I suppose that this would be the typical life cycle of a risk-taking investor:  The young maverick boldly charges into the market.  He thinks that high risk equals high returns.  On cue, the market moves in his favor, and he becomes absolutely sure that trading is fun, easy, and highly profitable!  The maverick trader will inevitably get stuck in a losing position and have no pre-determined exit strategy.  At this point, his choices are to hold on and hope that the position will recover, or sell it out at a loss and “wise up” to the fact that he cannot beat the market.  His experiences with active management and personal financial loss with likely lead him to invest in index funds, where at least he can do no worse than the average.

But wait!  You saw the title of this article…and it’s true!  100% of S&P 500 index funds underperform the S&P 500 index.  Their costs may be low, but they are not zero.  In this way, index fund investors guarantee themselves a slightly below average return because they are afraid that any attempt to do better will land them a failing grade.  This does NOT mean that actively managed mutual funds are necessarily a better choice.  Actively managed funds do charge higher fees, and give their clients’ money a little bit of a deeper hole that it has to dig itself out of before it can even think about outperforming the S&P.  And indeed, just as there are many average investors, there must be many average money managers, all of which are willing to extract fees from investors and deliver a return just close enough to the average that their investors do not cash in their shares.

I believe that the average mutual fund manager’s primary motivation is to perform well enough to keep his job for another year.  To do this, he must deliver returns that are at least similar to his peers.  This tendency to fixate on the averages results in something I like to call “average cling”.  If the average money manager is simply going to invest in a basket of stocks that will perform close to average by design, what is he doing to deserve the management fee?  Average cling is like taking an exam and knowing what the curve will be ahead of time, then deciding to stick as close to it as possible so as not to stand out on the downside and get kicked out of the class.

Perhaps the best way to achieve above average results inside of a mutual fund is to invest with a manager that completely disregards the averages and strives for absolute return.  Such managers are rare, but certainly not unheard of.

Granted, the strategies above are aimed at passive investors; that is, those of us who do not want to spend our time picking stocks or other assets to include in a portfolio.  There are certainly higher return avenues available to investors who are willing to do their own work, but understand that consistently outperforming the market requires a love of trading and investing.  Just focusing on returns will not be sufficient motivation to put in the necessary work.  The necessary work is considerable, and it might just outlast your attention span.  

Index funds are STILL a good choice for the average, risk-averse, passive investor. It’s okay to be average. Just don’t let the establishment fool you into thinking that it’s impossible to break the curve.

(This article is part of the 87th edition of the Carnival of
Personal Finance…check it out!)