Your Three Investing Opponents

By John Mauldin

December 24, 2011

It’s Christmas Eve and that time of year when we start thinking about what we did in the past year and what we want to do in the next. Why do we make the mistakes we make (over and over and over?) and how do we avoid them in the future? If it seems to be part of our basic human condition, that’s because it is. Recently I have been having a running conversation with Barry Ritholtz on the psychology of investing (something we both enjoy discussing and writing about). Since I am busily researching my annual forecast issue (and taking the day off), I asked Barry to share a few of his thoughts on why we do the things we do. He gives us even more, exploring the three main opponents we face when we enter the arena of investing.

Barry is the driving force behind The Big Picture blog, often cited as the #1 blog site in terms of traffic (and a favorite of mine!) and FusionIQ, a software service that uses both fundamental and technical analysis. Over the years Barry and I have known each other, we have become quite good friends. If you ever get a chance to catch us on a panel together, you are in for some fun, as we tend to go at it and each other just for the heck of it, while trying to share the little that we have learned along the way. Barry is all over financial TV and now has a weekly column in the Washington Post. And now, let me turn it over to Barry.

Your Three Investing Opponents

By Barry Ritholtz

“Tough Year!”

We hear that around the office nearly every day – from professional traders to money managers to even the ‘most-hedgedof the hedge fund community. This year’s markets have perplexed the best of them. Each week brings another event that sets up some confusing crosscurrent: call them reversals or head fakes or bear traps or (my personal favorite) the “fake-out break-out” – this volatile, trendless market has been unkind to Wall Street pros and Main Street investors alike.

Indeed, buy & hold investors have had more ups and downs this year than your average rollercoaster. The third and fourth quarters alone had more than a dozen market swings, ranging from 5 percent to more than 20 percent. Despite all of that action, the S&P 500 is essentially unchanged year-to-date. It doesn’t take much to push portfolios into the red these days.

Three Opponents in Investing

With markets more challenging than ever, individual investors need to understand exactly whom they are going up against when they step onto the field of battle. You have three opponents to consider whenever you invest.

The first is Mr. Market himself. He is, as Benjamin Graham described him, your eternal partner in investing. He is a patient if somewhat bipolar fellow. Subject to wild mood swings, he is always willing to offer you a bid or an ask. If you are a buyer, he is a seller – and vice versa. But do not mistake this for generosity: he is your opponent. He likes to make you look a fool. Sell him shares at a nice profit, and he happily takes their prices so much higher you are embarrassed to even mention them again. Buy something from him on the cheap, and he will show you exactly what cheap is. And perhaps most frustrating of all, Mr. Market has no ego – he does not care about being right or wrong; he only exists to separate the rubes from their money.

Yes, Mr. Market is a difficult opponent. But your next rivals are nearly as tough: they are everyone else buying or selling stocks.

Recall what Charles Ellis said when he was overseeing the $15-billion endowment fund at Yale University:

"Watch a pro football game, and it's obvious the guys on the field are far faster, stronger and more willing to bear and inflict pain than you are. Surely you would say, 'I don't want to play against those guys!'

“Well, 90% of stock market volume is done by institutions, and half of that is done by the world's 50 largest investment firms, deeply committed, vastly well prepared – the smartest sons of bitches in the world working their tails off all day long. You know what? I don't want to play against those guys either."

Ellis lays out the brutal truth: investing is a rough and tumble business. It doesn’t matter where these traders work – they may be on prop desks, mutual funds, hedge funds, or HFT shops – they employ an array of professional staff and technological tools to give themselves a significant edge.
With billions at risk, they deploy anything that gives them even a slight advantage.

These are who individuals are doing battle with. Armed only with a PC, an internet connection, and CNBC muted in the background, investors face daunting odds. They are at a tactical disadvantage, outmanned and outgunned.

We Have Met the Enemy and They Is Us

That is even before we meet your third opponent, perhaps the most difficult one to conquer of all: You.

You are your own third opponent. And, you may be the opponent you understand the least of all three. It is more than time constraints, lack of discipline, and asymmetrical information that challenges you. The biggest disadvantage you have is that melon perched atop your 3rd opponent’s neck. It is your big ole brain, and unless you do something about it, it is going to lose all of your money for you.

See it? There. Sitting right behind your eyes and between your ears. That “thing” you hardly pay any attention to. You just assume it knows what it’s doing, works properly, doesn’t make too many mistakes. I hate to disabuse you of those lovely notions; but no, sorry, it does not work nearly as well as you assume. At least, not when it comes to investing. The wiring is an historical remnant, hardly functional for modern living.

It is overrun with desires, emotions, and blind spots. Its capacity for cognitive error is nearly endless. It was originally developed for entirely other purposes than risk assessment in capital markets. Indeed, when it comes to money, the way most investors use those 100 billion neurons or so of grey matter, they might as well not even bother using their brains at all.

Let me give you an example. Think of any year from 1990-2005. Off of the top of your head, take a guess how well your portfolio did that year. Write it down – this is important (that big dumb brain of yours cannot be trusted to be honest with itself). Now, pull your statement from that year and calculate your gains or losses.

How’d you do? Was the reality as good as you remembered? This is a phenomenon called selective retention. When it comes to details like this, you actually remember what you want to, not what factually occurred. Try it again. Only this time, do it for this year2011. Write it down. Go pull up your YTD performance online. We’ll wait.

Well, how did you do? Not nearly as well as you imagined, right? Welcome to the human race.

This sort of error is much more commonplace than you might imagine. If we ask any group of automobile owners how good their driving skills are, about 80% will say “Above average.” The same applies to how well we evaluate our own investing skills. Most of us think we are above average, and nearly all of us believe we are better than we actually are.

(Me personally, I am not an above-average driver. This is despite having taken numerous high-performance driving courses and spending a lot of time on various race tracks. I know this is true because my wife reminds me of it constantly.) [JM here – I am also in the bottom 25%, as my kids constantly remind me!])

As it turns out, there is a simple reason for this. The worse we are at any specific skill set, the harder it is for us to evaluate our own competency at it. This is called the Dunning–Kruger effect. This precise sort of cognitive deficit means that areas we are least skilled atlet’s use investing decisions as an examplealso means we lack the ability to identify any investing shortcomings. As it turns out, the same skill set needed to be an outstanding investor is also necessary to havemetacognition” – the ability to objectively evaluate one’s own abilities. (This is also true in all other professions.)

Unlike Garrison Keillor’s Lake Wobegon, where all of the children are above average, the bell curve in investing is quite damning. By definition, all investors cannot be above average. Indeed, the odds are high that, like most investors, you will underperform the broad market this year. But it is more than just this year – “underperformance” is not merely a 2011 phenomenon. The statistics suggest that 4 out of 5 of you underperformed last year, and the same number will underperform next year, too.

Underperformance is not a disease suffered only by retail investors – the pros succumb as well. In fact, about 4 out of 5 mutual fund managers underperform their benchmarks every year. These managers engage in many of the same errors that Main Street investors make. They overtrade, they engage in “groupthink,” they freeze up, some have been even known to sell in a panic. (Do any of these sound familiar to you?)

These kinds of errors seem to be hardwired in us. Humans have evolved to survive in competitive conditions. We developed instincts and survival skills, and passed those on to our descendants. The genetic makeup of our species contains all sorts of elements that were honed over millions of years to give us an edge in surviving long enough to procreate and pass our genes along to our progeny. Our automatic reactions in times of panic are a result of that development arc.

This leads to a variety of problems when it comes to investing in equities: our instincts often betray us. To do well in the capital markets requires developing skills that very often are the opposite of what our survival instincts are telling us. Our emotions compound the problem, often compelling us to make changes at the worst possible times. The panic selling at market lows and greedy chasing as we head into tops are a reflection of these factors.

The sort of grinding market we had in 2011 only exacerbates investor aggravation, and therefore increases poor decision making. Facts and logic go out the window, and thinking gets replaced with naked emotions. We get annoyed, angry, frightened, frustrated – and that does not help returns. Indeed, our evolutionaryflight or fightresponse developed for a reason – it helped keep us alive out on the savannah. But the adrenaline necessary to fight a Cro-Magnon or flee from a sabre-toothed tiger does not help us in the capital markets. Indeed, study after study suggests our own wetware works against us; the emotions that helped keep us alive on the plains now hinder our investment performance.

The problem, as it turns out, lies primarily in those large mammalian brains of ours. Our wiring evolved for a specific set of survival challenges, most of which no longer exist. We have cognitive deficits that are by-products of that. Much of our decision making comes with cognitive errorssecretlybuilt in. We are often unaware we even have these (for lack of a better word) defects. These cognitive foibles are one of the main reasons that, when it comes to investing, we humans just ain’t built for it.

We Are Tool Makers

But we are not helpless. These large mammalian brains of ours can do a whole lot more than merely overreact to stimulus. We think up new ideas, ponder new tools, and create new technologies. Indeed, our ability to innovate is one of the factors that separates us from the rest of the animal kingdom.

As investors, we can use our big brains to compensate for our known limitations. This means creating tools to help us make better decisions. When battling Mr. Market – as tough as any Cro-Magnon or sabre-toothed tiger – it helps to be able to make informed decisions coolly and objectively. If we can manage our emotions and prevent them from causing us to make decisions out of panic or greed, then our investing results will improve dramatically.

So stop being your own third opponent. Jiu jitsu yourself, and learn how to outwit your evolutionary legacy. Use that big ole melon for a change. You just might see some improvement in your portfolio performance.

Individual Investors Have Certain Advantages Over Institutions

One final thought. Smaller investors do not realize that they possess quite a few strategic advantages – if only they would take advantage of them. Consider these small-investor pluses:

No benchmark to meet quarterly (or monthly), so you can have longer-term time horizons and different goals

You can enter or exit a position without impacting markets.

There is no public scrutiny of your holdings and no disclosures required, so you don’t have to worry about someone taking your ideas.

You don’t have to limit yourself to just the largest stocks or worry about position size (this is huge).

Cost structure, fees, and taxes are within your control.

You can reverse errors without professional consequences – you don’t get fired for admitting a mistake.

You can have longer-term time horizons and different goals.

And with those thoughts, good luck and good trading in 2012!

We All Need a Coach

John here. As long-time readers know, I typically suggest that readers find a professional to help them with their investments, as doing it on your own takes time and a certain emotional mindset. Most of us (myself included) don’t have it. But some of you do have the mindset or desire and just need some help. One way to get help is to find a tool, as Barry talked about, that helps you have some objectivity about your stock-picking decisions.

I have a very special letter planned for next week to start you off right for 2012, and then my own forecast will be out on January 5.

So much to read and think about. Have a great week!

Your wondering where the year went analyst,

John Mauldin

Copyright 2011 John Mauldin. All Rights Reserved.

December 23, 2011 8:21 pm

Debt relief: A time for forgiveness

Chromolithograph from a Bible published by Collins in 1869

As Christmas Eve dawns, the tent hamlet that popped up in front of St Paul’s Cathedral more than two months ago is still there. Today, the mood in the London outcrop of the global Occupy movement is relaxed – a little festive even – compared with the encampment’s tense October stand-off with church and city authorities.

But one thing that has not changed is the jovial jumble of causes and slogans. In defiance of those who dismiss the movement as having no unifying agenda, the protesters are happy for each individual to define what they are there to achieve.


Yet there is a strange absence in the cacophony of demands. Almost no echo can be heard from a long tradition of economic protest movements, which, since the dawn of recorded history, have put one unambiguous demand at the top of their agenda: cancel the debts, redeem the debtors.

According to David Graeber, an anthropologist at Goldsmiths, part of the University of London, the first act of many successful rebellions was to annihilate the records of debt owed. In his book Debt: The First 5,000 Years, Mr Graeber describes howcancelling the debts, destroying the records, reallocating the land, was to become the standard list of peasant revolutionaries everywhere”. Is this time different?

After more than four years of trudging through a global financial crisis, the road that seemed to lead to recovery is taking another turn for the worse. Most rich economies are bracing themselves for stagnation at best in 2012. The crisis has many causes but they all have to do with credit and debt: too much of it.

As the boom went on, households and financial companies gazing out on to a seemingly endless horizon of low interest rates and rising asset prices gorged themselves on debt. From 2000 to 2007, the average mortgage debt of US households went from two-thirds of disposable income to more than 100 per cent. British households raised their mortgage indebtedness from 83 per cent to 138 per cent.

Among other Group of Seven leading economies, smaller debt binges took place in France, Italy and Canada – but not in Japan, still deflating after its 1990s debt crisis, nor in Germany, where labour market reforms were depressing workers’ wage packets.

The greatest build-up of debt was within the finance business. In the eurozone, total financial sector debt doubled from 1999 to €20tn on the eve of the credit crunch, or from 155 per cent to 222 per cent of the monetary union’s annual economic output.

Today, “debts exceed what can be paid”, says Michael Hudson, an economics professor at the University of Missouri. This is at the bottom of most of what has gone wrong in the crisis: the sum total of debt claims is greater than the worth of what was directly or implicitly pledged against the debtwhether the price of a house, the value of banks’ assets or the economic growth of countries.

If this seems like a new problem, it is only because we have forgotten the past. The importance of debt management throughout human history is evident in how the main religions contain often detailed regulations such as debt cancellations and prohibitions on usury. The biblical jubilee demanded that every 50th year indentured slaves should be freed and foreclosed land returned to the ancestral owner.

Such rulestell us that the build-up of debtscollective and individual – should always send warning signals through the system because they are unsustainable”, says Lord Jonathan Sacks, Britain’s chief rabbi.

Debt itself is presumably as old as settled society: the earliest samples of writing that have been recovered are often debt records. Mr Graeber argues that credit and debt predated money itself. Contrary to the common parable of money arising from the need to overcome the inefficiency of barter trade, he points out that in early societies, little was traded in markets. But much was lent and borrowed as favours between neighbours, so a unit of account was needed to keep track of how much was owed.

Denominating debts in a common currency, however, is also what makes it possible to separate the purely economic and legal part of a credit relationship from the personal relations between lender and borrower and the moral context of those relations. In one sense, this is what makes commercial society possible.

“It is important”, says Lord Sacks, “to differentiate between community and society. Community is the logic of relationships between friends. Society is the logic of relationships between strangers. Both are valuable in their very different way: if you only have friends and never strangers, then you get crony capitalism . . . So the Hebrew Bible does not say it is morally wrong to charge a reasonable interest ratejust to friends.”

But there is a shadow side to the evolution from paying back a favour with another to formal currency-denominated debt relationships. It strengthens the hold a creditor has on a borrower who falls on hard times. As Robert Shiller, an economist at Yale University, observes: “Ordinary fixed-interest debts make people more vulnerable to their economic fortunes. That’s a reason why lenders have always been seen as questionable figures.”

Measuring what counts as equivalent to what is owed makes it possible both to post and to exact collateral – which historically was often the freedom of debtors or their dependants or their means of livelihood. Sometimes this has been explicit. In the Brehon laws of mediaeval Ireland, debts were denominated in bondmaids.

Hence the importance of jubilees and other debt regulations in the ancient world: they were a way to prevent credit systems from degenerating into the enslavement of debtors by their creditors. Mr Graeber describes how the Sumerian king Enmetena in 2400BC declared “a general debt cancellation within his kingdom . . . the very first such declaration we have on record – and the first time in history that the wordfreedom’ [of former debt slaves] appears in a political document”.

Since then, few debt build-ups have occurred without debt cancellations or calls for them. In modern times, inflationary policy platforms – such as the “free silvermovement in the late 19th century US, have played a similar political role.

At least until the latestgreat recession”, inhabitants of the developed world would have treated the association of debt with slavery as a historical curiosity or an aberration of poor countries. But the parallels are closer than they might seem. A look around the countries ravaged by recession and unemployment shows how excessive debt can even today be experienced as a real reduction in freedom.

In the US, many economists say the job market remains depressed because unemployed people who in better times would have moved where there was work are trapped by mortgagesunder water” (their house is worth less than they owe on it). Austerity programmes now being required from peripheral European states – and willingly engaged in by others, most prominently the UK – are leaving people without a livelihood or with emaciated real incomes.

The small countries that were first lifted by the global wave of debt and then brutally deposited as credit dried up are seeing their young migrate. One-tenth of Iceland’s population has emigrated, says Prof Hudson. And he compares Latvia’s mortgage market to the Brehon laws’ system of co-signers and sureties: “Banks demanded personal liability from a borrower’s entire family. So whole families are now leaving the country. Trying to collect debts at this level is going to empty entire countries.”

Is it far-fetched to think that the history of debt writedowns carries a lesson applicable to the world’s current economic troubles? If Prof Shiller had his way, home mortgage deeds would containpre-planned debt workouts”. He adds: “It should say in the mortgage that if the house price index in your area goes down or there is widespread unemployment, then your payment should go down.” But what to do about existing contracts?

There have been modest moves towards latter-dayjubilees”. In the case of household debt, the US has implemented programmes for mortgage restructuring but these are not widely seen as successful. There is also do-it-yourself debt cancellation: “jingle mail”, in which the borrower sends the house keys to the bank and walks away, with a poor credit rating but debt-free.

In Europe, the single most important debt writedown is the “private sector involvement” in shrinking Greek sovereign obligations. Again, Prof Shiller thinks this could have been averted by making sovereign obligations less rigid, for example by linking them to a country’s economic growth. “The irony is that we don’t write these things in, even though we’ve had to forgive debts so many times . . . The history of debt is one of unreliability of payments.” But recent European Union summits have reaffirmed a determination that Greek-style writedowns should not be an option for other countries.

As for banks, governments’ determination that unsecured debt to senior bondholders should be honoured in full remains as strong as ever. Only Iceland and Denmark have written down banks’ senior creditors – but Iceland had no other choice and Denmark is having second thoughts. Within the eurozone the policy remains taboo. Ireland, whose public finances were wrecked by assuming bank liabilities, has been a tough negotiator on junior debt – but even as Dublin plans to refinance the senior obligations of its (now largely publicly owned) banks, it remains adamant that it will not repudiate or restructure anything.

What do you do then?” asks Prof Hudson. Either you enter a process of debt deflation and “concentrate property at the top of the income distribution”, he says. “Or you write down debts to amounts that can be paid, in which case you can keep a middle class.” If these are the alternatives, jubilees may yet stage a comeback.

Copyright The Financial Times Limited 2011.

December 23, 2011 8:34 pm

We wish you a merry Christmas. . . and a luxury new car

Of course, not everyone was introspective or serious enough for that. For them, Christmas meant sitting around a steaming goose with four generations of extended family, gossiping about the neighbours and getting tipsy on sherry.


What Christmas ought never to mean, though, was going into hock to buy great big piles of merchandise stamped out on American assembly lines, that television advertisers had misled people into thinking they needed in the first place. There seemed to be a consensus about this.

One hears complaint about the materialism of Christmas much more rarely nowadays. This is probably not because we are better at discerning the holiday’s true meaning. More likely it is that materialism has prospered to such an extent that none dare call it materialism. For the past couple of years, Lexus has run television ads suggesting ways for people to give their loved ones cars for Christmas. There is something obscene about these spots, which promote something called the December to Remember Sales Event. (Why it’s not called the Grind-the-Faces-of-the-Poor Sales Event is anyone’s guess.) The giving of the gift usually involves some elaborate consumer goods equivalent of a striptease or treasure hunt to heighten the atmosphere of materialism. Someone gets the present of a smart phone, for instance, which has the picture of a new car programmed on to it. Maybe next year, the cars will come with GPS directions to a newly bought country estate. Just an idea.

The Lexus ads are certainly materialistic but they are, to some extent, exceptions. Christmas may be more commercial than it used to be but “commercial” is no longer a synonym for “material”. A lot of people give experiences instead of things. That is exactly what we ought to do with our money if we want to maximise happiness, according to a recent article in the Journal of Consumer Psychology by the social psychologists Elizabeth Dunn, Daniel Gilbert and Timothy Wilson. But in practice, the line between experiences and things is hard to draw. If you buy someone a video game, have you given him a thing or an experience? Is it less materialistic to give someone a pretty, hardcover copy of Pride and Prejudice than it is to give them a television? Is it less materialistic to give the Kindle edition of Pride and Prejudice than the hardcover?

One suspects that complaints about materialism proliferated in the Charlie Brown era because children proliferated in the Charlie Brown era. The real gripe was that having to buy expensive toys for kids distracted adults from servicing their own consumerism. The opening up of China, from which an astonishing 89 per cent of American toys come, has fixed matters a bit because toys nowadays are, by historical standards, inexpensive.

As US companies have shut down assembly lines, agitation against Christmas materialism has grown more political. There is a character named Reverend Billy, who shows up at Occupy protests and calls for people to stop giving Christmas gifts. There is a website called It’s surprising there isn’t more organisation against Yuletide avarice – because efforts to stoke that avarice are well organised indeed. Retailers and etailers co-ordinate month-long selling strategies to separate consumers from their dollars, running from Black Friday, the day after Thanksgiving, to Super Saturday, the last one before Christmas.

In the old days, materialism was considered the opposite of spiritualism and thus a threat to the Christian aspects of Christmas. Now, it is more a threat to social and family life. According to a recent poll by the Family and Parenting Institute in Britain, 84 per cent of parents worry that Christmas makes children more materialistic. This year may be different in Britain, where a VAT rise, inflation and austerity have dented retailers’ expectations for a big Christmas shopping season. In the US, Kmart and other stores have, at customers’ request, re-established old-fashioned layaway plans, under which, every week, buyers pay a 10th or a 12th of the cost of some expensive appliance or article of clothing and then go in and pick it up with their last payment.

Such developments reveal another reason not to complain too much about materialism. It is a problem that tends, however painfully, to solve itself.

The writer is a senior editor at The Weekly Standard

Copyright The Financial Times Limited 2011.