Karl Popper’s Skepticism

Karl Popper’s contributions to the philosophy of science and economics were invaluable. His way of thinking can also be useful for investors.

If an investment thesis relies on inductive reasoning, it may be a good probabilistic guess, but be skeptical. For example, consider a prediction like “Every time the economy does X, Y happens the following year. X just happened, therefore will happen this year.”

Why might this relationship not hold true in the future? Could this be a case of correlation, not causation? Consider the logic and assess probabilities, but don’t be persuaded with this type of evidence alone.

Investors should also remember the importance of falsification. If you find yourself persuaded by an investment idea, consider what could prove the logic wrong. If you hear a theory about a stock or market movement with a list of “reasons” supporting it, ask yourself what those reasons could be missing. Asking skeptical questions will help assess risk. As the saying goes, if it seems too good to be true, it probably is.

‘In so far as a scientific statement speaks about reality, it must be falsifiable; and in so far as it is not falsifiable, it does not speak about reality.’

Furthermore, don’t be persuaded by a theory that seems unfalsifiable. Don’t fall for a pundit’s prediction that, if the anticipated event fails to materialize, comes with a pre-programmed excuse.

‘Whenever a theory appears to you as the only possible one, take this as a sign that you have neither understood the theory nor the problem which it was intended to solve.’

Below is a short BBC video summarizing Popper’s ideas on the dangers of unfalsifiable theories:

Night of the Living Funds

This is part two in a series on active management. For part one, click here.

A few years ago, a friend asked my advice about an IRA. Her financial advisor had chosen the investments while she was in high school.

When I looked at the statement, I was appalled. The advisor had picked two variable annuities—a long/short fund and market neutral fund—both completely inappropriate for someone with a long time horizon. My back-of-the-envelope math showed these annuities had cost her more than 100% in gains, or about $15,000, compared to a S&P 500 index fund from Vanguard or Fidelity.

How does this kind of thing happen? Simple: the advisor was paid a commission. He received a fee for putting her in products which themselves charged high fees. He had little incentive to do the right thing for his client, and every incentive to choose a product that would earn him a fee.

Unfortunately, that’s why many overpriced products still exist. Commissions-based financial advisors and cheaply designed 401(k) plans routinely put unwitting investors into products that charge outrageous fees. If we didn’t have a system that encourages these products, they simply wouldn’t exist. They would be competed out of existence by superior, cheaper alternatives.

Meb Faber has an excellent post about certain index funds that charge inexplicably high fees. One example, the Rydex S&P 500 Fund C Shares (RYSYX), has an expense ratio of 2.31% and the gall to charge a 1% exit fee on top of that. By comparison, the equivalent fund from Vanguard (VFINX) charges 0.14%. The chart below shows the performance of this fund against the S&P 500 since its inception.

Rydex fund (white line), index (orange line). Data: Bloomberg
From its inception in 2006 until April 2017, the Rydex fund has underperformed its index by a cumulative 51%, and that’s before the 1% exit fee. Imagine what that would do to your retirement fund over time.

As outrageous as these fees are, it gets worse in many active funds. First, take the Sparrow Growth Fund (SGFFX). It’s an equity fund with an expense ratio of 2.45%, a 5.75% front load (entry fee), and a 1.00% back load (exit fee). If you buy this fund, you’re signing up for over 8% in fees even if you only hold it for a year.

There’s also the Saratoga Technology & Communications Portfolio (STPAX). It has an expense ratio of 2.24%, a 5.75% front load, and a 2.00% early withdrawal fee. If an advisor bought this for you, you may not be happy about the 7.99% in fees you’ll pay in the first year. If you want to sell, no worries, just pay an additional 2.00%.

If you were a fan of the technology sector, you could have instead purchased a NASDAQ 100 index fund like QQQ, which charges 0.20% and no load. The below chart shows the performance of these two funds since QQQ’s inception date, and doesn’t even account for the 5.75% front load.

Active fund (white line), index fund (orange line). Data: Bloomberg
This underperformance is not just due to bad stock picking: the active fund would be much more competitive if not for its high expense ratio.

What about those painful front-end load fees? Consider a hypothetical fund that outperforms the S&P 500 by 0.50% every year, but charges a 5% entry fee. The chart below illustrates your dollar underperformance if you invested $100,000 in this hypothetical fund:

If you bought the fund at the end of the year 2000, it would take more than ten years for that 50 basis points per year of outperformance to “catch up” to the 5% fee you paid initially. This also assumes you picked a fund that can consistently outperform after management fees, which is a serious hurdle.

Fighting off the Zombies

Many hyper-priced funds are small, but they still survive. The way some funds stay open is by obtaining investors through unusual means. Maybe a financial advisor gets paid a sales commission or a poorly structured retirement plan offers the fund as a 401(k) option. Maybe someone buys the fund, pays the high entry fee, and feels mentally “invested.” This is the sunk cost fallacy in action.

There are still some excellent active funds with reasonable fees, but many funds remain on the market when they shouldn’t. Fund companies know that high fees are a drag on performance, and it’s easy to see how funds fail to outperform their benchmarks if they charge fees of 1%, 2%, or above. They’re like the living dead; they limp along, dragging down the healthy in the process.

Joel Greenblatt on Investment Philosophy

Most investors have probably heard of Joel Greenblatt. He is a value investor with fantastic insights on analyzing special situations like mergers and spin-offs. I would recommend his books to anyone interested in investing or business.

The video below is a talk he gave at Google. The whole talk is worth watching, but I want to highlight a portion (11m:18s) where he discusses his investment philosophy and contrasts it to momentum investing.

Greenblatt explains that with momentum, it’s hard to know what to do when a trade isn’t working. He admits there’s plenty of evidence that it often works, but there are certain times it doesn’t work. If it’s not working at a given moment, it’s hard to tell if you should be patient or if the trade is too crowded. If your timing is wrong, it may not work, and there’s nothing fundamental to guide your decision.

This isn’t the case with a value approach. If Greenblatt is confident in his assessment of intrinsic value, he can be patient, and he won’t rely on price movements to dictate his decisions.

Why Drawdowns Matter: A Visual Demonstration

Common knowledge in investment circles is that drawdowns are bad. But are they always bad? Are there times when they’re especially bad?

Let’s explore these questions by looking at stocks and bonds. From 2001-2016, the S&P 500 returned +133% and the Barclays US Agg. Bond Index returned +112%. In this time period, the cumulative returns of stocks and bonds were fairly close, but the return patterns were very different.

The chart below shows the growth of a $100,000 investment in these two indices. As you can see, stocks had significant drawdowns during the period while bonds were less volatile. If you simply bought and held for the 16-year period, you would receive a +133% return in stocks and +112% return in bonds. Your account balance would have ended about 10% higher investing in stocks than bonds.

The next chart shows the same initial investment of $100,000, but this time let’s assume you deposit/buy an additional $500 per month. You will notice that under this scenario, stocks worked a little bit better—your ending balance would have been 25% higher investing in stocks than bonds.

The third chart shows the same initial investment of $100,000, but let’s assume you sell/withdraw $500 per month. You will notice that under this scenario, bonds did much, much better—your ending balance would have been 154% higher investing in bonds than stocks.

The three scenarios above illustrate the drastically different outcomes that are possible when investing in the same two indices. The only difference between each scenario is the assumption that you made deposits or withdrawals along the way.

What it means:

The three scenarios above demonstrate the importance of drawdowns depending on your situation.

1) If you make no trades, the return pattern doesn’t matter—the only thing that matters is your return. Of course, this is not how most people invest.

2) If you’re depositing on a regular basis (e.g., a young person with a 401(k)), big stock market drawdowns shouldn’t scare you. In fact, drawdowns help you, because they allow you to buy more shares at a lower price.

3) If you’re withdrawing on a regular basis (e.g., a retiree), drawdowns matter a lot. If you sell during a drawdown, you have to sell a larger quantity of shares to get the same dollar proceeds.

This is not a comment on the behavioral effects of volatility. These scenarios assume you can stick to a regular plan.

The above simply demonstrates  how much return patterns matter depending on the investor’s situation. Drawdowns are not always bad, and can be beneficial to someone  with a long time horizon who is dollar-cost averaging. But drawdowns are absolute killers if you’re making regular withdrawals.

Postscript (Into the Weeds)

I often see discussions of the negative effects of volatility. For example, this Michael Batnick post makes the valuable point that “outsized volatility is a drag on returns.” It shows how a portfolio can erode over time if it experiences alternating gains and losses.

The below chart shows what happens over time to a dollar if it experiences alternating gains and losses of +10%/-10%, and +20%/-20%:

But here’s the thing: volatility is not what causes the value to drop. The reason is that a gain of 10% is not equivalent to a loss of 10%.

If you lose 20%, you need a 25% return to get back to zero. So -20% is equivalent to +25%.

To find the equivalent loss for a gain of 10%, we can use the formula 1/(1+r)-1, which in this case is about -9.09%. This is because single-period returns are compounding, not additive.

In other words, a single-period return of 10% is actually equivalent to a loss of 9.09%. You could alternate returns of +10% and -9.09% forever and never fall below your original dollar.

A portfolio can experience equivalent gains and losses forever, but the trick here is that +10% is not equivalent to -10%, and +20% is not equivalent to -20%.


Single Stock Portfolios and “My Friend is Beating Me”

Michael Batnick wrote a great post this week about a reader with a friend who invested his entire brokerage account in a single stock (Facebook). It’s hard to argue with an investment strategy when someone shows you eye-popping returns in their personal account. Although you know about the importance of diversification and the benefits of index funds, hearing this type of story can cause jealousy, a fear of missing out (FOMO), and the thought “if my friend did it, there’s no reason I can’t do it too.”

As Batnick points out, one of the major problems with holding a portfolio of volatile stocks is the emotional swing. Huge drawdowns scare investors into selling when they should be buying. Rapid gains entice people to buy more shares when they should be trimming an oversized position. So even if a stock performs well over time, the investor’s emotional mistakes eat away at their returns.

If someone asked me if they should hold individual stocks, I’d ask them a few questions. First, I would ask them how they handle volatility. Have drawdowns ever caused them to sell their stocks or go against their long-term plan? If that’s the case, I would encourage them to take a hands-off approach.
Second, I’d ask what they like about the company they want to invest in. If someone loves reading about business and can speak passionately about capital allocation, brand, long-term strategy, or return on equity, I think they’re fine investing some percentage of their portfolio in the stocks of companies they believe in. Engagement and interest will lead them to save and invest more.

My friend did it, so why can’t I?

There’s another point I’d make to someone who hears about a friend’s amazing single stock returns. Their friend may have picked a good stock, but that doesn’t mean they’re a good stock picker.

Let me explain. There is a fundamental principle in forecasting: a prediction’s apparent “success” doesn’t prove it was a good prediction. This idea is counterintuitive, and is one of the most common misconceptions in probability.

Imagine I said there is a 95% chance the New England Patriots will win the Super Bowl next year. Vegas oddsmakers would laugh in my face. There are 31 other NFL teams who follow the same rules. Even though some teams are better than others, forecasting that any individual team has a 95% chance of winning the Super Bowl would be crazy.

But what if the Patriots did end up winning the Super Bowl? Was my initial forecast of 95% proven “correct” given the outcome? No, because the ex-ante probability of an event is separate from the outcome. If you replayed the season 1,000 times, the Patriots wouldn’t have won 950 Super Bowls.

Skilled, Lucky (Photo Courtesy: United Artists)

Similarly, if I claimed “I have a 100% chance of rolling a six on this dice roll,” and then I happen to roll a six, that doesn’t prove me right. It proves me lucky.

It’s important to remember this point when judging an investor: don’t assume someone is a great stock picker based on a sample size of one. With a sample of one, the best you can do is decide if their stock pick made sense at the time, before they knew the outcome.

So Michael Batnick is right, there are plenty of pitfalls investing in a single stock, even one that performs well over time. Excessive volatility triggers emotional decisions, and emotional decisions are usually mistakes.

But you should also not assume your friend is the next Peter Lynch because they got a great return on a one stock. More information is needed.