Tough Year!”

We hear that around the office nearly every day – from professional traders to money managers to even the ‘most-hedged’ of 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 is a 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.

Institutional Competitors

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 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 year – 2011. 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.

(Despite having taken numerous high-performance driving courses and spending a lot of time on various race tracks, I am only an average driver. I know this because my wife reminds me constantly.)

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 at – let’s use investing decisions as an example – also 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 have “metacognition” – 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 evolutionary “flight or fight” response 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 errors “secretly” built 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!


This was originally published as part of a longer piece in Thoughts from the Frontline exactly one year ago, on January 25, 2012.


Category: Apprenticed Investor, Investing, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

18 Responses to “Your Three Investing Opponents”

  1. The advantages of the small investor are not to be neglected. If he knows what he does, and he knows the nature and time-frames of his bigger opponents, he’s got an edge.

  2. eroldictat says:

    Start by turning off CNBC altogether. Instant improvement in decision making.

  3. louiswi says:

    Wow Barry,

    This is just an EXCELLENT piece. Thanks for the work that went into it.

  4. phillips49 says:

    Add a couple of more significant advantages for the small investor:

    1. Liquidity – the small investor can liquidate nearly instantly. Click in, click out.
    2. Portfolio investing constraints – the small investor does not have the constraints on the mix of investments they are allowed to make the way funds do. They can mix and match whatever they feel good about. They can concentrate or diversify in infinite combinations.
    3. Flexibility – a small investor can restructure an entire portfolio nearly instantly.
    4. Time – small investors have time, they can sit and wait and they have the option of not being in at all.
    5. Rules – for rules based investing, the small investor makes their own, they don’t have to confine themselves to someone else’s and they can change them instantly based on their own experience.

  5. wally says:

    “Mr Market” and “Institutions” are opponents only if you are looking at equity prices as the way you make money, it seems to me. This is all part of what I consider the cult of equities. There are alternatives.

  6. mad97123 says:

    Great stuff.

    I have been trying desperately to overcome my bearish confirmation bias, but all I can think of is to act the opposite of my gut instinct which served me well leading into the crash.

    Buffett and his partners famously sat out of the Dot-com Bubble in the late nineties because technology wasn’t a field he was comfortable with. Government intervention and manipulation is not a field I’m comfortable with.

    It still feels like this Lance Armstrong market will be striped of it’s metals.

  7. ToNYC says:

    “– 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.”

    the smartest people are gaming and empowering humans, observing and waiting for the fat tails to be denied by the hard working sons of bitches all day long.

    or: nice work serving man, but only eating the vegetables.

  8. TR says:

    My favorite delusion is when people don’t subtract their contribution from their “Personal Rate of Return”. What a riot ( I hate that funds don’t separate this data. It’s quite new and misleading.).

    You don’t have to participate regularly. Pretend you are looking over the shoulders of players and when the unbeatable hand is dealt go all in and wait for top-out. While you wait (yes it’s hard and boring) keep diverting cash till the next Ace high straight flush.

  9. Pantmaker says:

    Good stuff Barry. Investors need to keep a healthy perspective on the relationship between the siren song of short term price action and the tendency of things like earnings and valuation to mean revert over longer periods of time. The latter ultimately wins all of the chips, while 95% of internet blogs, clicks and noise are dedicated to the former.

  10. VennData says:

    Imagine playing chess against a computer. You and the computer each put up a fee.

    That’s what you’re doing in the market. You are “Trading” against not one, but hundreds, thousands of computers, that are faster, better, have more data. improving.

    Your ideas and strategies have already been tried, tested, tossed out by legions of IT pros with petabytes of storage, millions of processors running 24/7.

    If these computer systems, which are parsecs ahead of you, are making money, the pros simple add more capacity, increasing the number of advanced computer systems you’re competing with.

    Now I know you think it’s fun and ten, twenty years ago, people were buying – and on average making money because of the Nineties bull market – but even that was a lie because you still weren’t beating the market, just making money because there was a bull market.

    But it isn’t like that anymore. If you think it is, than I have some Supply Side tax cuts that will decrease the deficit to sell you.

  11. TLH says:

    Most of Wall Street is just trend following and momentum. Our government enables those who give political contributions (bribes). The biggest problem is the financial manipulation of the markets. What will happen when the music stops? Thank you BR for all you do. Sell high, buy low. Not always the mantra of Wall Street,i.e. suck in the public at the top.


    BR: Its much more nuanced than that. You should some spend some time looking at our behavioral discussions, especially the section on confirmation bias.

  12. bonzo says:

    The idea that institutions are something to be fear is absurd. Institutions have an agency problem. If they sit on cash when the market is getting giddy (like now), they will lose their jobs. “The sound banker is the one who loses money when everyone else loses, whereas the banker who wins when others lose is suspect, on the grounds he did something unconventional.” The agency problem makes institutional behavior stupid, regardless of how smart the agents themselves might be. The really smart agent puts his smarts to work convincing his clients to give him their money to run, which means pandering to their prejudices, rather than trying to beat other pros. A pro who loses but still gets his 2% fee on huge assets under management does much better off than a pro who wins, and thus gets both the 2% and the 20% on the winnings, but has small AUM.

    What the small investor really has to fear is smarter individual investors. Buffett, in particular, is effectively an individual investor, since he can’t be fired, and is a formidable competitor. There are also some retired wall street pros who chose to continue playing the game as a hobby, and these are also fearsome competitors. Luckily, this category is not that large compared to the market as a whole. Also, Buffett and other very wealth persons in this category are handicapped by their sheer size, whereas the small investor can buy or sell all his investments at once without budging the market.

  13. ancientone says:

    Speaking of longer term time horizons, I put money into stocks regularly from July of 1984 until July of 2007 when I saw what looked like a double top (2000-2007) pretty much like the one of 1965-1972, and took all my retirement accounts out of the market and into a long term CD at 4 1/2 percent. That would make me about 24% higher now than in 2007. It’s been a great rally since then, but I’m happy where I am.

  14. [...] This post from the Big Picture reminds me of things I have said multiple times to multiple audiences [...]

  15. To Barry’s behavioral summary, here’s one about fishing which I think has some hard-wired relevance to how people act within a market. Down on Cape Cod, our neighbor Al Zaffini would come down into the cove in his boat at sunset, turn off his motor, and throw ten casts with his striper plug. If he didn’t get a fish or a strike in ten casts go back to his beach cottage and have a cocktail. Unlike Al, we’d sit there in our boat casting ’til after dark. Sometimes Al Zaffini was right: there were no stripers down in the cove that night, not biting at least. But sometimes, ten minutes after Al took his ten test casts and left, we would start catching stripers like crazy, or at least get a few. But I bet on the whole, over an entire summer, Al Zaffini was right about half the time (for leaving after ten casts) and we were about right half the time for staying. And in support of Barry’s ‘selective retention’ model, me and my brother and our Dad would only remember those nights when Al Zaffini was wrong and the stripers started hitting right after he left. We tended not to recall those times when we never got a single striper the whole night — and Al and his ten casts turned out to be right.

  16. In recounting the above fishing story, my wife reminded me of a similar behavioral algorithm with slot machines, which is if you play slot machine X for 50 pulls lose every time, you build up a behavioral reluctance to leave that slot machine in fear that the next person who puts in a token will win because your 50 pulls have now created a large, pent-up amount of luck inside that particular slot machine, just waiting to be let loose. Barry is correct that the human brain is hard-wired by evolution to be a pattern-seeking-machine, because in even slightly non-random scenarios, pattern-recognition is a useful tool. In an evolutionary time-scale, being able to detect even a small signal in a sea of random noise can confer benefits. This is why truly random landscapes confound our hard-wired, pattern-seeking brains and tend to generate false positives.

  17. ToNYC says:

    Douglas Watts Says:

    Fast forward to the next life try after all that experience, and teach your children then to try ten casts then realax for at least ten but no more than comfortable but less than 30 min, then try another 10 casts. Often at the point of losing patience, the message arrives later than the immediate fiction delivery expectations.
    On the slots, only play machines for ten tries after a long sitter folds up the tent then look for the next fail. The machine don’t know the house payoff timing, and couldn’t care less about the next roll of unloaded dice, but it feels better. Slots are just obstacles on the floor to a player in any event, but there’s always a behavioral game to beat whatever blues the band is playing.

  18. faulkner says:

    Two of the three opponents are personifications – attributing agency to stochastic processes (Mr. Market), and intentions to the automatic processes of System 1 of oneself. The point of metaphor making is to offer insights for action that otherwise wouldn’t be attained. In this, Mr. Market is a psychopathic carny and our big ole outdated brains, filled with defective hard wiring, are trying to deceive us.

    You also present an evolutionary view. Our big ole brains – which include our bodies as we process experiences and emotions – are highly adaptive to immediate circumstances especially involving people. As ‘modern’ events change time scales, number of participants, and abstractness of the objects (ex. cash vs. options), we naturally substitute our personification strategies and feel confidence with our minimal knowledge.

    Metacognition is a curious phenomena. One needs a sufficient number and variety of examples, a generalization strategy, and an ability to identify counterexamples. In everyday language, to usefully question oneself. This is developing expertise and suggests a skill building approach – a lot less exciting than having opponents.