Oh, the Mistakes I Made

A few years ago, I was faced with a conundrum. I had money in the bank from my advance for my next book and from the savings of living in Bolivia, where everything costs about a fifth of what it costs in the US—we’d been living there for about six months. But there was no obvious (to me, at least) way of investing that money and making it grow—the interest rate on certificates of deposit, which is what I'd used in the past, were minimal. So I asked my sister-in-law, who’s a banker, what she’d suggest, and she told me about ETFs—exchange-traded funds that were pegged to indexes and thus avoided the fees associated with mutual funds. She suggested a few.

There are a plethora of these on the market, and I had no idea how to choose the right ones to invest in. I’m a systematic person and don’t like to put my money in anything I haven’t checked out thoroughly. I began to wonder if there wasn’t a system I could use to choose ETFs. And that logically led to a hunt for a system for buying and selling ETFs.

Well, if there is a good system, I failed to find it, despite spending practically all my spare time invest(igat)ing. Using two of my retirement accounts along with my savings, I started investing in a variety of ETFs; in the middle of 2014, I started investing in individual stocks as well. But by the end of October 2015, after almost two years of investing (and researching like crazy), I had lost at least 25% of my money. (To put this into context, if I’d followed my sister-in-law’s advice and invested in ETFs like SPY, which tracks the S&P 500, I would have gained over 12% instead.) And in order to make up for a 25% loss, you need a 33% gain.

What mistakes did I make? Every single one in the book.

• I bought and sold based on technical analysis. Technical analysis is the examination of short-term price movements for patterns that indicate points at which to buy and sell. I used complicated algorithms involving stochastics and other indicators to measure short-term price performance and market sentiment. Some people claim to be very good at this, but I wasn’t.
• I changed my strategy every few months. I would be convinced I’d found a strategy that worked, and then a few weeks later I’d realize it had a fundamental flaw, so I’d fix it. Or I’d replace it with a better strategy. The only way to invest profitably is to implement a strategy that you’re completely sure will work and stick with it, making incremental improvements to avoid too much buying and selling.
• I chose ETFs based on past performance. The past performance of an ETF may or may not indicate future performance, depending on what factors the index depends on. There are a few index funds that will always outperform a few others—SPY will always outperform SH in the long run—but past performance is not the best way to figure that out. There has to be a reason why the fund has performed well in the past.
• I only invested in companies with high ethical standards. As is well explained here, this may well be an ethically and financially counterproductive move.
• I used stock screeners based on faulty data without thoroughly evaluating the stocks I was buying. Screening for stocks that satisfy a handful of criteria means that you’re failing to look at other, equally important criteria. A stock can show great earnings growth, but if that growth is based on excessive accruals or if revenue is shrinking, you’re sunk. And most data providers on the Internet—the ones you don’t pay for—give you numbers based on outdated statements and faulty calculations. If you compared the number of fully diluted shares of a hundred companies as stated on their latest earnings statements to the numbers on public websites (or given by your broker), you’d probably find about 5% of them were wildly inaccurate, and without an accurate measurement of shares, you can’t figure out anything about their earnings per share or their relative value.
• I based my choices on past Sharpe ratios. The Sharpe ratio is a measurement of “risk-adjusted returns” that, when you think it through, makes about as much sense as “Jabberwocky.” I’ll be devoting two long posts to risk-adjusted returns in the near future, but in the meantime, this is a good read.
• I bought things whose price was going up and sold them when their price fell. Probably every beginning investor does this, and a lot of experienced ones do too. It’s human nature, but it’s bad investing. You look at a stock chart and you see periods when a stock's price goes up and you think, aha, that’s a trend. If I can buy when the trend starts and sell when it ends, then I’ve made money! Unfortunately, this ignores the principle of short-term mean reversion. Studies show that over the last ninety years, stocks that have gone up in price over the last few weeks are more likely to go down over the next few weeks than to continue going up. The opposite is true as well. Why does short-term mean reversion happen? It’s because most investors overreact to news, buying or selling a stock in quantity, and this is reinforced by day traders. After a few days, wiser investors take advantage of the sudden price move, so the price moves back to the norm. I did a little experiment about this. Let’s say that over the past fifteen years you ranked all the stocks in the Russell 3000 according to how well they did over the past two weeks, and you bought the top 20%, rebalancing weekly. Ignoring transaction costs, which would definitely break your back, your annualized return would be 3.6%, far below the S&P 500, with its 6.3% annualized return. Now let’s say you bought the worst 20%, the stocks that have fallen the most in the last two weeks. Again ignoring transaction costs, you would have beaten the market handily, with an annualized return of 14.2%. Now let’s say you bought the worst 20% but only if the volume of trades has increased over the past two weeks, thus indicating an overreaction to market news. Now you’re really in the money: you’d be making 19.1% annually. (Warning: don't try to actually make this your strategy! Transaction costs would likely eat up every penny of your profit, and then some.) One’s natural instinct is to sell a stock when its price is falling and hold onto it while it’s rising, or to buy a stock when its price is rising and take a pass on it when its price is falling. It takes a lot of emotional control not to do this, but the only way to make money is to buy a stock when its price is low and sell it when its price is high. If you buy when a stock's price rises and sell when it falls, you're definitely not buying it when its price is lowest and selling it when its price is highest. If you do this consistently, it will kill your returns.
• I used stops and got whipsawed. A stop is an order to sell a stock if it goes down by a certain percentage. Getting whipsawed is selling when the stock goes down only to see it go up again, losing money in the process. This happens a lot because of short-term mean reversion. Everyone on the Internet advises you to use stops to protect your profit. Don't.
• I paid a lot of attention to broker recommendations. The problem is that a lot of other investors do too, so doing so gives one no advantage whatsoever.
• I relied on backtests using very limited samples. I didn’t know about Portfolio123. I came to inaccurate conclusions using very limited data.
• I bought stocks based on their “value” without regard to their growth prospects or quality. All investments should be evaluated thoroughly from a variety of angles.

In the end, I learned from my mistakes and turned it all around, as I explained here.

My ten largest holdings right now: FONR, APT, EMMS, BTN, PCMI, UWN, GSOL, SNFCA, BLBD, GVP.

YTD CAGR: 50%

Comments

[Jerry Parker]

I bought things whose price was going up and sold them when their price fell.

And yet momentum has proven to work!

[Yuval Taylor]

Momentum works--modestly--over the long term (six to twelve months). There's a good explanation for this that has nothing to do with a stock's price: it's that companies with good, solid performance tend to continue to have good, solid performance. But I was relying on short-term momentum (one to two months), which doesn't exist.

[Eric]

Great post, thanks for sharing. I can remember learning a few of the same lessons on my own the hard way.

I've read some of your other posts about how you test your hypotheses and come up with the best criteria for sound companies to invest in using Portfolio123, but could you please share how you discover the companies that match your criteria?

Thanks a lot for the help!

[Yuval Taylor]

Well, Eric, I have a ranking system on Portfolio123 that ranks all the stocks in my universe (over 3,000 of them) by the criteria that I choose. I then buy the top-ranked stocks. Those are the ones that are most likely to fit all of my criteria.

[Michael]

Hi Yuval, I'd be interested in a (non-investing) post about your experience living in Bolivia that you mention. There's a little bit on the internet, but there's probably

[Yuval Taylor]

I kept a diary while in Bolivia. It's at http://backland.typepad.com/