Most investment returns are bull****

More often than not, you’ll hear about people beating the market or otherwise doing really well.  But a lot of them are misleading and/or overstated.  Here’s why.

People are more likely to report great returns than crappy ones

Most people have egos and/or want themselves to look good.  If their investment returns suck, then they are highly likely to keep their mouth shut because they don’t want to look dumb.

Sometimes, it’s in the speaker’s self-interest to promote themselves or their companies.  And it’s almost always that case that behaviour follows incentives.

Here are some ways to overstate returns.

Cherry picking

Suppose you flip a coin 10 times and it lands heads 5 times and tails 5 times.  The first two flips are tails.  So, you start counting from the third flip.  Lo and behold, your coin flipping record is 5 heads and 3 tails.  It gives the impression that you’re good at flipping heads.  But the actual track record (5-5) is simply average.

Mutual funds do this by reporting the 3-month, 1-year, 3-year, 5-year, 10-year, since inception, etc. return… whichever happens to be better.  If a mutual fund really stinks it up, it will usually end up being merged or shut down.  Which leads us to…

Survivorship bias

If all the poor/unlucky performing mutual funds are taken out, then the survivors will be stacked towards having good track records.  So you end up with a world where it looks like most mutual funds are able to “beat” the market.  But this might not be the case.  (The reality is that most mutual funds charge way too much in fees.  On average, they will lag the market a lot because of these fees.)

Not actual returns

Sometimes people report returns based on backtesting historical data.  It’s not based on actual returns.  The problem with backtesting is that it often suffers from data mining.  If you look at enough data, you will find correlations that won’t predict the future.  For example, if you categorize stocks based on the first letter of their name, you will find that some letter will outperform all others.  However, a company’s name will have little to do with how well that company will perform in the future.

Simply lie about it

Some people like Bernie Madoff just make stuff up.  Is this really news?

My investment returns 😉

2008-2009 combined  +22.1%

2010  +25.8%

Yes, my penis is bigger than yours*.

(*Just kidding.  It probably isn’t.)

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How I invest (part 2 of many)

My goals

1. Achieve a consistent 20% return on my investments (this is a very high bar!).  In both bull and bear markets.
2. Avoid blowing up, otherwise I have to get a real job.
3. Know that I am actually good at investing.  This means a track record of a lot of trades.  I will achieve this goal faster if I focus on shorter-term trading.
4. Not expose myself to hidden risks or a very small chance of catastrophic losses.

Avoiding blowing up

I don’t want to have a devastating financial loss if I am wrong about my investments.  I try to structure my portfolio so that I’m not that exposed to crazy, unexpected events (some people call them “black swans” or “fat tails”).

Short selling and selling call options exposes you to unlimited downside.  I usually limit these positions to 2% of my portfolio.  If I lose 900% on one of these positions, then my portfolio is only down 18%.  I can live with that.  Even this might not be a great idea as there have been stocks that have gone up over 10 times in a short time period.

Also, I try to avoid being heavily exposed to a sector that may implode like how technology stocks imploded after the Tech bubble.  But I’m probably just saying this and not actually practicing it, because my portfolio is heavily weighted towards commodities.

But actually I’m crazy

I take pretty large positions in individual stocks.  I had/have 30% of my portfolio in QXM.  I had/have 25% of my portfolio in CREE put options.  If both of these positions go to 0 then I lose 55% of my portfolio.  While the CREE put options can easily go to zero (I am OK with losing 25% if the reward is high enough), I see it as highly unlikely for a cash-rich company like QXM.  I don’t worry about car crashes and I don’t worry about QXM going to 0.  I would be much more fearful owning a 30-year variable rate mortgage.  But I am probably crazy.

Making very high returns… even in falling markets

Because about half of my portfolio is in options, I should gain money if crazy things happen and lose money if they don’t.  Chances are good that crazy things won’t happen and I could stand to lose money on my options.

Current strategies

1. Bet on a shady pump and dump company (QXM) going up.
2. Bet on shady companies (CREE and several others) going down.
3. Bet on junior mining companies going up.  Junior mining is pretty shady and extremely speculative.  Almost all of this is in QMI.TO (Queenston Mining).
4. Companies with honest management that can grow earnings fast.  MCF, CMG.TO.
5. Special situations.  Spinoffs, tender offers, etc.  I don’t have large positions doing this right now.

Strategies that I am fooling around with:

1. Shorting pump and dump penny stocks.  I have been burned by this in the past as other people engineer buy-ins to force short sellers to cover their positions at a loss.
2. Shorting companies where long-term/activist investors give up their board seats.  This can happen when the investor knows that the proverbial excrement is about to hit the fan.  To sell their stake in the company, they have to give up their board seat first.  e.g. David Einhorn and New Century, Ontario Teacher’s Pension Plan and Maple Leaf Foods.  I have no trades with this so far.

How I invest (part 1 of many)

The two most important things are:

1. Reward.  Best measured by after-tax rate of return.
2. Risk.  Difficult to measure.

To me, the goal of investing is to get the best balance out of risk versus reward.  The best metric for reward is rate of return- the percent at which you expect your portfolio to grow.

Simply buying stocks at “half of intrinsic value” (cigar butt investing) is not so great if it takes a long time for those stocks to reach intrinsic value.  How fast you make your money matters.  Unfortunately, it’s often really hard to predict that.

Risk

Losing money seriously hurts your returns.  If your portfolio has a small chance of going to 0, then eventually your portfolio really will go to 0.  And your expected return will be -100%.  This is known as gambler’s ruin.  In real life, everyday people sometimes run into this problem when they take on mortgages and they lose their house.

What is you lose 50% of your portfolio?  You will have to double your money just to break even.  So it is really important to avoid devastating losses in your portfolio.  Taking on too much risk will actually hurt your returns, as it is really hard to claw out of devastating losses.

Those in the professional gambling field sometimes use a mathematical formula called the Kelly Criterion (here’s a link to an online Kelly Criterion calculator).  It’s a formula to calculate how much you should bet on any given position/investment/speculation.  It gives a percentage of your portfolio that you should bet on that position to maximize your returns (the Kelly Percentage).  However, you need to provide assumptions as to your chance of (not) making money and the expected payoff.  If you are off in these assumptions, then you may be overbetting and taking on too much risk and hurting your returns.  So, a prudent strategy is to bet a half or quarter (or some fraction) of the Kelly percentage.  This has much lower risk while keeping most of the returns.  Because the future is uncertain, there is no way you can be accurate about your assumptions and I would not bet the fully Kelly percentage.

Taxes

Of course they matter!  Unfortunately, most quoted investment returns do not take taxes into account.  This completely misses the point as you are trying to grow your money after tax, not before it.

Because capital gains are taxed at 50%, I currently will probably end up in a very low tax bracket and pay very little tax.  Right now I don’t worry about taxes much (I live in Ontario Canada).  It sort of makes sense for me to churn my portfolio so that I realize gains early and pay taxes on gains now instead of the future (income smoothing).  This way, my gains are taxed while I am in a very low income tax bracket (I do not work).

I should try to avoid receiving dividends on US stocks as the withholding tax is very high.

How to lose money

Common ways in which everyday people lose money.

Investing in private businesses

Oftentimes, people starting businesses have no clue what they are doing but think that they do.  Myself included.  People lose money starting businesses because:

1. It’s a dumb idea, but they are too stubborn / head-stuck-in-ass to realize it.  People tend to be overconfident in their abilities and they tend to stick to a belief (e.g. their business idea is good) even when the evidence indicates otherwise.
2. High risk does not mean high reward.  It’s no different than a casino.  When you play the casino, you have a negative expected return unless you really know what you’re doing.  I would look at startup businesses the same way.  It’s the startup business casino.  Assume that the expected return is negative unless you really know what you’re doing.

I’ve started a business.  I’ve seen other people start businesses… and lose a lot of time and/or money.  Go watch Dragon’s Den and Kitchen Nightmares (UK version).  A lot of money in the world is destroyed by the lure of starting your own business.

Yes you can make money starting a business.  But it is much likelier that you will lose money.  And it’s much easier to lose money starting your business than to make it.

Stocks

If you buy and hold random stocks (or an index fund), you can make 6-10% per year.  A few problems:

1. Very few people actually buy and hold stocks.  Most retail investors act like other human beings and experience fear and greed.  They buy when everybody is “making” money and sell when everybody is “losing” money.  They like to believe in conventional wisdom and tend to follow the herd.  Studies on mutual fund inflows and outflows show that retail investors almost always lag the performance of their mutual funds by a significant amount.
2. Most people don’t pick stocks randomly (or hold index funds).  Stock-picking/market-timing/active-management talent is probably distributed unevenly.  At least 80%+ of people in the world will be below average in stock-picking ability.  By picking their own stocks, they are actually hurting their performance.
3. The future may not resemble the past.  It’s possible (though highly unlikely in my opinion) then stocks underperform your other investment alternatives.  Anything can happen.

You should do fine if you own index funds and don’t hold too much of your money in stocks.

Hot stocks

The other way to lose money in stocks is to chase a fad like tech stocks during the Dotcom Bubble.  Especially if you borrow money to do it.

Complicated financial products

Such as market-linked GICs.  It is almost always the case that complicated products are ripoffs due to adverse selection.  The products are designed to be complicated so that you won’t understand them and won’t realize how you’re getting ripped off.

Investing in things you don’t understand is a bad idea.

Real estate

You get a variable mortgage.  Interest rates rise.  Now you can’t afford your house.

Or, you are in the middle of a real estate bubble and lenders are so crazy that they give you a mortgage you can’t possibly afford (e.g. you have no job).  This is why the US housing market is a mess.

Or, you decide to speculate on housing and take on an insane amount of leverage (e.g. down-payments on multiple condos at once).  This happened to people I know (Hong Kong real estate bubble).

Spend too much

This is so obvious, yet many people in Canada/US have a negative savings rate.  This is not sustainable.

Crazy events

Divorce, unforeseen illness, loss of job, etc.:  Some savings are generally a good idea.

Civil war, communists taking over your country, war, discrimination, etc.:  China and Russia alone represent a huge portion of the world’s population, yet a lot of people lost their wealth in these countries when communists took over.  (This happened to my parents.)  Even in democratic capitalist countries like Canada where I live, some minority groups lost all their wealth due to discrimination (e.g. Japanese Canadians during World War II).

Whenever crazy historical events happen, you should figure out if you should flee the country and if you can take some of your wealth with you.  Maybe you can keep some wealth if you plan ahead and have some assets overseas or own physical gold in a vault.  Or maybe not (e.g. border guards may take your gold).  I have no idea what the future holds.  But most conventional financial advice never consider these scenarios, even though such events have affected billions of people on this planet.