Homerism (and notes)

I’m rereading The Four Pillars Of Investing by William Bernstein.

This is a terrific book, that I highly recommend everyone interested in investing to read at least once.

Bernstein is a remarkable mind who is able to take complex economic history and theory and calculations and distill them all down into a very readable and entertaining narrative that actually helps you come up with an investment plan suitable for most contingencies.

And some of the concepts are so simple that their brilliance makes you wonder why you hadn’t thought of them yourself.

One of the tenets of behavioral finance is that we humans are biased to favor our own backyard. We all have tendencies to think that our home countries are uniquely structured and just. And we’re more comfortable pouring our own money into the familiar (when perhaps we shouldn’t be).

And you see evidence of this bias everywhere. Despite the fact that the US makes up only 50% of the world economy, people will routinely argue that they achieve enough international diversification just by investing in the whole US stock market due to the presence of multinational corporations and the foreign sales of these companies. This is despite the fact that there is an imperfect correlation between foreign and US indices, and thus a diversification benefit (at least historically) in owning both.

I myself am somewhat guilty of this in that I invest 60% of my equities domestically and only 40% internationally which is not in keeping with the structure of the whole world market. My justification for this slight favoring of domestic equities is that they are cheaper. But who am I to deny that I am also guilty of the home court bias?

People will also commonly refer to the unique infrastructural, and regulatory advantages of America over the rest of the world. And I am not so sure that there is so much evidence for this going forward.

But the point is this. A common graph you will see in investing is this one.

This purports to show the growth of one dollar in the US stock market over its history. And it is used to justify the magic of compound interest. (Which is in fact a very magical thing.)

But the point the Bernstein makes is that when we focus on the historical returns of this particular stock market, we are guilty of two biases: selection bias and survivorship bias.

Selection (or sampling) bias occurs when your study is flawed because the population studied has already become skewed by the method of recruitment.

The classic example of this was the polling data from the 1948 election between Truman and Dewey. Because the novel telephone was used to collect the polling data, The polling population was skewed towards the wealthy who had the resources to own phones. This made it seem as though the more conservative candidate was winning, when fact he was not.

Survivorship bias occurs when you study a population that gets smaller throughout the course of observation. Because the final population has been whittled down, it becomes skewed towards the traits of survival.

The classic example of this is in studies of mutual funds, where you look at the performance of current mutual funds over the last 15 years. In doing so you’re ignoring all of the funds that have gone out of existence during the time period of your study prior to your starting of the study. So there is a an invisible portion of your population that you unwittingly exclude from your analysis. You are, in fact, only looking at the winners.

The point being that when we look at the incredible performance of the American Stockmarket of the past couple hundred years, we are unwittingly selecting a winner.

I mean, how would a dollar invested in the Prussian stock market look right about now?

In a way this is quite similar to looking at Warren Buffett’s Record of success investing in the stock market and concluding that stock market investing is incredibly profitable.

Investing is easy

As Bernstein points out, when the American stock market started out it was a frontier market (even more unstable than what we would call an emerging market these days.)

It was indistinguishable at that time from any number of other markets whose subsequent track record was quite a bit less successful, an in some cases calamitous.
And just because there’s been tremendous success in the past for America, this does not mean that it was inevitable, nor that future outsized success is inevitable.

America could be just like the lucky active investor who has beaten the broad market year after year through good fortune.  Research suggests you should be very wary of betting on that investor.  Past performance does not guarantee future success (and may even increase the probability of future failure.)

And the take-home message is this I think:

• When we look at data, we must be very careful about drawing broad conclusions. We often have blind spots and biases.

And

• It’s probably a good idea for us to mix in more foreign assets into our portfolios, than feels comfortable.

And before I sign off a couple notes.

1. Check out this site.

https://www.robinhood.com/?ref=B3rAqJ

It’s a coming brokerage that will offer fee free trading. If they include ETFs this is pretty exciting. I’m on their waitlist as of yesterday.

2. Here’s a new manufactured spending opportunity which I’m thinking about looking into. See if it has any appeal for you. (It’s chief appeal for me is that it involves no Walmart.)

http://themilesprofessor.com/2014/05/10/paypal-square-cash-business-debit/