Richard Beddard’s response to my previous post, is not the end of the argument, although I will go along with his approach and answer his questionnaire.

My view of what it takes to out-perform is not very different from Richard’s, but it is an arithmetical necessity that most investors will not out-perform. I am very skeptical of anyone who claims that they are in the minority who can reliably do so.

Responses to Richard’s answers

The answer to the first question needs no response. I like the answer to the second question, because Richard is not paying a great deal for information and nothing for advice.

Can you tell me what market inefficiency your strategy is exploiting?

The essence of Richard’s answer is this part of it:

I try to buy shares when sentiment dominates the price and they are unreasonably cheap.

I think this is fundamentally correct. The problem is that this essentially replaces “I am a better stock picker because I am cleverer than others” with “I am a better stock picker because I can keep my head when all about are losing theirs”. This is necessarily (see below) only going to be true for a minority of investors.

Can you produce any evidence at all that your strategy actually works?

I like the way Richard quotes my own site against me, but that only gets him halfway there. I have acknowledged that inefficiencies exist, and are common at certain times. This does not prove that Richard, or anyone else, is likely to be able to reliably and consistently exploit them.

Richard’s 17% annualised market out-performance looks very good, but how much of that is due to the value effect? It is hard to tell without knowing the details of Richard’s portfolio. He makes it clear that he is very much a value investor, and the period over which he got these returns is one in which value did much better than growth.

The question is how well his performance will compare to a tracker fund that tracks an appropriate value index, or, in the absence of such a fund, a mechanical value strategy. Even a moderately complex mechanical strategy, such one based on the naked PE (which Richard blogged about not long ago) is much less effort than individual evaluations of each company.

From having read his blog for awhile, I actually think it quite possible that Richard is part of the minority that can out-perform: but it does not change things for anyone else.

Does it outperform consistently if you back-test it over different periods of time?

Richard’s answer is fair: you cannot back test a strategy that changes, or that depends on human judgement.

However this does mean that the only way to show that Richard does out-perform would be to wait till enough historical data accumulated on his performance. Shall we take another look in thirty years time?

So what do you know, or what ability do you have that other investors do not?

Richard claims that small investors have certain advantages.

The problem with his first claim is that the size effect is (largely or wholly) compensation for greater risk and spreads.

As I already pointed out, the value effect can be captured by the appropriate choice of funds or mechanical strategy.

His next claim is:

We are not bound to invest in particular categories of stocks (like growth, or value, or UK or US, or large or small companies) like most investment funds are.

You can choose which funds you invest in, and get the country or style exposure you want. Does it matter if you follow a style for yourself, or pick funds that follow the strategies you favour?

You might well be able to get something very similar to Richard’s portfolio by a combination of funds: perhaps US and UK value index tracker funds and a UK smaller companies fund.

Private investors are also constrained by lack of information. How well placed is the average British private investor to evaluate Indian or Russian shares? The manager of a global fund can.

We can be low-cost because we don’t have to pay for offices, let alone analysts, salesmen and management fees.

But your trading costs are higher, so it is very difficult to be significantly cheaper than a tracker fund. In addition, your time has value, and active investors need to put in a lot of time into following markets.

This does not apply to Richard who follows the markets as part of his job, but it is a significant cost for most people. A lot of us might make more money
by simply working harder at our day jobs, or otherwise applying ourselves.

If you are going to tell me that you have outperformed, can you tell me how high a level of risk you have taken?

Richard says:

Yes. The industry seems to equate risk with volatility. The riskiest companies, though, are overpriced, or heavily indebted*4. The former suffer savage price corrections when sentiment changes, and the latter risk going under when business falls off. I don’t own any of those, so, while earning higher returns by taking more risk relies more on luck than judgement, I’m not doing that.

Prove it!

The reason the industry equates risk with volatility is that it works, and it can be quantified. Richard denies taking high risks, but he cannot actually measure his risk.

It is fair to say that the standard methods of using volatility to measure risk assume that securities are correctly priced. Therefore, if you can find mis-priced securities (i.e. examples of market inefficiency), then your risk of making a loss will be lower than the models suggest. Once again we are back to the same question: can you find these mis-pricings better than everyone else?

How many small investors have you heard of who have become rich by their investments have out-performed?

Richard’s reply:

Not many but… Just because we don’t know about them, it doesn’t mean they don’t exist. I met a lady in the library who’d made a fortune buying and holding through the seventies, eighties and nineties. But ordinary investors don’t brag about their wealth.

True, but at least as many are not talking about having lost their wealth!

Out-performance is a zero-sum game. I realise a lot of people are going to say “but investing is shares has a positive sum”. Yes, but you can decompose any investor’s return into the market return, and that investor’s out-performance (or under-performance). As the market return is an aggregate of individual returns, the aggregate of all investors’ out-perfomance must be zero.

This brings me to my most important point. Active investors are gambling: the only questions are:

1. To what extent is it a game of chance?
2. To what extent it is a game of skill?
3. How much does the house (intermediaries) take?
4. How widespread is cheating (insider trading)?

For every pound one investor makes over market returns, another loses a pound. Take the costs of trading into account, and this becomes:

For every little less than a pound any investor out-performs by, another under-performs by a little more than a pound.

The really strong point of this argument is that it is true even if the efficient markets hypothesis is not.

You personally might not be one of the suckers, but they exist. Assuming a normal distribution, (or any other symmetrical distribution) and leaving for trading costs, more than half of active investors must be suckers.

I do not know of any research that shows what the distribution actually is, but I would bet on something of similar shape to a normal distributions but fat-tailed, with the cheats, geniuses and suckers at the extremes.

Richard also says:

Their objective isn’t riches, it’s financial security.

Good: it makes them less likely to make mistakes through greed.

What is not good is this: if their financial security depends on out-performance, most of them are not going to achieve financial security.

If a lot of people need out-performing investments to achieve financial security, we may well have an economic, social or political problem. However, this cannot be solved by everyone relying on cunning investment strategies to solve the problem.

My answers to Richard’s questionnaire

You think you can out-perform the market do you?

Yes, but only under certain conditions, which do not often occur.

Aren’t you just wasting money funding the huge industry that sells suckers like you financial information and advice?

No, because I have never spent much on advice and information. At least not much of my own money: I have had jobs that kept me in front of Bloombergs and Reuters terminals all day and that has helped.

Can you tell me what market inefficiency your strategy is exploiting?

My answer is not as rigorous as I would like. It is much the same as Richard’s. I only invest when I can find shares that are badly undervalued, which means that the market is clearly inefficient.

The difference between us is that I often give up on active investing altogether. Given that I have spent so much of my life (at least the bits when I have had money to invest) depending financially on the markets, I have often prefered simply to pull out of equities altogether rather than, for example, risk losing my job and much of my savings at the same time.

Can you produce any evidence at all that your strategy actually works?

Yes, but again not rigorously enough. I have invested heavily and out performed over three short periods (two or three years each) with years of inactivity between them. Not enough data to prove it, but useful evidence.

So what do you know, or what ability do you have that other investors do not?

I only invest when I am sure, and I have the detachment and self-control to keep clear when I am not.

If you are going to tell me that you have outperformed, can you tell me how high a level of risk you have taken?

Not to any rigorous standards, but as all three bouts of investment, using three different strategies, have all left me with profits well in excess of losses, I am either very lucky, or my judgement has been right.

How many small investors have you heard of who have consistently out-performed?

I have changed this question slightly to make it clearer and correct a typo.

Many, and many who have lost money. Sometimes they have even been the same person. I have seen day traders make and lose fortunes in a matter of days.

Shouldn’t you just give up and put your money in a nice diversified tracker fund or two with low charges, and leave it there till you retire?

Or even just be satisfied with interest? Most of the time the answer is yes, and I do so.