In 2020, a shocking report revealed that 90% of actively managed portfolios failed to beat the market over a 15 year time horizon.
According to the S&P SPIVA report, a full 88.4% of managed equity funds underperformed the market.
Many of the fund managers are Ivy League-trained with impeccable pedigrees and intellect, so what gives? How could you avoid the pitfalls they so commonly fall into?
#1 – Don’t Fall Narratives
In the financial media, narratives are commonplace. It’s hard for a CEO to pitch his/her firm as the next Amazon unless they, well, pitch their firm as the next Amazon, or the Amazon of such and such.
Some common examples of narratives over the past few years include:
- “Affirm is disrupting credit cards”
- “Upstart if making FICO obsolete”
Why would you buy old-fashioned Mastercard or Visa when they’re about to get disintermediated by Affirm, which allows customers to buy now and pay later with 0% interest for a fixed time period? Affirm is a much better value proposition to customers vs having a credit card, at least so said the narrative.
Similarly, FICO was written off as a crusty remnant of another age. It was “clear that Upstart” was a superior solution because it included so many other variables ignored by FICO to better evaluate credit risk.
As it turned out, both Affirm and Upstart share prices plunged by as much as 90%.
When you buy into a narrative, you can easily become attached to a stock. “I’m buying for the long-term” you tell yourself. And so you stick with the stock when its share price starts to fall. But then it falls further, and further, and suddenly your portfolio is down big, but still you cling to the narrative.
If you had not become attached to the “story” behind the stock, you probably would have made a smarter, more rational decision and sold the stock when a small loss was incurred. That’s smart trading in a nutshell, small losses, bigger wins. The old adage “cut losers quickly and let winners run” is sage advice.
#2 – Stop Forecasting
Some wise person once said there are two types of forecasters: those that don’t know and those that know they don’t know.
In the stock market, you should be wary of forecasting. But first you need to know what forecasting is. So let’s start with this example.
If you had an empty bucket and filled 10% of it up with water, and came back tomorrow and filled up another 10% and did so every day for 10 days, how much water would be in the bucket by the end of day 10?
Obviously, the bucket would be completely full.
Now if on day 1 you knew that each day an additional 10% would be filled, is it a forecast to predict the bucket would be full by the end of the tenth day?
Perhaps, but the odds of being wrong are slim because the forecast was quantitatively based.
That’s analogous to how Warren Buffett invests. He doesn’t guess where the market will be or where rates will be or where the economy will be. Instead, he can (we’ll simplify matters) assess the free cash flows of a company and quantitatively assess what the sum of those will be over time and how that will affect market capitalization.
A different type of forecasting is the charlatan who claims the S&P 500 will rise by 50% or fall by 50%, but provides no evidence or quantitative support to their hyped-up prediction. That type of forecast is generally made to entice a click and line their pockets, but usually not yours.
2 Trading Tips to 2x Your Returns
If all you ever did was put a post-it note in front of your computer before you make a trade and it has two checkboxes that read:
- Am I buying this stock because of a narrative?
- Am I buying this stock because of a forecast?
If you answer yes to either question, stop.
The tens of thousands of shareholders who bought Upstart and Affirm because of their “narratives” could have saved themselves enormous sums of money had they simply realized they were buying into a story.
If you’re not sure whether you’re stepping on a landmine, do the “bucket” test.
Ask yourself if you can sum up the cash flows over the next 5 years and arrive at a market valuation for a stock you’re considering buying. If you can’t, pause, and do the calculation before you hit the Buy button.
I’d hazard a guess that alone could well 2x your returns. At the very least, I suspect you’ll save yourself from losing a bunch of money holding losing positions when they start to go wrong.