San Juan Mountains

San Juan Mountains
San Juan Mountains: Grenadier Range

Thursday, July 23, 2015

Stock Traders Lie About Their Returns

Are you a compulsive liar?  Do you do everything you can to make yourself look like a financial genius when you attend a cocktail party and are desperately trying to impress the people there?  Do you manipulate the data about your portfolio to make it appear as if you are doing better than you really are?  If you answer "yes" to these questions, congratulations!  You are a stock trader.
I appreciate a good lie.  Some of my best friends are compulsive liars.  They can tell stories that sound credible enough but are really not true.  When I question them about the various details of their stories they are so quick on their feet they can create another lie to cover the first lie.  Only rarely am I able to catch them and expose their lying ways.
Lying is a Welsh national tradition.  Certainly all of you are aware of the story about the origination of Welsh rabbit, aren't you?  If not, I will let you in on it.  It seems that a Welshman wanted to pull one over on a Scotsman one day.  Given the fact that times are always tough in the Welsh and Scottish countryside there is rarely any meat to eat.  A steady diet of leeks and onions makes up the typical highlander diet.  So you can imagine the Scot's surprise when a Welshman invited him to his home for a dinner of fresh rabbit one evening.  The Scot jumped at the chance to have some fresh meat, especially tasty rabbit.  The only contingency was that the Scot could not come to the dinner empty handed, he had to bring some potato bread and a couple of pieces of cheese.  He was happy to oblige.
The Scot arrived at the Welshman's home with great anticipation.  The Welshman took the bread and cheese and disappeared into the kitchen.  A few moments later he came out with a lovingly prepared Welsh rabbit, or rarebit, if you prefer.  Do you know what it was?  A grilled cheese sandwich.  Tasty and satisfying!
Stock traders suffer from a variety of maladies.  Selective amnesia is one of them.  Somehow, no matter how hard they try, they are incapable of recalling any of their trades that ended in losses.  Hindsight bias is another characteristic of stock traders.  I understand a bit about hindsight bias.  After all, I was an impressive athletic specimen in my prime.  I have discovered that the older I get the better I was.  In a similar fashion stock traders are specialists at hindsight bias as the overall total returns on their portfolios inevitably get better with age.
To illustrate my point I have taken a screenshot of the top 25 holdings in the portfolio of a popular stock mutual fund.  Imagine for a moment that you are a stock trader and this portfolio of 25 stocks makes up your current holdings.  How do you think you would talk about your returns at a cocktail party?  Take a look at your portfolio and think about it for a moment....




Year to date this fund is up 7.8%.  In its top 25 holdings by percentage of portfolio, the best performing stock is up 126.5%.  That would be Netflix by the way.  The worst performing stock of the top 25 holdings is Precision Castparts Corp, down 18.4% year to date.  Now if you were going to describe your acumen as a stock trader, how would you describe your current portfolio?  My guess is that I am going to hear a lot about Netflix and nothing at all about Precision Castparts Corp.  If you talk about your tech holdings I will hear all about Amazon and nothing about Oracle.  But no matter how much you tell me about the stocks that you have selected that are up 126% and 57% this year alone, you will likely never inform me that your overall total return on your portfolio is a lowly 7.8% year to date.
Stock traders like to talk about their returns.  This is especially true when they have several big winners in their portfolios.  Listening to them can cause the average Joe like you and me to come to the conclusion that these people have some sort of gift for selecting stocks and realizing stellar total returns.  It is only when we examine their net worth at the end of a particular period and compare it to their net worth at the beginning of that particular period that we come to realize that they are no different than the rest of us.  They make some good calls and they make some bad calls and when everything is averaged out they are average, just like the rest of us.
I conclude that we should not be tempted by claims about fantastic total returns in the stock market.  I believe that if something sounds too good to be true it is too good to be true.  I encourage you to be satisfied with a decent long term total return on your stock holdings, somewhere around 12%/year sounds about right, and flee to the hills whenever someone comes along telling you he can get 20%/month if you only give him all your money and the discretionary power to manage it. 

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