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A Few Notes on Jackass Investing

| | Posted in: Big Ideas

Michael Dever (founder of Brandywine Asset Management) introduces his 2011 book, Jackass Investing: Don’t Do It, Profit from It, by stating: “…this book is designed to comfortably provide novice investors with a plan to follow to manage their money – one that they are unlikely to encounter if they are only exposed to the conventional financial wisdom. It’s also intended to provide a rational alternative to the beliefs of experienced investors who may have fallen prey to the myths; written to help you to specifically exploit some of the countless opportunities that are ignored by, and very often created by, the mass of irrational investors who litter the virtual Wall Street landscape. …the most important theme of them all is the fallacy of the myth that ‘There is No Free Lunch.’ In fact there is a free lunch, a veritable free threecourse buffet. It’s called true portfolio diversification…a systematic process that results in a truly balanced diversified portfolio whose returns are derived from a multitude of return drivers.” Using anecdotes and references to some relevant research in describing and refuting financial market myths, he concludes that:

From Chapter 1, “Stocks Provide an Intrinsic Return” (Page 11): “…it has become widely accepted that a portfolio diversified across a number of stocks will provide inherent return over time, that it is virtuous and pragmatic to buy-and-hold stocks for the long-run, and that the longer your viewpoint, the lower your investment risk. This strategy is flawed because it is dependent on a single set of baseline conditions and return drivers, and there is no guarantee that the future won’t deviate substantially from the past. In fact, it’s a certainty that it will.”

From Chapter 2, “Buy and Hold Works Well for Long Term Investors” (Page 29): “Just because something happened in the past does not mean it will reoccur in the future. We must first understand all the return drivers, and then determine whether those return drivers are still valid.”

From Chapter 3, “You Can’t Time the Market” (Page 41): “It appears that people are hard-wired for investment failure. Because of that it is easier for financial professionals to instruct their clients to buy-and-hold rather than attempt to time the market, simply because most people will time the market incorrectly. But you don’t have to be one of those people. You can exploit their behavior.”

From Chapter 4, “‘Passive’ Investing Beats ‘Active’ Investing” (Page 49): “…not only are the indexes not based on a strategy designed to maximize returns, but their performance indicates that they may actually be based on a process that results in reducing returns.”

From Chapter 5, “Stay Invested So You Don’t Miss the Best Days” (Page 69): “…even if in our attempt to miss the largest losing days we also miss the largest profitable days, we’d be better off. So rather than simply spouting the overused fear-based mantra about staying invested to avoid missing the best up days, let’s react rationally to the market conditions with which we are presented.”

From Chapter 6, “Buy Low, Sell High” (Pages 74-75): “…in a bull market…buy low, sell high traders do worse than if they simply held on to their positions throughout the bull market. Conversely (and perversely), in a bear market you will almost certainly get the opportunity to buy the stock back at a lower price, only to be rewarded with ever lower prices… Over time you will underperform even a simple buy-and-hold approach.”

From Chapter 7, “It’s Bad to Chase Performance” (Page 84): “The fact is that chasing performance, meaning systematically identifying the strongest trends and allocating money to them, is a valid and proven strategy that captures the return driver…”

From Chapter 8, “Trading is Gambling – Investing is Safer” (Page 97): “Anytime your money is committed to a single strategy, such as being long financial assets (stocks, bonds, real estate, cash), you should expect that there will come a time when a single return driver will overpower all others and dominate your performance, turning your portfolio into a poor-folio. …Spreading your money across multiple market sectors does not diversify your portfolio. It leaves you dangerously dependent on a single return driver and exposes you to unnecessary risk.”

From Chapter 9, “Risk Can Be Measured Statistically” (Page 104): “While volatility may be a great indicator of risk in a random return stream, it is not a great indicator of risk for any given trading strategy. The risk inherent in a trading strategy is simply a function of the validity of its return drivers.”

From Chapter 10, “Short Selling is Destabilizing and Risky” (Page 131): “…the short-term risk to a long position (it selling off) is greater than the upside risk to a short position.”

From Chapter 11, “Commodity Trading is Risky” (Page 146): “Large losses that result from the abuse of leverage is a primary reason that commodities appear riskier than stocks.”

From Chapter 12, “Futures Trading is Risky” (Page 154): “Futures are not risky and, moreover, when properly traded by professional managers, they provide solid returns with lower risk. In addition, they hold the potential for profits when stocks slip into a nosedive.”

From Chapter 13, “It’s Best to Follow Expert Advice” (Page 167): “…you absolutely cannot rely on experts to guide your money decisions. You must develop your own systematic plan for managing your money.”

From Chapter 14, “Government Regulations Protect Investors” (Page 176): “You must protect yourself from bad investments. Regulators will not do it for you.”

From Chapter 15, “The Largest Investors Hold All the Cards” (Page 195): “…the ability to place money into less liquid markets isn’t the only advantage small investors have over larger investors. You also have the ability to [act] immediately…”

From Chapter 16, “Allocate a Small Amount to Foreign Stocks” (Page 207): “Geographic diversification should follow the same rules as those that apply to portfolio diversification in general. Simply spreading money across different countries does not necessarily spread risk. …many companies’ stocks are dependent on the same return drivers regardless of their base of operations.”

From Chapter 17, “Lower Risk by Diversifying Across Asset Classes” (Pages 213-214): “By classifying asset classes as being long-only in related markets, the various asset classes expose people to the same return drivers. As a result, there is risk that the failure of a single return driver will negatively impact multiple asset classes. Limiting your diversification opportunities to asset classes eliminates numerous trading strategies that, because they are powered by entirely separate return drivers, can provide tremendous diversification value to your portfolio. …The use of trading strategies in place of asset classes removes the diversification shackles that were put in place when the concept of asset classes was developed a half century ago.”

From Chapter 18, “Diversification Failed in the ‘08 Financial Crisis” (Page 219): “Portfolio diversification didn’t fail during the financial crisis of 2008. Conventional wisdom failed. The conventional wisdom that investment diversification consisted of allocating portions of a portfolio across stocks, bonds, cash and possibly real estate.”

From Chapter 19, “Too Much Diversification Lowers Returns” (Page 229): “To maximize profits over longer periods you must create a portfolio that is truly diversified across a variety of trading strategies and markets.”

From Chapter 20, “There is No Free Lunch” (Page 242): “…there is a way to simultaneously maximize returns, minimize portfolio drawdowns, and improve the predictability of future performance. …That is to expand the number of diverse return drivers employed in the portfolio…based on the diversification value they add to the portfolio, which is based on a combination of the uniqueness of their return drivers and the resultant correlations of their returns. This will ensure that…no single return driver will dominate the Free Lunch portfolio’s performance.”

In summary, many investors may find Jackass Investing useful in advancing their thinking about achievement of effective portfolio diversification. 

Cautions regarding findings include:

  • The “Actions” associated with chapter-by-chapter mythbusting are “reserved for owners of the book”. Because these recommended actions are in this way proprietary, this summary does not cover them.
  • Sophisticated investors who monitor financial markets research will likely already be skeptics of the myths covered in the book.
  • There may be trade-offs between degree of diversification and trading frictions (due to number of positions and complexity of specific positions), such that less diversification is sometimes better for bottom-line portfolio performance.
  • Financial markets are complex and plausibly adaptive, confounding confident beliefs.
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