Wednesday, August 25, 2010
Nicolas Taleb the author of the book ‘Black Swan’ proposes that the best investment strategy is not losing money. According to him, the normal situation is that people always lose money and it’s rare for one to really earn in the stock market. He uses an interesting analogy with doctors. He claims that most of the time, in centuries past doctors lose their patients and it’s only in the recent years that patients are actually saved by their doctors. One should pay the doctor to keep you alive rather than his usual practice of putting you to an early grave due to fatal mistakes or lack of education. Putting this analogy to investors, most people in fact lose money and one needs to develop a way to not lose his capital. It’s a capital protection strategy not a money earning strategy.
This type of thinking is called negativity thinking. It fits Taleb’s philosophy of randomness. Those lucky people making money are really outliers. From Malcolm Gladwell’s book ‘Outliers’, one becomes an expert due to culture, practice and lucky circumstances. Achieving about 10,000 hours of experience is the starting point but one should be in the appropriate situation, raised in the appropriate culture that one could really succeed. This would remove most of the usual investors in the stock market. So the general public who do invest are really losing money. Following foolish trading strategies like timing the market, listening to talking heads in MSNBC, following rumors and being overconfident result in high transaction costs with constant trading and generally losing their hard earned cash as one goes in and out of stocks.
So the best strategy is really ‘not losing money’. This would probably mean a buy and hold strategy following the fact that the stock market is steadily rises in the long run. But one could still make a mistake picking stocks. So the best method is buying an index fund or an Exchange Traded Fund (ETF). Gladwell’s book makes the case that society generally loves the lone hero or pioneer or genius. Outliers like Steve Jobs or Bill Gates who strike it rich and obtain phenomenal wealth in their lifetimes, convince the general public that they can make it on their own too. Most don’t realize that these outliers succeed due to their inherent culture or location or opportunistic situation that is not available to almost all people. So most folks make a mistake into thinking that one could devote time and hard work to achieve phenomenal success without the other needed ingredients.
Of course, hard work does bring you out of poverty and results in success but not the type of outlier success that these lucky folks have achieved. Warren Buffet, one of the richest men is a true outlier and his down to earth manner fool people into thinking that they can be an astute investor just like him. One spends a lot of time trying to learn his methods mistaking the fact that he had a special childhood. For example, Buffet studied under the legendary investor Benjamin Graham who coined the term value investing, had a father who was a congressman who provided opportunities like meeting famous investment bankers at a young age. These special opportunities do not exist for the common folks but the latest technology allows everyone to open a brokerage account in the Internet and start investing their savings in the market in the hope of becoming Warren Buffet.
An illusion occurs that one could take a short cut and achieve success but in fact it’s false. Hollywood movies and easy credit contribute to the illusion so one could buy as many cars and homes, invest in real estate and the stock market and live like a millionaire. But all has come crashing down in the recent financial crises and folks are trying to regain their balance and survive and remain in their homes. So the new normal is ‘doing nothing’ like Taleb says. One finally realizes the mistake he is living in and perhaps realizes that becoming an outlier is not as easy as it seems. So one should not really seek expert’s advice but follow common sense that is becoming less and less common. One succeeds only because of luck and to think otherwise is a mistake. Is this the lesson that Nicolas Taleb or Malcolm Gladwell are trying to impart? Perhaps it is a way of controlling hubris.