Trading is hard. So hard, in fact, that most retail traders underperform simple investing benchmarks, like the S&P500 Stock Index.
But it’s not just the amateurs that underperform – there is ample evidence that most mutual fund managers also underperform their benchmarks. Pretty shocking, right? So why do both amateurs and professionals fail to beat simple benchmarks? And what can we do to tilt the odds in our favour of outperforming?
If you’re interested in answering these questions, you’re in luck. We recently sat down with a successful hedge fund analyst, Toby Carrodus, and discussed exactly these questions.
Most Investors Suck
There have been ample studies revealing how bad humans are at trading stocks. One famous study, according to Toby Carrodus, is that of Brad Barber and Terrance Odean from the University of California. Barber and Odean studied retail investor behaviour across different countries and time periods. Based on the data, they concluded that individual investors sell winning trades too early, hold on to losers too long, exhibit limited attention span and recency bias, and in general tended to underperform simple investing benchmarks. That’s not really encouraging, is it? Well, it gets worse.
Toby Carrodus also references studies by Michael Jensen, Mark Carhart and Martijn Cremers that indicate that the same is true for most institutional fund managers. Essentially, the year-on-year correlation of outperformance is zero for most mutual funds. What this means is that any outperformance is generally more the result of luck rather than skill. Pretty damning, right? That’s not the half of it!
Forget the Talking Heads
You know all those talking heads on television confidently discussing the economy and where markets are headed? Their track record is even sadder. Most of the commentators on television are just trying to sound smart. They are rarely held accountable for their forecasts.
Toby Carrodus quotes a famous study by Philip Tetlock that examined the (in)ability of professional economic and political forecasters to accurately predict outcomes. Basically, the data shows that experts – those that derive their living from studying a certain field – tend to make worse predictions than randomly chosen forecasts! One reason experts often get it so wildly wrong, Toby says, is that the extra information available to them tends to make an “expert” more likely to consider overly complicated combinations of inputs and become overconfident in their analysis.
Toby Carrodus’ advice: switch of the TV and limit your news intake. He says most traders tend to think that if they follow the news they will have a better understanding of reality and ability to predict the future. This is an illusion of control that does not exist in reality! At best, most traders are using the news to medicate their anxiety about not knowing the future.
So, not only do retail investors tend to underperform simple benchmarks, but so too do so-called “professional” investors. And to add insult to injury, most financial commentators are also consistently wrong. Is there any hope for us?
The Human Mind
One way to beat the market, according to Toby, is adopting a rules-based, systematic approach to trading. Why? It comes down to how our minds work. Toby quotes the work of the double-doctorate Nobel prize winner, Friedrich von Hayek. Hayek conceived the human mind as an “instrument of classification” that can only perceive reality as an “interpretation.” Accordingly, our minds categorize things into one of several classes of objects.
Hayek argued that humans can never comprehend the full complexity of reality in its entirety apart from the categories formed by the mind’s classificatory apparatus. Therefore, we cannot respond to the “inexhaustible complexity of everything” but instead must use the classificatory apparatus of our minds to selectively focus on only certain situational characteristics deemed as relevant and ignore the rest.
Rules and The Limits of Reason
A direct evolutionary response to our own limited mental processing capacity is that humans have become accustomed to relying on rules as a means of determining the appropriate behavioural response to a given set of circumstances. Rules are essentially “a device we have learned to use because our reason is insufficient to master the full detail of complex reality.” Rules simplify the number of factors we need to consider in a given situation, “singling out certain classes of facts as alone determining the general kind of action which we should take.”
Hayek argued that due to our limited mental processing capacity, we tend to do better on average by following simple rules as opposed to trying to optimize outcomes discretionarily on a case-by-case basis. A pertinent example is the rules of road transport/traffic. Other academics, such as Ronald Heiner, have also confirmed this finding. OK, so we have evolved using simple rules of thumb given our inability to process reality in its full complexity. So, what sort of rules are appropriate, then?
The most appropriate rules are those that have evolved through the spontaneous growth of society, have endured a process of cultural evolution and hence embody the experience of more trials and errors than any single person could acquire. This is an important point, as there is so much inter-generational knowledge embedded in rules that have evolved this way and withstood the test of time.
Money Making Rules
So, if retail and institutional investors both underperform simple benchmarks, and if humans are likely to do better by following simple rules rather than trying to maximize outcomes discretionarily on a case-by-case basis, Toby Carrodus argues that the answer for any aspiring trader should be clear: utilize a simple rules-based approach to trading. In fact, the simple investing benchmarks that most investors fail to outperform are themselves rule-based systems. Take, e.g., the S&P500 Stock Index: among other things, this index requires that stocks meet a market capitalization threshold, which means that losing stocks systematically drop out of the index and winning stocks remain in the index.
So, for most investors, investing in index funds is likely to yield better outcomes versus ‘flying by the seat of their pants’ by discretionarily trading. That should at least rival the market in terms of performance.
What About Beating the Market?
Well, apart from standard index rules, Toby Carrodus says that there are many other simple trading rules that beat the market over time. Such rules meet Hayek’s criteria of having emerged though the growth of society, withstood the test of time and hence embodying the knowledge generations before us. One only has to think of David Ricardo (1772-1823), who amassed a fortune with the credos “cut short your losses, let your profits run on.” Such statements provide the foundation for a profitable, well-documented, rules-based approach to trading called “trend-following,” which has outperformed most standard benchmarks over extended periods of time, particularly during bear markets.
There are many reasons for such outperformance, but one noteworthy reason is that volatility tends to increase during bear markets, and emotions, which can bias human decision-making, tend to run high during times of heightened volatility. Toby says that sticking with a rules-based approach allows one to remain objective at times when you’re likely to succumb to emotional biases. He points to Michael Covel as someone who has done a superb job at documenting the success of trend-following traders through the ages.
Toby says another classic example is the old adage “buy low, sell high,” which is distilled in classic “value” strategies, such as those outlined in Benjamin Graham’s famous book, “The Intelligent Investor.” These strategies can easily be codified and applied systematically and in fact there are numerous successful hedge funds that have done so. There are a multitude of other successful rules-based trading strategies, such as those documented in Antti Ilmanen’s magnum opus, “Expected Returns.”
Your Road to Riches
So, there you have it. Not only has Toby Carrodus helped you avoid losses by showing that most traders lose money by trading on their whims, but he has also explained why systematic, rules-based trading works, and what types of strategies are available to you! We hope you’ve enjoyed this journey as much as we have.
If you’re interested in delving deeper, Toby has written an article on this topic here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4190925
Good luck on your trading journey!
Full story: https://www.finyear.com/Hedge-Fund-Analyst-Toby-Carrodus-on-How-You-Can-Beat-the-Markets_a48402.html