In the first part of this series I outlined how the Oakland A’s revolutionised the sport of baseball as chronicled in Michael Lewis’s book Moneyball. With less resources to compete against better funded teams they relied on data to make better decisions.

Read part 1 here.

Investors are constantly bombarded with data. We hear about how investments and markets have performed historically. We slice and dice financial statements into an alphabet soup of financial ratios. We treat each new piece of economic data as a window into an unknowable future. We forecast trends and speculate on how different investments will react.

Most of this data analysis is focused on investments or what we invest in. We tend to ignore data on investing or how we invest. In spirit of Moneyball I’ve come up with three data driven suggestions on how to improve your investing.     

Understand your goal to focus on what matters

The goal in baseball is clear. You want to win the game by scoring more runs than the other team. Based on that clear goal it was easy to analyse the data and come to conclusions. The Oakland A’s focused on what player attributes led to the most runs and prevented the most runs by the other team. They looked at what the data suggested was the right strategic choices during the game. 

Most investors don’t have a goal. They want more money. They want to be rich. Those are outcomes with a lot of subjectivity. A goal is specific. Start by defining your goal and understanding the return needed to achieve that goal. This will open your eyes to what matters.

Knowing your goal puts you at a big advantage over other investors and especially professional investors. When you invest in a fund or an ETF there is an asymmetry of information. You know what you are trying to accomplish and the professional money manager doesn’t. That puts them at a disadvantage.

When the Oakland A’s used the goal of scoring more runs than an opponent as context they found that conventional wisdom about baseball didn’t necessarily apply in relation to the cost. Once you define your goal you may discover the same thing.

Conventional wisdom tells us that what matters is which investments we select for our portfolio. To be a great investor means finding great investments. That myth is perpetuated by professional investors who don’t know your goal and mostly invest within a narrowly defined universe of securities – say Australian large-cap equities. They stress the importance of security selection because their job is to pick securities. But in reality most of what determines if we achieve our goal is our asset allocation.

Different studies provide different measures of the influence of asset allocation. Some indicate that up to 90% of the variability of returns can be explained by asset allocation decisions. Every study I’ve ever seen indicates it is well more than 50%. It is the type of investments in our portfolio and not the specific investments that matter.

The Oakland A’s not only focused on how to score more runs but also on how to prevent the opponent from scoring runs. If asset allocation is the best way to score runs in investing preventing runs is the investing equivalent of things that detract from our outcomes.

When we define the goal as what we can spend in the future it becomes obvious that an after-tax, after-personal inflation (how much your costs to live rise) and after-fee return is what matters. Most professional investors invest in a tax agnostic way, ignore inflation when reporting results and don’t highlight their fees.

If you don’t define your goal it is hard to know what should be done to achieve it. You are willingly suffering from the same information asymmetry as professional investors. You will spend too much time focused on selecting the best investments which likely means you will ignore things that matter more. That is asset allocation, minimising taxes, thinking about your personal inflation rate and minimising both transaction and management fees.

Trade less

There is an argument to be made that Moneyball has made baseball boring. Fans want to see action and they want to see teams take risks on the field. Moneyball prescribes a strategy where decisions are dictated by how each action impacts the probability of a win. Often this means doing less.

This is not a great outcome for a professional sport that needs fans to generate revenue. Boring may win games but it might end up ruining the viability of the sport. And there have been rule changes in baseball to try and counteract the Moneyballing of baseball strategy.

There is a good deal of data that suggests a boring approach to investing results in better outcomes. We have an innate action bias as humans. Fight or flight is our neanderthal brains telling us when facing adversity we need to do something. Resisting this urge could make all the difference to your investing results. But it is hard. We don’t just want to act. Deep in our primordial brains we need to act.

First the data. Two professors at the University California divided up individual investors into cohorts based on how much they traded. The looked at five years’ worth of data between 1991 and 1996. The investors that traded the most earned a return 6.5% below the market return.

In another study from the University of California researchers examined individual investor trading records. The study was focused on relative performance of two investments that were exchanged for each other. In other words, an investor sold one share, ETF or fund to buy another. The study measured performance over 504 trading days following the swap. The investment that was purchased underperformed what was sold by 3.32%.

Trading less is not going to be easy. Start with counting how many times in the last year you exchanged one investment in your portfolio for another. Try to cut back on that by giving yourself a limit on how many times you trade. Give yourself a speed bump by delaying any action for 48 hours. Find an investing buddy to talk through the rationale for making a change to your portfolio. Create structure through an investment policy statement with clear criteria for when you will trade. And know that chances are the decision you are about to make is going to be wrong. That is what the data tells us.

We’ve been preconditioned to think that succesful investors are always doing things. That is how great investors are portrayed. Great investors are yelling into multiple phones at once. Great investors are surrounded by monitors with charts showing minute by minute gyrations of the market. Great investors are always talking about how they are adjusting and fine tunning their portfolio.

Professional investors follow this stereotype because they know that is what investors expect. They do this because structural pressures force them to focus on short-term results.

If you want to be a great investor, be a boring investor. Be the person at a dinner party who has no answer to what you are doing with your portfolio in the face of whatever soon to be forgotten event is dominating the headlines. Be a boring investor who lives an exciting life because your investment results have helped you achieve your goals.  

Focus on the long-term

The approach that the Oakland A’s took worked very well over a long baseball season. In a large sample size the underlying attributes of the players and the probabilistic in-game decisions mattered more. In a small sample size chance was the main driver of results.

Investing works the same way. The performance of the investments in your portfolio on a daily, monthly, or even yearly basis will be disproportionately driven by chance. Over the long-term your investment strategy and your skill at applying it will have a larger influence over your outcomes.

What I described isn’t groundbreaking. Afterall, Ben Graham summed this up in a much more eloquent way nearly a century ago when he said, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine”. And there are few investors – professional or otherwise – that don’t claim to take a long-term view. The issue is that their actions don’t align with their stated intentions.

A study showed that the average turnover ratio for US domestic equity funds was 63% in 2019. That means that every year more than half of the positions are new. And it isn’t just professional managers who can’t practice what they preach.

In June of 2020 the average holding period of a share trading on the NYSE was 5 ½ months. This was down from 14 months in 2019. The average holding period has been dropping for decades after reaching a high of close to 8 years in the mid-1960s.

There are countless other datapoints that I could include but there is almost universal acceptance that all investors are turning over their portfolio more frequently. It is not hard to come up with theories on why this is happening. We are bombarded by more data and more opinions about investment opportunities. There has been a proliferation of new funds and ETFs. Trading costs have gone down significantly and the friction of trading has been removed. Professional investors are responding to these trends by focusing far more on short term returns so that fickle investors don’t switch to a new manager.  

The larger point is that investors actions are hurting long-term results. Tax outcomes are worse, transaction costs are going up and as previously mentioned most of the time when we continually swap investments we pick the wrong ones. We are inadvertently relying more on luck than the simple fact that over time markets have delivered incredible returns to investors. How much does this cost us? The Morningstar Mind the Gap study indicates 1.7% a year. Just doing what everyone else isn’t and focusing on the long-term can make you 1.7% a year better investor.  

Final thoughts

You may read my suggestions and ask a simple question. If what I am calling for is so obvious why aren’t more people doing it? That is a good question. I think about it a lot. More than anything I think most individual investors have lost perspective on what they are trying to accomplish and as a result have no idea how to do it. A story is illustrative of where I think we’ve gone wrong.

One of my articles was posted on Reddit the other day.  Reading the comments section is always humbling. In between a variety of expletive filled comments questioning my intelligence and manhood a reader pointed out that my suggestion did not take the efficient frontier into account. According to this Redditor I had not optimally achieved a disproportionately high reduction of risk per unit of return. Fair enough. I didn’t engage. But if I did, I would have simply replied that I’m not trying to win a Nobel Prize in Economics. I just want my portfolio to pay for a trip to Thailand every year.

Many investors have internalised a view about investing that I don’t think reflects reality. We have done this because we have let the way professionals invest cloud our perception of investing. Along the way we’ve lost sight of why we are investing in the first place. And we have turned to professional investors as a guide without interrogating why they invest the way they do and the motivations that drive them.

Professional investors are playing a different game. And they are operating within structural impediments that don’t apply to us. Most of them are trying to outperform an index over the short-term in a constrained investment universe on a pre-tax basis. I’m not trying to do any of that.

And the only reason they are trying to do that is because they know if they don’t investors will pull funds out and they will lose their livelihood.

They are incentivised to make things complicated. They spend all their time talking about picking investments because they are selling their ability to pick investments. They face intense competition which causes them to constantly search for ways to stay ahead of their peers.  

It isn’t surprising that they rely on complex strategies, trade frequently, search for short-term catalysts and react to each new piece of news and data.

What should us non-professionals do? Get the foundation right with a goal and an investment strategy designed to achieve that goal. Trade as infrequently as possible. Minimise taxes and fees. Focus on the long-term. After you’ve done all of that you are more than halfway home. Then you can spend time figuring out what to invest in.

What are your thoughts? Email me at mark.lamonica1@morningstar.com

Here are some ways to embrace the suggestions I provided

Part 1 of this article

Understand your goal to focus on what matters

Trade less

Focus on the long-term