Wednesday, December 14, 2011

ERROR CREEP and the INVESTING PROCESS

I am away from HQ today. I am not doing much for the remainder of this year. My next significant decision will be whether or not to harvest some large unrealized gains early next year. 

Today, I want to discuss one of my favorite topics, the compounding impact of error creep in the decision making process. 

Many investors will not do any source research prior to making an investment decision. When purchasing a bond, the general approach to conducting research might be to enter a search term at Google and then read whatever some other person had to say about the bond. The same would be true for a potential stock purchase. Research for a stock might also include an opinion offered by another investor or possibly a cursory review of an analyst report. No effort is made to review original source material that can easily be found at the SEC or to review even the last earnings call transcript. There is nothing wrong about reading analyst reports, but that can never be the sole extent of the research effort. Original source material has to be reviewed.   

When there is a total disregard for gathering and evaluating original source information, the odds of making incorrect investment decisions will substantially increase. That kind of investment process just adds to the error creep that will cause unsatisfactory results. Acquiring Relevant Information 9/18/11 Post 

It is also not unusual to have accurate and material information and yet fail to draw the appropriate conclusions. In such cases, I might as well not have the information, so drawing the proper conclusions from the information is just another source of error creep. 

Another source of error creep is an individual's refusal to learn much of anything about news developments in the world. Without an appraisal of the big picture issues, the investor is unlikely to arrive at a satisfactory asset allocation, except by happenstance, appropriate to what is actually happening in the world. The big picture issue will often dictate the appropriate allocations among asset classes.

Most of a successful investor's returns over time will be due to successful asset allocation rather than to security selection. And, successful asset allocations can not be performed in a state of ignorance about world events or in some static, predetermined fashion. The Big Picture Questions 8/25/11 Post I know a large number of people, particularly younger ones, who refuse to read anything about world news events.

Generally, the only way to outperform the market during a long term secular bear market for stocks is to engage in constant up and down allocation shifts, and those shifts have to be predicated upon an analysis of the big picture events. The Importance of Identifying the Underlying Causes of Long Term Bull and Bear Markets 6/27/11 PostPrecipitating Cause of Long Term Bear Markets 6/30/11 PostInstability & Volatility in Asset Correlations 5/30/09 Post

When the current long term stock bear market finally ends, the vast majority of stock mutual funds will have suffered an annualized loss since October 1997 adjusted for inflation.  The Roller Coaster Ride of the Long Term Secular Bear Market 5/16/10 Post

During a long term bull market in stocks, a different strategy has to be used, since most individuals will not be able to outperform a broad based index fund with low costs. Minor adjustments of the stock allocation may be made based simply on some valuation criteria such as forward P/E. 

So far, I have identified three major sources of error creep. Two involve an unwillingness to gather accurate factual information and to form reasonable and objective opinions based on those facts. The other is always problematic and concerns forming the best judgment based on accurate information. It is not unusual to form a sound opinion based on good research and to fail to act in an appropriate fashion for one reason or another.  This will often involve a discounting of negative information (something that I did earlier this year when purchase 1 General Maritime bond). Since I make a concerted effort to acquire relevant information, this last mentioned source of error creep is usually where a breakdown starts to develop for me.

Another error is that fact gathering and evaluation processes have to be ongoing, performed with no ideological filters. Any opinion previously formed has to be constantly challenged with new material information and without any interference from one's ego, as if someone else formed the original opinion. There can be breakdowns, and even more error creep, by failing in any of those decision making processes.  

Errors can creep into the process even with all of the foregoing followed without deviation. Some errors will occur just due to unknown and unknowable factors. The future is always a wild card. Every decision has to be made with unknowable material information about the future. I have discussed the game of blackjack to illustrate this problem. BlackJack and Stock Investing: Lessons Learned & Applied 3/15/09 PostInvesting process with a story illustration 1/6/09 PostMaking Decisions with Incomplete Information 5/29/09 Post

Then, there are a lot of personality quirks that cause error to creep into the decision making process. One of the more common reasons may be a lack of confidence in the opinion, which unfortunately is a hazard to those who start to question everything. Another common issue for me involves the error creep associated with trading too much, an occasional hesitation about realizing a tax loss until it grows to the point where it no longer matters, and an occasional desire to sit too long on a large unrealized gain for tax reasons or to stubbornly adhere to  predetermined target prices.  

When the investment process is broken down this way, the possibilities of making mistakes are quite large. This compounding error creep explains why individuals are unable to beat the market. Efficient Market Theory: Do Humans Really Behave Rationally-Seek out Relevant Information & Then Process Information With Good Judgment? 6/08/09 Post; Efficient Market Hypothesis as Hokum 3/29/2010 Post

Once mistakes are minimized and an investor learns how to profit from the irrationality of other market participants, it is certainly possible to outperform the market even when making a number of mistakes.

I took a snapshot of my three and five year returns in my main taxable account and in the regular IRA. Those returns were calculated by Fidelity, not by me. Those results are shown in the post from yesterday in Item # 2 Main Taxable and Regular IRA Accounts Performance Numbers Calculated by Broker (12/13/11 Post) As shown in that snapshot, the IRA was up 100% in value for the three year period ending 10/31/11 and the main taxable account handily beat the S & P 500 index by a large amount. 

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