Top 20 investment Myths: Part 2

Blog first appeared in DanCollinsReport on Aug. 22, 2013

Jackass Investing: Don’t do it. Profit from it”, has been a Kindle best seller since its release in mid-2011. Written by 30 year hedge fund veteran Mike Dever, the ground-breaking and controversial book introduces several innovative concepts – proven over decades of trading – including the replacement of “asset classes” with “return drivers” and a risk-based portfolio allocation method to replace conventional portfolio diversification.

In it Mr. Dever exposes 20 common investment myths. Earlier this week Mike described the first five myths of investing. Here are the next five, which relate to why traditional investing logic has such a hard time with trend following.

 

Myth #6: Buy Low, Sell High

Isn’t this the ultimate goal of investing? Shouldn’t you always strive to sell at a price that is higher than the price bought? Well… yes. But the way it is often practiced has more to do with making the trader feel good (taking a profit! buying at a discount!), than with actual profit potential. I show how common methods of buying low and selling high yield results that are even inferior to buy-and-hold (which I already showed in busting the second myth as being highly risky). The best part of busting this myth is that it segues into the next myth, which really does produce profits.

Myth #7: It’s Bad to Chase Performance

Even as buy low, sell high serves as a siren song to many people, the opposite, chasing performance is considered anathema. But in this chapter I show how a systematic approach to chasing momentum – trend following – is the more rational approach and produces profits. Perhaps most importantly, I show:

1)      A simple trend following strategy, even one as poorly designed as the S&P DTI, can outperform buying and holding stocks, and do so with less risk, and

2)      Portfolio diversification is not simply a matter of the number of markets in a portfolio. A 24-market portfolio can be more diversified than the S&P 500 with its 500 stocks.

Myth #8: Trading is Gambling – Investing is Safer

This myth permeates the investment community. It is considered “virtuous,” and the sign of a true “investor” to buy and hold stocks, while trading is considered gambling. In fact, the opposite (once again!) is true. What I said in the summary for Myth #5 can’t be repeated enough, “Investing is the process of taking the best trades and avoiding the disasters. Gambling is being afraid to cut losses for fear of missing out on profits.” Whether a person is investing or gambling has nothing to do with the markets they trade or the frequency of their trading. It has everything to do with their psychological behavior. If they take unnecessary risks by riding through severe losses (dot-bomb meltdown & financial crisis anyone?) or putting their money at risk in concentrated portfolios (60-40 anyone?) then they are gambling. To avoid those risks (by trading) and create a truly diversified portfolio, is investing.

Myth #9: Risk Can Be Measured Statistically

I present numerous examples where what is perceived as risk, is not: such as a popular low volatility spread trade that was orders of magnitude riskier than originally perceived; and its opposite – a highly volatile market that trades with the certainty of the seasons. But perhaps we need to look no further than the example of the geniuses at Long Term Capital Management, who were comforted by their statistical models that virtually assured the safety of their clients’ money. But their models proved wrong when their “20,000 year storm” hit them in their 4th year of business, which not only vaporized their clients’ money, but required a Fed-engineered bailout to prevent the collapse of the U.S. financial system. Statistics do not reveal risk. As I state in the summary for this myth, “risk can only be determined by an understanding and evaluation of the return drivers underlying any given trading strategy.”

Myth #10: Short Selling is Destabilizing and Risky

As I show in busting this myth, short selling is not destabilizing. In fact, the opposite is true, the banning of short selling is destabilizing. In support of this I present the result of the Securities and Exchange Commission’s (SEC) ban of short-selling of financial stocks during the financial crisis. But, more importantly to investors, short selling is essential in creating a truly diversified portfolio and, as I show with historical data, actually less risky than buying long.

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