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PATH FINANCIAL LLC

Registered Investment Adviser

1990 Main Street #750

Sarasota, FL 34236

941-350-7904

www.PathFinancial.net

The 90% Solution

Why stock-picking is a waste of time

In an experiment designed to measure the accuracy of predicting what light will come on next, rats and people are positioned in front of two lights: a green one that flashes 80% of the time, and a red one that flashes the remaining 20% of the time.

Rats, figuring out pretty quickly that the green light flashes more often, always pick it and thus are accurate 80% of the time.

People, however, try to outguess the system by identifying “patterns.” When they think it’s time, they pick the red light. But doing so reduces their accuracy to 68%. What is remarkable is that they continue to do this after being told that there are no patterns and that the lights flash at random.

People do the wrong thing even in the face of evidence that what they are doing is wrong. Investors often fail for the same reason: even after confronting the evidence, they persist in the same patterns of investing that have yielded poor results in the past.

They can’t be entirely blamed, though. Years or even decades of Barron’s or CNBC “experts” urging people to keep trying the same old recipes are difficult to contradict. Old habits die hard.

Some of the advice that failed includes “Buy And Hold” (although the stock market is where it was 12 years ago), “Keep Your Mix Of Stocks And Bonds” (which proved to be a disaster for those investors that kept buying falling stocks to keep the percentage constant), and “Buy Stocks of Companies That Pay Dividends” (even though the first quarter of 2009 saw the largest dividend cut since 1955).

There are several reasons why most investors lost money following the conventional advice. One is that the advice is based on the premise that stocks always go up, and “risk” is defined as prices vibrating around a long-term trendline that is always positive. The risk of that trendline going down is rarely acknowledged. Another reason is that much of the advice is largely focused on stock-picking. On that front, the main problem with the counsel given is not so much that it is inaccurate. It’s that it is irrelevant.

A much better approach was to be found in the Financial Analysts Journal (a magazine that most individual investors don’t even know it exists). An eye-opening article in 1986 showed that asset allocation is responsible for over 90% of the performance of a portfolio. That means that time spent researching what stock or mutual fund to pick is largely wasted if the overall asset mix is not what it should be.

For example, according to data from Bloomberg, the best mutual fund investing in large-cap value stocks in 2008 was US FMI Large Cap, which lost 25% of its value in the period. In contrast, the worst mutual fund that invests in long-term government and agency bonds, BlackRock’s US Long Duration Bond Portfolio, lost only 0.1% in the same year. The lesson here is that picking the right sector is much more important than picking the right instrument. Time spent reading balance sheets, listening to conference calls, or pouring over Morningstar ratings is quite wasted if the mix of assets is not optimal.

Path Financial’s focuses precisely on portfolio construction and asset allocation. We do this through the use of ETFs, or exchange-traded funds, that pool together stocks, bonds and other instruments in different asset categories. This is quite different from the stock-picking exercise that most investors regularly perform with or without their advisors, but it is far more important when it comes to delivering investment results.

Path Financial’s portfolios are put together through the use of mathematical models which are based on three main concepts: diversification; taking small steps; and downside control.

1. Diversification. Most investors understand the benefits of spreading wide their dollar net: this can smooth out returns. However, this works primarily during bull markets. During periods of sharp market distress the benefits of diversification tend to disappear: in a panic, everything is for sale and prices become highly correlated. The catch to diversification, therefore, is that it needs to be managed.



2. Taking small steps. Putting together a portfolio with a multi-year horizon does not work. People simply cannot reasonably forecast the future beyond a few months out. Just two years ago the Dow Jones Industrial Average was still climbing to its all-time high. The success of a portfolio built with such long-range horizons depends on sheer luck. At Path Financial we target objectives one quarter at a time, and that’s how we build long-term results.



3. Downside control. Assets tend to trend, both on the upside and on the downside. This means that once a trend is established, chances are that it will go further than anticipated. Therefore, when stocks are in a free-fall, it is better to cut losses than to wait for the turnaround. That’s why stop-loss triggers are essential in preventing disastrous losses on a portfolio that can become exceedingly difficult to repair.

Proper portfolio construction depends on more than a few rules of thumb. Entire textbooks have been written on the subject, and they all focus on mathematical and computational techniques. Drab as the subject can be, however, portfolio management is much more relevant to investors’ performance than more entertaining, but far less consequential, stock-picking anecdotes.

A well-designed plan to put together a portfolio not only can deliver much better investments results but can also improve an investor sense of control. And in the current turbulence, a sense of control can provide much-needed peace of mind when it comes to investing.

 

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