Dilbert: Beating the Average

Lazy, hmmmm? …without a doubt.

I doubt that any one person can read all the information for every item making up “the average”. Much easier to construct your own “average” based on things you are either familiar with or have some exposure to on a daily basis.

The goal would be to focus on segments of the economy that are doing better than other segments — those who specialize on the Greek economy, Russian economy, Egyptin economy, the EU … those are likely to have fewer gems than a more sparkling field like the US or China.

Those who advocate “matching the average” tend to have difficulty defining what their preferred “average” is, and fall back to broader selection methodologies, such as “asset allocation” (which is merely stock-picking using asset classes as a proxy for stocks). The reason that I think one finds fund managers homing in on a melange of indexing and asset allocation is that as a practical matter, it exceeds the capabilities of individuals (or groups of individuals) to identify/select better performers on an individual basis, when hundreds or thousands of selections would be needed to lower the risk in even a modestly sized fund. Those managers are for all practical purposes, forced into aiming for the averages.

Individuals of more modest means may find that an assortment of a dozen (at most, at least that is my limitation) investment vehicles can deliver consistent performance that is well above the averages. The keys to success are:

1) don’t trade (taxes and timing errors will eat you alive)
2) structure your portfolio with risk management in mind
3) work hard at choosing your investments, buy in a little at first, increasing as you gain confidence
4) don’t trade
5) work just as hard at error detection and correction
6) if you can identify an area that is a standout performer, but have no expertise in it, go for an appropriate index, either comparing past performance to select, or going for a broad representation — I do this with biotech, but limit it to between 10-20% of my portfolio, due to the volatility of that segment
7) don’t trade
8) if you are attracted by a foreign stock/industry, ask yourself exactly what gives you better insights than someone who lives there? Nothing stays on top forever, and it is my experience that when things turn sour, it is the outsiders who are left holding the bag. Plus, in the area of foreign investments there are the additional complications of taxes and exchange rates that make them doubly hard to make a profit with, compared to assets in your own back yard. Of course, this matters a lot less to basis-pointers, who travel sufficiently and have local managers are around the globe … but I am discussing what lesser mortals can do, not those with private jets or regular first class accommodations.

Those who advocate “aiming for the averages” should be prepared to define exactly what “the averages” are that they aim for, in a continually changing continuum or investment vehicles, all oscillating back and forth with differing frequencies, some soaring high and others crashing and burning, with various asset classes changing position relative to each other on a random and ongoing basis. How anyone can even begin to define an “average” of such a thing is beyond me.

One final question for indexing advocates: in an equity allocation of a portfolio, how much of it should be allocated to penny stocks, and why?

Selectivity is the basis for success in any scheme of portfolio management. We select for future gain, present income, and minimal risk. Aiming for the averages is just as big a canard as is chartology, as the averages predict the future no better than the charts (mostly because we are unable to define what an average is of something that is made up of a multitude of fluctuating indiviual elements. Kinda like trying to determine the temperate of a container of a mixture of several gasses, by taking measurements of individual molecules that in aggregate comprise far less than a percent of the whole. The error bars for such an “average” are gonna be HUGE.

Investing works best when markets are efficient and transparent. This holds for both indexing and stock-picking. I cannot recall a time when markets have been more inefficient and opaque.