Friday, December 26, 2014

two important points

You've probably seen the headlines: New York magazine admits to being conned. The biweekly published a story of a brilliant New York high school student--Stuyvesant High School, naturally--who had made $72 million, or something near that amount (he was coy), from stock trading. In truth, he had made nothing. The student's stock market experience consisted of simulated trades at Stuyvesant's investment club, where, he claims, performance was "incredible," as his portfolio "outperformed the S&P 500."

(Note that the quote equates "incredible" with beating a market index. Oh, how active management has fallen ...)

You might wonder how the story got into the magazine. The obvious answer is that journalistic standards have badly slipped. That is how the story has been reported.

While correct in its way, that reason glides over two other important points.

One is that people are bad in math. For example, when I was in junior high school, a syndicated newspaper column stated that if two dice were rolled 100 times, the average sum would be 638. (The column was marketed as a "Grab Bag" of little-known facts. True enough: That the dice would sum to 638 was indeed little known.) That rather basic error escaped the writer, his syndication editor(s), and the local newspaper's staff. As the column never ran a correction, it seems that the mistake escaped many others as well.

To cite another example, in the 1990s the Beardstown Ladies had convinced themselves (through bad math, ironically) that their amateur stock portfolio had grown an annualized 23% for the decade from 1984-93. That was scarcely credible, as the S&P 500 had gained less than 15% per year, only two U.S. diversified stock funds had beaten 18%, and the Ladies followed a stolid investment strategy of buying and holding blue chips. Where on earth could they generate so much extra alpha?

Nowhere on this planet, it turned out. The Ladies' claims went unchallenged for several years. Eventually somebody realized that the Ladies couldn't possibly have been correct. The portfolio's actual annualized gain after costs, it turned out, was only 9%.

The too-good-to-be-true stories have a second essential prop: naivete. Those who do not invest tend to grossly overestimate what actual investors can accomplish. My father, for example, would have fervently believed the New York story. He invested only occasionally--just enough to "learn" that those in the know reaped fabulous gains, while he sadly did not. (He was skilled at accumulating tax-loss carryforwards but less adept at generating gains against which to offset them.)

My father was undeterred by the math of the improbable. For one, he wouldn't do the work. He wasn't about to calculate that even if a teenage boy somehow got $1 million to invest when entering high school, the youth would have needed to make more than 300% annually over the next three years to achieve his claims. But even more, he didn't wish to know the answer. He liked his fantasies. He relished dreaming of when he would crack the code, so that he, too, could make the easy money.

In that he was not alone. Famously, Discover Brokerage Direct ran a 1999 commercial featuring a truck driver who owned a private island, courtesy of day trading. While the ad was not meant to be taken literally, neither was it intended as a complete joke. The company selected an amateur actor to play the role of the truck driver, so as to make the ad feel more like a documentary. It wished for viewers to believe that the most ordinary of Americans could become investment geniuses.

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