In the spring of 1976, 82-year-old Benjamin Graham sat down with Charley Ellis for a Q&A about the stock market.
Investors were still reeling from the brutal 1973-1974 bear market and wanted to know what the legendary investor and author thought about the current level of the market.
During the Q&A, Graham opined on index funds, financial institutions, the advantages small investors have over professionals and his approach to portfolio management.
Graham described Wall Street as a “madhouse” and said the stock market “resembles a huge laundry at which institutions take in large blocks of each other’s wash without true rhyme or reason.”1
Following their presentation, Graham and Ellis continued their conversation, where Graham carried on about the dangers of speculation. Robert Hagstrom describes this conversation in his book Investing: The Last Liberal Art :
The problem with our industry, Graham insisted, is not speculation per see; speculation has always been part of the market and always will be. Our failure as professionals, he went on, is our continuing inability to distinguish between investment and speculation. If the professionals can’t make that distinction, how can individual investors? The greatest danger investors face, Graham warned, is acquiring speculative habits without realizing they have done so. Then they end up with a speculator’s return — not a wise move for someone’s life savings.
Through a confluence of events, 2020 has spawned a market oozing with speculative activity. There are millions of new brokerage accounts. Options activity is through the roof. People are even trading the stocks of bankrupt companies because…I don’t know…YOLO?
Speculation can and will pay off for some tiny subset of the population through a combination of luck and good timing but it never lasts. And since luck runs out eventually the average results for speculators are awful.
In a study of retail day traders in Taiwan from 1992-2006, researchers discovered more than three-quarters of all day-traders quit within two years, with unsurprisingly disastrous results. The aggregate performance of all traders over the entire 15 year period was negative. Surprisingly, many of the worst traders stayed with it even after seeing periods of large losses.
It’s estimated that only 1% of day traders studied earn profits over time.
Another study that was updated just last month looked at day-traders in Brazil between 2013 and 2015. This group was using the equity futures market to make their bets. Researchers found 97% of all speculators who stuck with it for more than 300 days lost money. Around 1% of these traders earned more than the Brazilian minimum wage while just half of one percent earned more than the salary of a bank teller.
Their conclusion was fairly straightforward: “We show that it is virtually impossible for an individual to day trade for a living.”
Day-trading is an easy target but there are far more subtle forms of speculation investors can succumb to during times of market stress:
Abandoning your plan. Investment plans can be helpful when things are going well to keep you in check from straying too far from your comfort zone but they really earn their keep during a crisis.
Giving up on your investment plan at the wrong time will be indistinguishable from an investor who has no plan in the first place. Unless you have a good reason to make a change, a plan is there so you follow it, even when it feels like you shouldn’t.
Looking for stock tips. I’m sure it’s happened but you don’t hear too many stories about people who became fabulously wealthy based exclusively on stock tips.
Even if they “work” stock tips are ephemeral because any stock position requires thought behind position-sizing, risk management and sell discipline.
It would be wonderful if your brother-in-law or co-worker or old college roommate could offer up the next hot stock just before it goes to the moon but that’s about as speculative as it gets. Basing your portfolio moves on stock tips is a sure sign you have no investment plan or guidelines driving your actions.
Investing with unrealistic assumptions. One of the most important things you can do as an investor to stay the course is set reasonable expectations up front. Having a handle on the potential returns and losses you can expect to see in your portfolio over time gives you proper context when everyone else around you is losing perspective based on the market’s us and downs.
If your long-run expectations are constantly moving in line with the market by going up when the market rises and going down when the market falls you’re bound to be disappointed at some point.
Timing the market. I get the appeal of market timing. Think about how much more money you could have if you could just sell before stocks crash and then buy them back at the bottom!
Volatile markets and economic crises tempt investors with the prospects of market timing even more than normal times as recency and hindsight bias shift into overdrive.
Alas, the only people who sell at the top and buy at the bottom are liars and people who are eventually going to make a big mistake at the worst possible time.
As Old as the Hills
1If Graham was disappointed in the markets of the 1970s, I’m guessing he wouldn’t be a huge fan of high-frequency trading and the like in today’s world.