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Learning the Wrong Lessons: Avoiding the Peter Lynch Bias

PETER LYNCHPeter Lynch is one of the all-time greats. While running the Fidelity Magellan fund from 1977 to his retirement in 1990, he generated almost hard-to-believe annualized returns of 29.2% per year. And take note that this was before the roaring bull market of the 1990s. If there were a pantheon of investing gods, no one would question Peter Lynch’s place in it.

But Lynch was also responsible for some of the most misunderstood and poorly-used words of investment advice in history when he recommended that you “invest in what you know.”

Lynch’s advice here is actually pretty solid if used right. Wall Street analysts and fund managers often never leave their elegant New York offices. Regular, everyday investors can often see a budding trend years before Wall Street simply by virtue of having boots on the ground. And new trends in consumer goods are often visible on the street months or years before they show up in the financial statements. Lynch routinely wrote over the years that he found some of his best investment ideas from trips to the mall.

But this is where good advice can go very wrong. “Buying what you know” can very quickly degenerate into buying a stock because you like its product—what I call the “Peter Lynch Bias.”

Liking the taste of their burritos is not a sufficient reason for buying shares of Chipotle Mexican Grill any more than liking their lattes is reason to buy shares of Starbucks. Peter Lynch was never that simplistic, and we shouldn’t be either.

On a related note, we need to look past the hokiness of another legendary investor, Warren Buffett. Buffett likes to play the part of a simple Midwesterner –the kind of guy that really would buy Coca-Cola stock because he likes the taste of Cherry Coke. Don’t believe it for a second. It’s an act. Buffett is one of the sharpest financial minds in history, and he didn’t build Berkshire Hathaway into a financial empire with such sentimental nonsense. He did it by having discipline and buying the shares of great businesses when they were reasonably priced.

So, how can we avoid the Peter Lynch Bias?

Simple: By staying emotionally detached, having a process in place and sticking to it.

By all means, follow Lynch’s advice by looking for emerging trends on your next trip to the mall. But before you pull the trigger to buy or sell something, make sure you’re following your process.

Here are a few practical suggestions on avoiding the Peter Lynch Bias:

  • If you’re looking to “invest in what you know” with respect to a product you like, try using one of their competitors before seriously considering purchasing the stock.  Years ago, if I had really taken the time to learn how to use an Apple (AAPL) iPhone, I probably wouldn’t have gotten sucked into the BlackBerry (BBRY) (Back then, Research in Motion) value trap. Yes, it was one of the cheapest stock in the world when I recommended it in 2011.  But I cannot deny that my decision to recommend it was biased by my ownership of a BlackBerry phone at the time. (For a longer piece on avoiding value traps, see “How to Spot a Value Trap: Research in Motion.”)
  • To the best extent you can, try to follow trading rules and use stop losses.  What works for one investor will be very different than what works for another.  Perhaps you use a hard stop loss of, say, 10% below your purchase price.  Or perhaps you use a trailing stop or 20-25%.  If you are a value investor, perhaps you base your sell decision on valuation or fundamentals rather than market price.  But in any event, my point stands.  Lay out the conditions under which you intend to sell and stick to them.  Stock ownership is a marriage of convenience with quick, no-fault divorce if your situation changes.  Don’t make the mistake of falling in love.
  • Unleash your inner Spock.  For readers who are not Star Trek fans, Spock is an alien from the planet Vulcan who has completely supressed his emotions.  If talking about a stock or watching its price fluctuate gets your heart racing, take a step back and try to look at the investment through Spock’s eyes.  Is it logical?  Do the numbers make sense?  Are the growth projections based on reasonable facts or on optimistic hope?  Would you buy a different company if it were trading at the same price multiple?

One size does not fit all here. But whatever investment discipline you follow, don’t allow your enthusiasm for a product to cloud your judgment.

Charles Sizemore is the principal of Sizemore Capital Management. As of this writing, he was long AAPL.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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It’s Hard to Beat Risk-Free 46% Annual Returns

Even in his prime, Warren Buffett couldn’t consistently deliver 46% returns year in and year out. The sage of Omaha is good…but not that good. (Ok, there was a stretch in the 1960s when he really did generate those kinds of returns, but we won’t split hairs.)

Amazingly enough, those kinds of returns are offered to the vast majority of employed Americans. And even better, they are offered with absolutely no market risk…or any risk at all, for that matter.

Today we’re going to take an unconventional look at that most conventional of investment vehicles, the 401k plan.

Most people look at a 401k plan and see a boring collection of mediocre mutual funds. And unfortunately, that is often true. But today, I’m not going to tell you what mutual fund to buy, nor am I going to give some wonky “guaranteed” trading strategy. Instead, I want to dig into the nuts and bolts of how 401k plans work, and show you exactly what I mean when I say that 46% risk-free returns are possible.

It comes down to two important things:

  1. Employer matching
  2. Tax savings

Let’s dig into matching. Not all employers offer matching, and some employers are more generous than others. But the tax code—and a desire to maintain a happy workforce—incentivize employers to contribute to your 401k plan on your behalf. A common matching level these days is 6%.

Now let’s consider taxes. Let’s say you had a fantastic year and you find yourself in the highest marginal tax bracket of 39.6%. Every dollar you divert into your 401k plan avoids this taxation…which means that you effectively just “earned” nearly 40% simply by not having to pay taxes. Between tax savings and matching, you just hit that 46% return level, and I haven’t said a word about investment returns. I’m assuming the funds went into a money market fund paying 0% interest.

Ok, I realize there are a few problems with my argument. Tax savings and matching are not technically “returns.” And obviously, not too many Americans are in the top marginal tax bracket.

But the takeaway is this: Your investment returns matter, but other considerations–such as tax effects and matching–can actually matter a lot more to your effective returns. Simply shifting your investments from one type of account to another can make a major difference to your wealth.

Before you do anything else with your money, you should absolutely max out your 401k every year, or at least come as close as you can given your living expenses. Yes, the mutual funds available might be cheesy. Big deal. You’re starting out as much as 46% ahead simply by showing up.

In 2015, you can put $18,000 of your own money into a 401k plan, and this does not include employer matching. If you are aged 50 or older, you can chip in an additional $6,000. Whether you are in the 39.6% bracket or the 15% bracket, the tax savings alone would make it worth your while to dump every penny you can into your 401k plan. Add in the free money from matching, and you’d be a fool not to take advantage of it.

 

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Investing Lessons from House of Cards’ President Underwood

He may be a murderous bastard with no conscience, but if Frank Underwood were a real-life candidate for the presidency, I would vote for him.

Golden Globes Nominations

Frank Underwood is not a real person, of course. He’s the crooked politician portrayed by Kevin Spacey in the Netflix series House of Cards who claws his way into the White House by manipulating the press and ruthlessly crushing anyone that might get in his way. But sadly, with one line, he delivered more honesty than I have seen from any president, senator or House representative, from either party, in my lifetime:

We’ve been crippled by Social Security. By Medicare. Medicaid. Welfare. And entitlements. And that is the root of the problem. Entitlements. Let me be clear: You are entitled to nothing.

Underwood then goes on to propose a ludicrous $500 billion make-work program for the unemployed, but we’ll ignore that for now. Instead, I want to focus on that last line: “You are entitled to nothing.”

If you’re in or close to retirement, those words are going to rub you the wrong way. But that doesn’t mean that they’re not true. Social Security and Medicare are not “rights” in any sort of legal sense. Congress decides on the payout, and Congress can change it—or eliminate it— at any time.  You really are not “entitled” to anything and certainly not guaranteed.

But that’s not the message we get from our leaders. Instead, they make promises that they know can never be kept, but they do so knowing that they will not be up for reelection—or possible even still alive—when they have to be broken.

You are entitled to nothing. It’s not fun to hear, but it’s important to keep it in mind when doing your retirement planning. You should go forward with the assumption that your benefits in retirement will be lower than currently promised…and possibly much lower.

Here are some specific recommendations on how to approach your planning:

  1. Focus on income rather that the “magic number.” Most financial planning centers around amassing a nest egg of a certain size, but this is completely backwards because it doesn’t take market yields into account. A million-dollar bond portfolio would have paid about $40,000 ten years ago. Today, it would pay about $22,000. So again, focus on the income being thrown off rather than a certain net worth number.
  2. Consider investments you might have never considered before. With the stock market priced to deliver lousy returns over the next decade—and yielding a pitiful 1.8% in dividends—investments like preferred stock and closed-end bond funds can good income producers if bought at a good price.
  3. While I’ve never been a fan of variable annuities due to their high fees and maddening complexity, an immediate annuity can be a way to turn part of nest egg into a safe stream of income resembling a pension.

Just take President Underwood’s words to heart—you are entitled to nothing—and set about planning accordingly.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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The Bangladesh Butter Indicator Says Buy!

Get ready to buy. Our most reliable technical indicator—one that has historically been 99% accurate—is  suggesting that stocks are poised for a major breakout.

Bangladesh butter production surged in February, as moderating grain prices allowed Bangladeshi dairy farmers to boost production by getting higher milk yields from their existing stock of cows. Meanwhile, butter production in neighboring India dropped significantly in February, as a change in government farm subsidies forced Indian dairy farmers to cull their herds. With Bangladeshi butter production set to rise further, we should be looking at a massive rally in the S&P 500 throughout March and April.

By now, I sincerely hope you realize I’m joking.

Whether the S&P 500 goes up, down or sideways over the next two months will have absolutely nothing to do with the Bangladesh butter indicator. But in a paper published two decades ago, David Leinweber and Dave Krider found that butter production in Bangladesh had the tightest correlation to the S&P 500 of any data series they could find. It wasn’t GDP growth…it wasn’t earnings…it was Bangladeshi butter, which “explained” 99% of the S&P 500’s movements.

ButterBangladesh21

The authors weren’t quacks. They knew the correlation was a random coincidence and completely meaningless. But they published the paper to get a good laugh and to make an important point about number crunching. Correlation does not mean causation, and if your model doesn’t make intuitive sense, it’s probably bogus.

I’m not bashing quantitative models here. Done right, they can help you build a really solid trading system. Various value and momentum models have been proven to work over time. But the trading system needs to reflect some sort of fundamental reality or it’s one (small) step removed from voodoo.

Adam touched on the same idea two weeks ago in Economy & Markets. As Adam wrote, “Computers, databases and statistically sound algorithms can only refine the discovery and implementation of a fundamentally sound investment strategy. At the end of the day, computer algorithms or not, you still need a rock-solid investment strategy.” The model isn’t the strategy. It’s a tool to help you execute; nothing less, nothing more.

Whenever you see someone touting a trading strategy, ask them to explain why it works. Back-tested returns aren’t good enough. If they can’t explain the fundamentals behind their model, it’s probably a matter of time before they blow up.

Oh, and one more thing about Bangladeshi butter. Leinweber wrote in Forbes a few years ago that he still gets phone calls—20 years later—asking for current butter production figures.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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