One of the most important decisions for market participants to consider is made well before they ever make a trade. It is in deciding whether they are going to be a trader, an investor or simply a gambler. This critical determination, which is often overlooked, will determine whether one has failure or success in the markets.
So how do you know which category to choose, or if you are already involved in the markets, which category best describes you?
While most beginners believe they are either traders or investors, they are actually gamblers. If you have no methodology and are buying a stock or exchange-traded fund merely because it has risen sharply over the past few days, was recommended by a guru/analyst/friend, or due to a certain alignment of the planets, you are a gambler.
This is fine if you accept the fact that you are gambling for the thrill of it, and not to make a profit. After all, you have just about the same chance when betting on an individual stock over a short time period as you do at the blackjack tables. Although the stock market gambler may not appear as degenerate as the typical off-track betting gambler, they suffer from the same foibles. They are addicted to the constant action, employ no money management techniques and lack the ability to walk away with a small loss.
Assuming you can avoid the path to gambling, you are left with either trading or investing. For most individuals, the more sensible choice is far and away the investor path. This is particularly true when your full-time job is not following the markets. Trading is an extremely difficult endeavor with a low success rate even for the most experienced market professionals, let alone someone who may have only a few hours per week to devote to analyzing the markets.
That leaves us with investing. For most individuals, successful investing means maintaining a diversified portfolio of assets and having the patience to remain invested in that portfolio for a long period of time, typically greater than five years. That last part, of course, is key. Investing in a basic ETF that tracks the Standard & Poor’s 500 index is a good start, but if you panic and sell every time it drops 5 percent to 10 percent, you are not investing.
More experienced investors will try to incorporate valuation into their decision-making process, using factors such as book value to determine whether an asset is cheap or expensive. Studies have shown evidence of such factors producing abnormal returns on average in the past. However, this also requires time to research those assets and the patience to wait for the undervalued security to return to fair value. Many investors lack this patience and want immediate results, which is precisely why the valuation anomaly persists. These investors would be better off simply maintaining a diversified portfolio and not attempting to time their purchases by overweighting or underweighting an asset class due to valuation considerations.
For those investors with a more patient disposition, uncovering potential valuation opportunities can add value to their portfolio over time. But where should such an investor begin looking for such opportunities? I would start with a list of the worst performing ETFs over the past three years. A 1989 study by Werner F.M. De Bondt and Richard Thaler showed that the worst-performing (bottom decile) securities over the prior three years tended to show significant outperformance on average over the subsequent one to five years years. Conversely, the best-performing securities (top decile) over the prior three years tended to show significant underperformance on average over the next one to five years.
Which ETFs reside in each of these categories today?
In the worst-performing group, you’ll find anything related to commodities and/or emerging markets. On the commodity side, this includes gold miner stocks, coal stocks and silver miner stocks. These ETFs are down anywhere from 50 to 80 percent over the past three years. On the emerging market side, the biggest losers include ETFs with exposure to India, Brazil, China, Russia and emerging markets broadly. These ETFs are down anywhere from 16 to 57 percent over the past three years.
In the best-performing group, you’ll find ETFs with exposure to biotech, health care, consumer discretionary and U.S. small-caps. These ETFs are up anywhere from 80 to 180 percent over the past three years.
If an investor can, on the margin, increase exposure to the first group and decrease exposure to the second group, they should, in theory, be able to add value to their portfolio over time. Of course, this is easier said than done, as the worst performers tend to be the most-hated asset classes of the day, while the best performers tend to be the most-loved. But it is for this very reason that the deviation from fundamental valuation exists, as the most-hated asset classes are driven below fair value, while the most-loved asset classes are pushed above fair value.
In summary, market participants would be well-served to look in the mirror and ask themselves if they intend to be a trader, an investor or simply a gambler. If one intends on gambling, I would suggest forgetting the markets and taking a trip to Las Vegas instead. The entertainment value will be much greater there.
For most market participants, the investor path is the only realistic path to success, as the time commitment and learning curve to trading is far too great. The investor path will require building a diversified portfolio and having the patience to stick with that portfolio through ups and downs. An individual may even be able to add value to their portfolio over time by increasing exposure to the most-hated asset classes and decreasing exposure to the most-loved. While this may not be the most exciting road to take, it is the only time-tested road to successful investing.
Charlie Bilello is the director of research at Pension Partners, LLC. He is responsible for strategy development, investment research and communicating the firm’s investment themes. Prior to joining Pension Partners, he was the managing member of Momentum Global Advisors. Bilello holds a Juris Doctor and Master of Business Administration in finance and accounting from Fordham University and a bachelor’s in economics from Binghamton University. He is a chartered market technician and holds the certified public accountant certificate.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.