Fisher Investments Reviews Automated Trading, Modern Portfolio Theory and More

Transcript

Teaser of Ken Fisher comments:

The biggest single mistake that people make and the biggest what should be self revelation for people in the stock market that isn't is the stock market is a place where a person who knows themselves really well can make money, and a person who doesn't know themselves really well is going to lose money regularly.

Ken Fisher:

So, every month, I answer questions that people mail in, and this month there's less than normal. So, it won't take as long. So, the first one that was sent in to me says,

Does an S&P 500 ETF achieve the goal of diversification, having things that have long term expected return, but in the short term, covary with each other?

So, this question is one that wants to ripple off of the concept of modern portfolio theory, as derived from the year after I was born, in 1951, in the writings of Harry Markowitz.

And it's kind of right, but not quite right. And actually, the way people have always interpreted Markowitz, it's been kind of wrong. Not what Markowitz himself wrote.

So, what Markowitz basically was saying, and which is fundamentally correct, is that diversification should be defined not as, you know, spread your eggs into a lot of different baskets, but own things that have similar long-term return expectations where you expect them to have similar long-term returns, but in the short term, they do what's called "vary" or "covary", wiggle in opposition to each other to stabilize the returns of the portfolio in the short term relative to that long-term return.

So, if you had two stocks and you expect them to have the same long-term return, but they don't wiggle together, because they have very different industries in the short term, that accomplishes the goal of diversification. I'm not suggesting a two-stock portfolio, don't get me wrong, but blending things that wiggle against each other in the short term, but with the same long-term return expectations—or very similar long-term return expectations—gets you to that long-term return with less volatility than if you just had the ones that moved perfectly together all the time, which would have more wiggle and more chop. So, the way I've always tried to explain that is, people say, "I want to own X because I think X is going to do well."

And I say, great, but what do you think would do similarly well in the long term, but would do terribly this year if X does well—and they go, huh? What are you talking about? Huh? And I say, well, do you think X is going to do really well? What do you think will have the same long-term return as X, or about the same long-term return, but you think it will do badly this year?

Own some of that too, because you'll get to the same long term return, but you'll stabilize your portfolio. And they're usually so myopically focused on the short term that all they want to own is what they think will do really well right now. But think about it in a different way. That is exactly what you do when you buy casualty insurance.

You put some money into it that, you know, you hope you'll lose, because you hope the casualty doesn't occur. You hope you've thrown the money right down a rat hole. But you know that if the casualty occurs, then the insurance pays off. And that's why you're doing it. This is the same thing, because if you're wrong in the short term about the thing that will go up, you ask yourself what would do well if the thing I think will do well actually does badly and own some of that—that's diversification. So, what you really want in a portfolio is exactly a portfolio full of stocks that effectively pair that way. And that's the answer to the question.

What are your thoughts on automated trading?

Well, I'm not even sure what you mean by the question. If you mean, do I think digitized trading is good compared to human-based trading, a digitized trading run by thoughtfulness is actually more efficient. Yes, I do think that's true. If you mean algorithmic trading, algorithmic trading is only as good as the presumptions that go into the algorithmic trading, and for the most part, people who engage in algorithmic trading haven't always done so well, but some have done very well.

It's based on a similar concept—different, but similar to the concept that you've always heard about in computing: garbage in, garbage out. If your algorithmic system is bad, it's going to be bad.

So, beyond that, I don't know that I really know how to answer the question. The fact is, there are some people—like legendary, recently deceased Jim Simon, maybe the greatest algorithmic trader of all time—who appeared to be, as near as I can tell, genius in ways that I can't even begin to calibrate, deploying mathematics into trading to create algorithmic trading that worked, although at times for him, it did break down. But he did very, very well his whole career. Most people who engage in algorithmic trading are like most people in every other methodology, they're mostly not too good, but some are. I don't think you can make a blanket statement about it.

And that leads to the next question, ironically, which is, can you explain the role of a market maker like SIG or Citadel? What exactly does SIG and Citadel do?

Well, first we need a definition of what a market maker is, and a market maker is a person or entity that buys and sells for its own account at a publicly visible price and does that as a function to make money. On a stock exchange, there's a concept of the designated market maker,

and this is what you think of as the market maker on a given stock on the floor of the New York Stock Exchange, and they're creating what's called a book of buy orders and sell orders, and they stand ready as the market moves to be the other side of a trade. The world also has the non-designated market maker, which is anybody that is just routinely trading in volume, on the bid and the ask, and that's effectively what, let's say, Citadel Securities does.

Now, Citadel Securities is part of the broader Citadel entity owned by Ken Griffin. But Citadel Securities is a  brokerage firm, which is both the largest designated market maker on the New York Stock Exchange, as well as does market making on the side in principal markets trading for its own account, much of it algorithmically, but also designated down into subcategories that are run by people. It is separate from the hedge fund that is also Citadel, again, owned by Ken Griffin.

Susquehanna (SIG) does a similar thing, these are both very, very successful entities, and they're basically providing liquidity to the marketplace, and they're betting that they can figure out that world of buy and sell better than the market, better than people as a whole.

They typically trade on very thin margins for very small markups, but do it in very high volume, and they do a good job of it, and they've done a good job of it forever, and it's something that is understandably baffling to most people.

I encourage you on this to start by just doing a simple Google search on market makers on Wikipedia, and then do, similarly, a simple Google search going to Wikipedia on these two:

Susquehanna and Citadel. And I think just if you read the Wikipedia pages on those, it'll take you through most of it and you'll come to understand it much better. Thank you.

What are common mistakes when investing in the stock market and how can you avoid them? Lack of planning, not diversifying, failing to set aside an emergency fund, being an emotional investor?

Yes, all that and much, much more. I sometimes get, uh, requests from some young man or woman, in their 20s, fresh out of school, wanting to know how they can be a better investor and what they should do as a better investor.

There's an age old saying in the marketplace, which is that the stock market is a place where—and because it's age old, it was always stated in the vernacular of men, not in the vernacular of women—but the saying was, the stock market is a place where a man with money goes to get

 an experience, and a man with experience goes to get money. And there's some truth to that. But learning how everything works is really central to the whole thing, and the first thing I tell a young person, you know, a year or two out of college, is go to a library.

I think they still have those someplace. I'm not quite sure where they have libraries anymore, but I think they're still around somewhere. And in my first couple of years, when I was first in the investment business, I would just go to the library and I'd just go down the stacks and get all the investment books, and I'd read 40 investment books a year.

And you do that for 2 or 3 years, and you know a lot, and you don't need me to tell you anything before then, because after you've read more than 100 different investment books, you'll know enough to ask me more precise and specific questions.

But yes, I think the biggest single thing, the biggest single mistake that people make and the biggest what should be self revelation for people in the stock market that isn't is the stock market is a place where a person who knows themselves really well can make money, and a person who doesn't know themselves really well is going to lose money regularly. The fact of the matter is, I routinely see people who believe firmly this is going to work, but it's not really based on serious analysis.

It's not based on knowing something other people don't know, which is supposed to be the key to a successful trade. It's not based on anything other mostly than emotion and what they want, and that almost always backfires on them.

Being an emotional investor, not knowing who you are—I see people all the time who, if you ask them, how much volatility can you take? They say, oh, I can take volatility a lot until they get a lot of downside volatility, and suddenly, they got a million reasons to get out of the marketplace, and then they get out of the marketplace, and the market goes straight up.

You see that all the time and that's pure emotional investing. So, I think the biggest single one is knowing yourself; I think that's the hardest thing for most people to do and I think that mostly comes with time. It doesn't mostly come, there's not that many people that kind of get out of college and they're 22 years old, and they already know who they are in capital markets. That would be a tough go.

Might be some, not many—most people can't. So, the reality is the rest of it just comes with self-training one way or another, the discipline that comes with self-training. And so, I'd start if you're young or if you haven't, and go to the library and read 40 books this year, and then the next year read another 40 books on investing, and the next year read another 40 books on investing.

And someplace off in there, you'd come back to me with a lot more specific questions, and then I'd be delighted to answer them then, in the mailbags that we do every month. Thank you for listening.