In a recent note, DataTrek's Nicholas Colas, who prior to becoming a market strategist was a portfolio manager at SAC and a sellside analyst, focuses on an age-old question "Is investing an art or a science?" His answer is that it is neither: "It is a craft, a combination of both sorts of disciplines. And like all crafts, one learns it in part by making mistakes."
He details his observations and lessons below:
Given everything that’s happened in the last few months, I’ve been thinking a lot about “rookie mistakes”, those errors of judgement that stem from inexperience. Having done everything from being a sell side analyst to working at a hedge fund to writing market strategy over a +30-year career, I think I’ve either made every rookie mistake in the book and/or watched others do the same.
And, because investing is a craft, some of these lessons come from masters in the field who either stumbled into a rookie mistake or showed me how to avoid one. Three-star Michelin chefs still burn themselves, and master carpenters will occasionally hammer their own thumbs. It happens.
Here is a Top 10 list of “rookie mistakes” that I still consciously try to avoid even after +3 decades in this business:
#1: Planning IN a crisis instead of planning FOR a crisis. Trading at SAC during the dot com bubble bursting taught me one thing: just as there seem to be only geniuses in bull markets, there’s a lot of bad decision-making in down ones. In part that is because many investors wait until markets are in free fall before developing a plan to profit from the chaos. By then, fear has captured body and spirit and planning is nigh-on impossible.
The only solution for this problem is to plan ahead, something else I learned at SAC. For example, when things started to go south in March 2020, we told you to buy every 5% down day on the S&P 500. The history of the Financial Crisis showed that was a winning approach, and it worked. If/when we have another round of market volatility, we will tell you again to buy every down 5% day.
#2: Believing in "Buy low, sell high". Rookies mistakenly think this adage says to buy new lows, especially in single stocks or sectors. Big mistake. Assets make new lows for a reason, and generally they’re pretty good reasons. The right approach is to “scale in off the lows and scale out higher”. Not as pithy, but a whole lot more profitable.
#3: Thinking XYZ stock/sector is up/down for no reason – it’s just “general market action”. If I learned one thing from Stevie Cohen, it is that there is always a reason for any price movement. The issue is “is it worth my time to find out what’s happening?” Sometimes it is, but most of the time it is not. Understanding how to tell the difference is a big part of the investment “craft”, because time is the only truly scarce resource.
There is an apocryphal story that Stevie only traded one stock when he started his hedge fund: IBM. He got to know all the analysts who covered it, the specialist who made the market, and the investment criteria of all its largest owners. He knew why every tick was happening in Big Blue. It was never just “the market”.
#4: Believing valuations actually matter. Steve had another saying I’ll never forget: “math is not an investment edge”. Stocks, sectors, and even entire countries trade with a given set of valuation metrics like price/earnings ratios. But everyone knows that number, which means there is no investment value in that analysis. The “why” matters much more – why so cheap, why so expensive” – and the “how” is the center of the investment case – “how do market perspectives change?”.
#5: Thinking policymakers play by the rules. One of the oddest things about the last 4 months has been seeing the raft of negative commentary about the Federal Reserve’s corporate bond buying program and the $2 trillion CARES Act stimulus. “They can’t do that!” is the most common critical thread, with the idea being that fiscal/monetary policymakers are constrained by the letter of the law or historical precedent. Wrong – they make the rules and investors have to allocate capital based on their decisions.
#6: Saying “this won’t end well”. I get the idea – that markets can be so unbalanced that they crash – but the rookie mistake is believing anything actually “ends”. Bad endings are the best entry points.
#7: Thinking stocks move just on fundamentals. There’s an old saying among traders: “Analysts? In a bull market you don’t need them, and in a bear market they’ll kill you.” I first heard that from hedge fund clients in the 1990s, and since I was an analyst it stung… But there are certain times when stocks don’t care about fundamentals. There are two reasons why. First: as we saw in March, price leads fundamentals since markets quickly sniff out future economic reality. Second: asset price correlations always go to 1.0 in a crisis, and it doesn’t matter if a company sells electric power or electric cars.
#8: Using inappropriate timeframes for historical analysis. A senior Fidelity money manager in the early 1990s taught me a trick I use to this day: only look at charts where the time period shown matches your holding period. If you plan to hold US equities for 20 years, look at a 20-year chart. If you want to understand how the US dollar trades through an economic cycle, only use a 10-15 year chart.
All the chatter about the US dollar’s sudden recent weakness or gold’s resurgence comes from those who are looking at 1-year charts or shorter. Historical context (which is all charts really show) is a productive thing to have, but only if you look at an appropriately long history.
#9: Sizing an investment idea inappropriately (both large and small). The smartest hedge fund risk consultant I know makes a very good living by monitoring his clients’ position sizing like a hyper-attentive bird dog. His edge: looking for the scattered small positions that can cumulatively hurt a portfolio. Even rookies know that a big position gone wrong will kill performance. Only veterans know that 5 lousy 1% positions can do the same thing.
#10: Believing you’ll never make a rookie mistake. You probably saw this coming, but it’s a good place to end the conversation. The craft of investing is not one anyone really masters; the best goal may well be to just make fewer mistakes.