Vol 2, Issue 6. Quarter 4 – 2025.

One underappreciated book on investor behavior is “The 5 Mistakes Every Investor Makes and How to Avoid Them” by Peter Mallouk. (See Mallouk, 2014.)  But to be more specific, I often come back to one of his favorite lists – 9 Misunderstandings about Financial Information. To keep things brief, let’s dive right in.

1. Judging performance in a vacuum

This deals with the idea of ignoring a suitable reference set when considering claims about financial performance. Peter’s example is to consider a room full of 12,000 people in which all of them flip a coin 10 times. Odds are that roughly a dozen of them will get heads (or tails) 10 times in a row. Would you like to hire any of them to manage your money, and if so WHY? All that happened was that one out of about 2^10 = 1024 did something that chance suggest they would do anyway. This is meaningless. However, if you simply look at the “performance” of a stock-picker and it looks impressive it may feel like an important event. He goes on to state that “It is not uncommon for a money manager to manage 6 to 10 portfolios of funds.” Why would you be impressed if he selects the best performer over the last year and holds this up as an example of his great “skill”. If you cannot see the entire reference set, the anecdotal performance is meaningless.

2. Believing the financial media exists to help you make smart decisions

This belief is somewhat understandable, since the talking heads on the “idiot box” as my mother used to call it, will explicitly say that is exactly what they are doing. But never lose sight of one brute fact. The talking head with the lowest ratings will be replaced, and the one with the best ratings will be given more time. More viewers means higher prices for ad space, which means more profit, which means happier shareholders. This is similar to any other business. The talking head who says, “as far as anyone can tell, nothing much happened today with any long-term significance, and to be honest, no one actually knows what event ultimately matters anyway” won’t be on the air for long. The guy who has predicted 20 out of the last 3 recessions will always find another network to put him on the air.

3. Believing the market cares about today

Remember my adage. An asset price (stock, bond, gold, real estate, etc.) is a number from today multiplied by a story about tomorrow. In the case of a stock, that story almost always revolves around future earnings. A tariff today says something about profit margins tomorrow. A new law today says something about the firm’s ability to maneuver tomorrow, and so on. The story is always about tomorrow. Some will say that in the short term a stock market is a voting machine, but in the longer term, it is pretty simple scale. Higher earnings eventually mean higher prices.

4. Believing that an all-time high means that the market is due for a pullback

This one is particularly funny to me. The S&P 500 has hit about 1200 new highs since its inception in 1957. This is roughly the equivalent of a new high every 2 weeks. It’s hard to see how this is even relevant. Inflation has averaged about 3% per year for the past 90 years. If your costs and prices charged simply change with inflation, the difference between the two, which will be profit, will also rise. If my cost to produce an item is $10, and I sell the item for $20, I have a $10 profit margin ($20 – $10). If both selling price and cost rise by 3%, they become $20.60 – $10.30, so the profit becomes the difference – $10.30. If the stock price is a multiple of earnings, we will have a new high. Woo-hoo! In fact, if there were no variability in prices, we would literally have a new high every day. Again – meaningless.

5. Believing correlation equals causation

The proportion of people on the street wearing short sleeves today will be highly correlated with the number of people wearing shorts. This is not happening because one causes the other. It is happening because they are both responses to the same thing – warmer weather. Being correlated is not informative in and of itself. The recognition that they are both responses to a common cause may be meaningful once you figure out what that cause is and how that ultimately affects your money. 

Part of the problem is that humans are pattern seeking animals. That’s how we develop quick decision rules based on experience with the real world. But remember, if I have 1000 variables that are all independent, and I stare at their plots long enough, I will eventually see that the level of thing A shows a pattern that is very similar to the level of thing B over some span of time. Without a causal explanation, this is nothing more than cute noise. This style of reasoning has led to a host of stupid rules including: A) If the NFC wins the super bowl, the market will rise; B) October is a bad month to buy stocks; C) If the woman on the cover of the SI Swimsuit edition is American, markets will rise. NO – I didn’t make any of those up. The data clearly shows these patterns, as long as you restrict yourself to the time span where they appeared to work.

6. Believing financial news is actionable

The most obvious problem here is that the financial news is generated after the market moves. Look at your favorite financial media outlet at the end of the day – any day. Watch how they backfill a headline to explain statistically insignificant moves in the market. They have no choice really. Think about what would happen if they simply said, “Nothing big happened today – just a simple random walk. Check back tomorrow!” You would immediately switch to the “OMG – it’s the end of the world” channel. It’s so much more entertaining.

7. Believing Republicans are better for the market than Democrats (or vice-versa)

Consider this. Looking at data from 1950 to 2016, when the presidency transferred from a Republican to a Democrat the stock market averaged a 22.2% return in the inaugural year. When the presidency changed from a Democrat to a Republican the market averaged a 6.6% loss. If we consider entire 4-year terms, annual market returns with a Democrat President average 15.3% while returns with a Republican averaged 5.5%. Of course, this is true as long as you begin and end the measurements at just the right points in time. If you extend it to include earlier or later periods, the numbers all change. The main point, is that they were not really informative to begin with.

8. Overestimating the impact of a manager

Any successful fund manager will create a great presentation that looks to “prove” that his/her/their strategy is wonderful. Of course, this will only be from the fund that performed the best over the last period because they will ignore all of the others. In addition, more rigorous research has consistently shown that performance over any 5-year period tells us nothing about performance over the following 5 years. This is problematic because it flies in the face of almost everything else that we see in life. The NBA player who averaged 20 points a game last year will probably have similar stats this year. This just doesn’t work for stock pickers regardless of how many times they tell you that it does. Almost sounds like stock picking is a random selection – doesn’t it? I wonder why?

9. Believing that market drops are the time to get “defensive”

This has been discussed in a myriad of ways with quotes like, “Stocks are the only thing that no one wants to buy when they go on sale!” One of my favorite writers in this space, Nick Murray likes to say that, “Human nature is a failed investor!” Every market drop over the past 100 years has been followed by a rise that was greater than the fall. I understand that the rise may not have been as fast as you would like, but it has always been real. If you thought that a company’s stock was a good buy when it was $100, why would you not think it was a bargain after it fell to $50? (The answer is “cause you scared!!!”) The fatal flaw in the logic of bailing out after the fall is that it is the biggest days that drive the total gain. If you take out the 100 best days for the S&P 500 this century, the total return is close to 0%, and many of these best days occurred in the middle of the crisis du’jour. The only way to capture these great days is to stay in the market during the difficult days. That’s just how this works.

We can go on as long as you like with these pithy lessons, but here is the bottom line.

1. The time to invest is NOW. The amount to invest is the money that I do not need to live off of today.
2. The correct share of equities in my portfolio is as much as I can stomach.
3. The correct planning horizon is the retirement of my grandchildren.
4. Diversification is the only free lunch that I know of, and I want it at the lowest possible cost.
5. Until I feel like I have a better model, that I can live with in any possible outcome, I am going to stick with my plan. 

Whatever you are selling that deviates from this plan is of no interest to me. Have a nice day!