Retail Investors + Complex Investments = Failure

I feel like Will Ferrell in The Wedding Crashers uttering his signature line, "What is she doing back there?" The only difference is that he is wondering when his meat loaf is coming while I am pondering when retail investors are going to wake up and adopt a realistic view of their investment abilities. I'm sure Will's ma brought that meat loaf a hell of a lot faster than most retail investors will say, "You know what, I'm not as smart as I think I am. Smart investing is pretty complicated and is a serious business." As IA readers know, idiot retail investment ideas and approaches are a pet peeve of mine and drive me absolutely bonkers, and my ire was raised to a fever pitch when reading a thoroughly disgusting article in Tuesday's Wall Street Journal titled Small Investors, Too, Get Nailed by Arcane Trades. I have only one simple question upon hearing this news: WHY???

So glad you asked. Here are my theories (in no particular order):

1. Hubris
2. Greed
3. Stupidity
4. Fear
5. Lack of knowledge
6. Because most humans are wired to make dumb investment decisions

When I hear of retail investors engaging in multi-legged option strategies, trading foreign exchange and commodities and shorting stocks, I cringe. How many lumps are people going to require to wake up and grow a little humility? I get it - the psychological phenomenon, that is - but I DON'T GET IT. There have been countless stories documenting the sheer idiocy of so many retail investors, being in way over their head and getting killed. So why do people continue making the same mistakes? For the exact opposite reason of why Warren Buffett really is a once-in-a-generation type investor: discipline.

Discipline, especially when it goes against one's native instincts, is hard. When your friend brags about a particular stock or strategy on the golf course, you are jealous, right? And when you hear stories of people making tons in _____ (choose your era - tech stocks, commodities, currencies, gold, etc.), regardless of a lack of documentation (self-reporting is notoriously poor as people tend to remember wins and forget losses), you want in, right? It is very hard to be the tortoise when you are seemingly surrounded by hares. But you know what, you can try your hand a bit if you adhere to a few simple guidelines:

1. Set an asset allocation mix that makes sense for your age, stage, family circumstance, etc. If you can't do this with confidence get some help;
2. Establish the majority of your allocation using low-cost, liquid instruments like index funds and ETFs;
3. Figure out if you want to try and dicker with investing at all, and if the answer is yes;
4. Limit your "play money" to 5-10% of your total portfolio.

By all means have some fun. Do some research. Collaborate with others. Try and generate some real alpha. But don't, DON'T have this be the core of your investment strategy. Please. Don't. Do. It. If you follow my advice you can get the high of investing without running the risk of an overdose. Because an overdose can kill you.

Comments

[Extramayo]

Of the total population, my guess is 5% are interested in investing (I once managed an early 401(k) operation -- 5% jumped on the first interactive voice response system to exchange funds; that number, to my knowledge, has never gotten much higher.) But within that 5%, the number who actually do a good job at investing is mighty slim. We all have our share of winning trades, but at the end of the day, are we really beating the market for the level of risk we are taking? I think, very few, whether they're professionals or "amateurs" such as myself. I agree with your comments, and I think we should all continue to make comments like these, because adult education isn't about instructing, it's about reminding.

[HedgeGuy]

I couldn't agree more. My day job is as an emerging markets trader for a large hedge fund. I have an MBA, an MA in applied math, and a CFA. At work, I trade credit derivatives, interest rate swaps, currency barrier options, and all sorts of other strange stuff.

What does my personal account look like? 100% common stocks.

[Roger]

Mitch, I think you are missing my point. By commenting on retail I am not commenting on investment "pros," i.e. if retail is prone to mistakes then pros are not. Clearly this is not the case. Not the case at all. So my focus of this post is on retail, for starters.

As to whether or not you made a good trade, that is neither here nor there. You are a single data point. I have no idea how much capital you invested in your put option strategy, but if you did you homework (which you did) and it fell within the 5-10% parameter I mentioned in the post, then I'm not sure how your actions are at odds with my suggestions at all. Thanks for commenting.

[Mitch]

It's not clear that retail investors actually do that much worse than the pros. A few anecdotes do not make an argument, and in any case there are plenty of anecdotes of pros screwing the pooch lately.

If there's any actual data on this question then I'd appreciate a pointer.

I'm certainly happy with the housing/subprime put options I bought last year as a retail investor. The blogs understood what was happening with subprime a long time before the market at large. Isn't the main thesis of Monitor110 the idea that relevant information scattered across the internet isn't efficiently integrated by the market? If so, I certainly agree. In fact, I'd go a bit further and say that many people who aren't professional money managers probably understand the specific markets they work in and around as well as any of the analysts covering those markets. The doctor with a short strangle on wheat may have been dumb, but I bet he'd be in a pretty good position to evaluate pharmaceutical companies.

More sophisticated investments are a way for the market to integrate all that main street information that's been locked away in people's heads. If I could have bought options on the ABX index I can guarantee you that I would have done my part to help the market understand the subprime crisis.

[Quentin Cassidy]

I agree with Yaser Anwar's assessment. Most human beings are simply not disciplined creatures. Or more optimistically, people have discipline in some aspects of their lives, but not in others.

Perhaps those who are already disciplined will read this post and feel a renewed sense of purpose. Those who are not disciplined may get scared, move all their assets into treasuries, and join the next fad way too late in the cycle.

[wcw]

Hey, we retail investors can do great works. If we're bored, underemployed CFAs, mind you.

Me, I tell all my friends to index and to work their asses off in their careers (I mean, those who want money; many of my friends don't).

And speaking of which -- what a great few weeks in the markets, huh?

[Mike]

Roger - just curious, what's your view of the Motley Fool community? Do the investment strategies advocated by the Fools make you cringe?

[Shrek]

Seems to me that the last three weeks has produced a lot headlines about prominent HF's taking a beating not small retail investors.

I think we can thank Goldman for the end of 2/20.

[Yaser Anwar]

Sir,

Honestly speaking I think you're wasting your time by saying this. I mean no offense but this advice has been passed down for generations, yet investors fail to learn from the past.

Like George Santayana put it so eloquently, "Those who cannot remember the past are condemned to repeat it."

This is partly what creates inefficiencies in the market- people straying from their circle of competence and delving into unchartered waters. Not only retail guys, but even institutional investors.

The best example of this would be Bob Citron of Orange County. They say his knowledge of the instruments he was buying and selling was close to nil.

I personally like it when retail people, or anyone, talk about fancy products and exotics, that are not their core expertise.

We as mankind are bound to repeat are mistakes again and again. Bookstaber gives a good example of this in his book by expressing it in economic form- even though the variability in GDP and economic activity has reduced by a lot over the past 50 years, the markets have become more risky in the same time; we're all haunted by the demon of our design.

I recommend that book to everyone! It's fantastic to understand human and market psychology.

[Soren]

Here here!

discipline - the magic word. I read somewhere once that professional pilots tend to make good traders/investors. This makes perfect sense to me. In a plane, if you don't follow procedures to a t, you die. That's it, no do over. I personally like the health analogy for investing very much. People tend to make more sensible and risk adverse decision when it comes to their own health. If more people took this approach in regards to their investments, I think we would see less of the problems that you've outlined here.