Motley Fool Hidden Gems Investing - Fool School: Can You Beat the Big Guys?

Episode Date: November 11, 2023

Here at the Motley Fool, we like our individual stocks. But – what if we’re wrong?  Jonathan Berk is a professor of finance at the Stanford Graduate School of Business and co-host of the podcast “All Else Equal: Making Better Decisions.” Ricky Mulvey caught up with Berk to discuss – and debate – the merits of individual stock investing. They also talk about: The ripple effects of decision-making, Whether short-term investing deserves its bad reputation, And the time horizon needed to differentiate between luck and skill.  Tickers discussed: CMG, NFLX, NVDA, MCD Host: Ricky Mulvey Guest: Jonathan Berk Producer: Mary Long Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

When WestJet first took flight in 1996, the vibes were a bit different. People thought denim on denim was peak fashion, inline skates were everywhere, and two out of three women rocked the Rachel. While those things stayed in the 90s, one thing that hasn't is that fuzzy feeling you get when WestJet welcomes you on board. Here's to WestJetting since 1996. Travel back in time with us and actually travel with us at WestJet.com slash 30 years. you hear it all the time investors are short-term the problem with that thinking is not realizing that if you are short-term you have to sell the stock to someone

and the person buying the stock isn't going to buy something that that that is bad they're going to pay the fair price and that person uh might be long-term or even if that person's short-term he has to sell to another person. Eventually, when you unwind that, you realize that the price at which you sell at impounds the long term. I'm Mary Long, and that's Jonathan Burke, a professor of finance at the Stanford Graduate School of Business. He's also the co-host of the podcast All Else Equal, Making Better Decisions. Ricky Mulvey sat down with Burke to discuss how all-else equal thinking affects markets, and to sound off on whether at-home investors can really beat the pros. This is a little different than our typical Saturday episode. It's less

fool school and more office hours meets debate club. We hope you enjoy it. I want to give an introduction to all-else equal thinking. I know this is popular among academics. Why is it so useful? Well, yeah, let's start there. Why is all-else equal useful for those who study economics, who study finance? I would go so much further. I think it's useful for everybody, in particular the business decision makers, which is who the podcast is directed in favor or whatever the word is. Anyway, here's the reason.

We think, and I almost call it equilibrium thinking. What does equilibrium thinking mean? It means when you make a decision, that decision causes other people's behavior to change. So what you can't do is say, I'm going to hold all else equal, and if I make this decision, this is what's going to happen, because that never happens. People, when they see your decision, change their behavior. We call that in economics, equilibrium thinking. I think that's the biggest mistake business leaders make.

They don't think in equilibrium. And the podcast is centered around that concept, that when you make a decision, when you do something, in order to figure out what the effect of that decision is, you have to anticipate how people will react to your decision. So what is an example then of a business leader making an all else equal decision making mistake? I mean, you know, there are lots of them, but I just take a very, very simple example. And it's so simple that I'm assuming mostly business leads wouldn't do this. But let's say you say, I'm going to decrease the price or increase the price of our product. And we'll still sell the same. But obviously, if you increase the price, you're going to change consumer behavior.

And that's an obvious example of a business decision. But of course, it gets much more subtle. I mean, you know, take, for example, Waze. In the beginning, Waze worked very well because very few people were using Waze. But then as everybody used Waze, they all changed their driving behavior. And so suddenly, there is an easy way to get from A to B. It's another simple example. But in the podcast series, we have a whole series of examples of business decisions that we look at.

but I really think the correct way to think about this is when you make a decision, how are people going to react? Yeah, I mean, in the case of prices, I think that's going on with a lot of businesses right now where they're trying to flex their pricing power. You know, in some cases it seems to be working. You have a company like Chipotle

that has managed to raise prices continuously throughout this year. You could also add Netflix onto this list and yet they haven't seen their customers walk away necessarily. In fact, they may be adding more. Well, most likely, the other fast food chains are also raising their prices. So another way of thinking about it, Chipotle might be the follower, not the leader.

Maybe Chipotle looks at the other fast food chains and says, well, if we keep our prices the same, we'll get more customers. On the other hand, if we raise prices, well, it's the same amount of customers. And which one of those two scenarios makes more money? I mean, of course, the other possibility is they're rising prices because costs are going up, right? If the cost of everybody is going up and everybody raises prices and maybe profits have stayed constant. I appreciate the way you've challenged especially investors to think about all else equal decision-making. You had an episode about NBA players and setting an NBA lineup.

And the idea is that, well, on the surface, one may think that what you want to do is you have the players with the highest shooting percentage on the court together, because all else equal, they're going to make the most baskets, and this creates the best team. I think the same is true for investors, where you might only look at all else being equal. I just want a company with a very high return on invested capital or really high sales growth, and then really focus on a couple of metrics, and then maybe ignore the other things going on. Well, so let's go back to the NBA, because i really like that example yeah um you know you may think okay um i look at michael jordan's record and if you look at the astonishing is the sound michael jordan is uh is something

like 150th on the all-time list of uh free throws and he's one of the greatest players ever played basketball i mean how does that work well of course that's all else equal thinking michael jordan's the greatest player in basketball everybody knew that so they double covered Michael Jordan. So the fact that he made 150th on the list, despite the fact that he was double covered a lot of the time, is an indication of how good he is. The same is true in investing. If I see a really good company, or I see a really good mutual fund manager, then you might think, well, if it's a really good company, if I invest in the company, I'm going to make money. No, because you're not the only person who sees that it's a very

good company. Everybody else also sees it's a very good company and they bid the price of the company up. And so when you go in to buy the company, you're buying the company for a high price as you should. It's a good company, but that means your returns are not going to be any better than any other company. People will compete with each other to find good returns. And in that competition, they drive the returns down. And that's a beautiful example of all else equal thinking. Yeah, I think one of the things you said is that if you're a stock investor or you're looking for a stock, you really have to arrive to the party early if you have any chance of beating the market. But I also wonder if the same is true for sticking around too late. I think the average

stockholding right now is less than a year for most people. So they don't give themselves enough time for a thesis to play out. They might not have the quarterly demands that a professional fund manager might have. Okay. I know you invited me to the show, and I don't want to point out to you an all else equal mistake, but I'll go ahead and do it anyway. That's why I invited you on the show. The problem with that, and you hear it all the time, Investors are short-term. The problem with that thinking is not realizing that if you are short-term, you have to sell the stock to somebody, and the person buying the stock isn't going to buy something that

is bad. They're going to pay the fair price, and that person might be long-term, or even if that person's short-term, he has to sell to another person. Eventually, when you unwind that, you realize that the price at which you sell at impounds the long-term. So even if you sell early and you only collect one or two dividends, that doesn't mean you don't have to worry about the long-term, because the price you sell it at depends on the long-term prospects of the company.

So the idea that investors only care about short-term is a wonderful example of the mistake Take up all our SQL thinking. Oh, I didn't say that investors only care about the short term. I said the average holding time for an American holding stocks is less than a year. Yes. And so that definitely is true. One of the things that's happened in my lifetime is this just gigantic increase in the turnover of stocks. And that, yeah, more people hold the stocks for a short period of time.

I'm pushing back on the argument that there's something bad about that. There could be something bad about it in terms of investor behavior, right? You might ask, well, why are you only holding stocks for a short period of time, right? What do you know that you think you've got to trade that off? And there I would say it seems unlikely that investors know so much that they have to keep trading. It seems to me that there might be investors who are fooling themselves into believing they know a lot when they don't. I agree with you.

I mean, obviously, I, as a finance professor, buy and hold. I don't know anything about companies. I buy a well-diversified portfolio, and I hold it. And I ignore the value of that portfolio. It's of no interest to me. I can't time the market. and when I retire, I will consume whatever the portfolio is worth. You've also talked about if you're going to be a stock investor, or I think sometimes stock

investing and trading is unfairly lumped together. But I do think it's fair to say that you need to think about who is on the opposite end of the trade. And in most cases, you've used the example of Tom Brady. You're getting onto the field with Tom Brady if you're going to buy and sell a stock. I guess, can you explain that metaphor? Because in some ways, I think it makes sense, right? If you're trading stocks, but also if you're buying a business over the long term, it's an alignment game. You might be playing a different game than those short-term traders. Yes. And you're making a very, very good point. So let me explain it as I would say it. And that is, look, when you trade with somebody that is zero sum right if you're making that person's losing if you're losing that

person's making so you have to ask the question who knows more about the company me or the person i'm trading with if the person you're trading with knows more about the company than you do you'll likely be losing money and if you're an average investor it's unlikely that you will know more about the company than the person you're trading with. You might trade with somebody who knows as little as you do, in which case it either win or lose. But there's also the probability you'll trade with somebody who has better information than you and you will lose. Meaning on average, you'll lose. And so the advice I give is don't trade. Because every time you trade, you expose yourself to the possibility of trading with somebody more information than you,

smartening. So in that sense, you're right. You should buy and hold. Now, the question is, why then do investors trade so much? Why is there such high turnover in stocks? I would say that is an important puzzle that academics haven't got a very good answer for. The most typical answer for that is, well, you've got a bunch of naive investors who think that they know and are trading, but in fact they don't know and they lose money. And there's evidence of that. There's evidence that retail investors lose money when they trade. My own feeling is yes, certainly there are a lot of retail investors that fool themselves and don't know what they're doing, but they are not a big enough part of the market to explain all the trading, right? And to make the assumption

that institutional investors are naive and don't know what they're doing, I think is a little bit of a stretch. Institutional investors are pretty sophisticated. So the question then is, why then do we see so much trading? And I think it's an open question. And it's a question which I think exposes how little we as academics and financial economists really understand about markets. Well, I think that a lot of it's the algo traders. So you have your market makers, and then there's a lot of algorithm-based trading, which I think, in my opinion, explains some when you see these wild jumps where, what is it, Nvidia gained the entire market share of McDonald's in a single day. I don't think that's driven by human trading. I think there's some algorithmic component

to it. But I also think that if you're an individual, you might have some advantages over, and this is, I work for The Motley Fool, so I'm biased towards the individual stocks. But there is a case that I think individual investors have advantages over the institutional traders. There's some evidence. It was an investment research firm called Vanda Research looked at data from nine years ago, basically found that the average investor beat the market by about 10%. The reason being is that they're holding these mega cap tech companies in a lot of cases like Apple, Tesla, Nvidia. But it's also because they're playing different games than the institutional investors that have to have layers of management before they can make

a trade, or they have to report to other investors who might take out their money when markets go down versus putting money in when that's when they should theoretically be buying. Okay. You said a lot. Let me unpack as much as I can. I looked briefly at the study. I didn't read in detail, it contradicts all the academic evidence, and there's a lot of academic evidence that reach investors lose money. And so you might ask why? Well, first of all, the study makes a mistake that many studies, many academic studies make, and they compare the performance of an individual against the performance of an index. That's not a fair comparison, because the index doesn't include transaction costs.

Individuals and companies have to pay transaction costs. And I'm not talking about the cost of trade that's basically zero. I'm talking about the bid-off spreads. And if you can't compare a strategy where you pay transaction costs to a strategy that you don't pay transaction costs and say the strategy that you don't pay transaction costs

does better. So that's the first thing. Now, of course, in this case, the claim is that the investors do better, not worse. So they do even better than you think because the index, there's no transaction costs. The second thing is it's only 10 years. One of the biggest lessons about markets is to learn about volatility. You know, the average person really has no idea the level of noise in markets. The level of noise is so big that it takes an enormous amount of time

for you to say anything about people's return. And certainly 10 years is not enough. So for a 10-year study, finding something like that, there's so much uncertainty. You can't say for certain whether or not individual investors are better than the market, and it could have just been charts. Now, having said all of that, oh, and then the other thing you talk about is high-frequency traders.

I would disagree with you. I don't think high-frequency traders are causing those big jumps. I think what's causing those big jumps, especially in very small stocks, are individual investors parting in to a stock that doesn't have a lot of float and the supply-demand imbalance causes a big spike in the price. And I'll talk about that in a second. High-frequency trading is not the full story. The turnover in stocks started before high-frequency trading started.

Now, obviously, high-frequency trading is a big contributor to that. But when you think about high-frequency trading, the way I think about it is it's really just replaced market makers. that what high-frequency traders really do is match buyers and sellers, but in a sophisticated way. Whereas in the olden days, a human being would stand there, now the high-frequency traders stay there. So it's not obvious that the high-frequency traders are a bad thing. And then to your final point now, what about an individual investor buy a small, not frequently traded stock? Couldn't an individual investor have an advantage there?

And yes, I agree with you. That is, if you're going to look for a place where an individual investor might have an advantage, that's where you would look. Because first of all, if the stock is small enough, the institutions, it's too small for an institution to invest. A, because there's not a lot of, the total supply is so small compared to the large institutions that they can't really take a position. but more importantly, these stocks are very illiquid, and institutions like to be illiquid

stocks. So you're right. There wouldn't be a lot of institutions in the stock, and by the same token, there wouldn't be a lot of analysts following the stock. So you would say, okay, since there's not a lot of information and there's not a lot of people following it, the competition isn't as strong, and so therefore individuals might have an advantage. All of that is true, but it still ignores the fact that you have to have skill, right? If you want to be able to find a good deal, you have to be skilled at it. And that skill is something that's in very short supply. So then you ask the question, if you're that skilled, why are you dabbling in small stocks? You can go and tell you, why did you go and compete with the big boys?

Because it's fun. It's fun. Right. Actually, that's exactly where I was going. That's exactly where I was going. So the answer is, what if you're a person who actually enjoys doing it? So you have a day job, but you actually love looking at companies, researching companies, buying stocks. Well, then in that case, you could think about it like putting in efforts where you don't need compensation for it. It's part of your recreation. And there you might have a competitive advantage because many people see it as effort. You don't see it as effort.

You're willing to work hard. So yes, in that particular case, and I tell my students, if you're the kind of person who really enjoys researching stocks, and you realize that unless you do something stupid, you shouldn't lose money, right? As long as you don't trade too much, so you're not paying a lot in transaction costs. Because worst case is, you're randomly picking stocks, and random stocks are going to do like the market. So if you are a little bit better at doing that, you probably could do better, but be very careful because there are many investors who fool themselves. And the biggest mistake they make is they trade too often. Because if you fooled yourself and you trade too often, you're going to be trading with somebody informed and then you will lose money. I agree with all of that. I appreciate you taking the three. A skilled interviewer wouldn't put three topics into one individual question, so I'll try to break it into one for this next one. I know you've done research on active managers and the skill and sort of where

that skill ends up, but you also said that 10 years is not nearly enough time to measure the skill of an investor. Let's say 10 years ago, we're at 2013. Since then, you've had a market cycle. You've had interest rates rise. You've had the COVID pandemic with stocks going down. How much time do you need then to separate luck from skill for investors? You need a very long time. And in particular, the world changes, right? So you could say, let's just start with a stock you could say what is the expected return i should get in the stock and you say well i need a very long time series let's say i let's say it's where a stock has been around for a very long time it's a bit too soon it's a hundred year old stock maybe a hundred

years is enough to measure the expected return the problem is that hundred years ago this company was so different to the company today you the data is irrelevant so you're stuck you need a long time series but then a long time series isn't going to work because there's a different company So, what you have to do is you have to attack the problem from a different perspective. What we do as financial economists is we build a model of what we think explains risk and return. And then we essentially say to the model, well, based on things other than the return of the stock, what would the model predict the expected return of the stock is?

would the model predict the um the skill of the manager is um now if the model is correct that will work you don't need anywhere near as enough data the model the models depend on volatility volatility very easy to measure because uh you know you don't need a lot of time to measure the volatility which is different from the volatility changing but let's just say the monitor isn't changed of something the volatility isn't changing you don't need a lot of data to measure the it. But of course, there the problem is, is the model correct? And unfortunately, we know for sure the model isn't correct. So the question really isn't, is the model correct? But is the model close enough to give us informed information? And I think today, I think in academics, there's

quite a debate about that. I was educated 35 years ago, back in the heyday, and so I'm still biased towards my education. And so I'm biased towards the view that the models do give us enough information to get informed estimates. But I think that a large fraction, maybe not half, But a large fraction of financial economists would disagree with me and say the models, you know, have failed so badly that they don't give us informed predictions on things like skill. and you know if you have that view which i don't but if you have that view then you're in a pretty pessimistic world because there's really no way then of figuring out you know who what are good companies and what a skill is or any of those questions i can see how believing that models don't work would make an academic's life or it would make if you're trying to measure these

things if you're trying to be an economist if you're trying to explain how things work in in the world would make things significantly more difficult. I want to spend some time on one of your studies, which was about active managers. Right now, they're sort of in the news a bit more as there's been hundreds of billions of dollars of outflows for a lot of these actively managed mutual funds. And I think your study found something surprising, which is that in a lot of cases, active managers are skilled and they do contribute value. But the surprising thing is where that value is actually captured yes i mean first of all that's one of the biggest myths uh perpetuated by academics but you know ubiquitously um uh believed which is that

active managers are not skilled you know we found overwhelming evidence that active managers are skilled and i should qualify that by saying that it's not that's not the same thing it's like every active managers skilled. And I'm not even the same thing that's saying, if I randomly pick a active manager, that manager will be skilled. What the data shows is that on average, managers are not actually skilled, but the skilled managers have all the money. So if you look at the average amount of money skilled managers make, you get a very large number because all the money is in the hands of skilled managers so large funds are managed by skilled managers now then you say to me well if they have all the skill how come investors don't

have higher returns when they invest with these skilled managers which is another well-established fact it investors do no better if they invest with a in a mutual fund with a skilled manager than if they invest in an index fund where supposedly there's no management. And the answer is, well, let's think back to all else equal thinking. Let's take the opposite. Let's assume that the investors did do better. Well, everybody wants to do better. Everybody will want to invest with the best managers.

And so like anything else in life, when a manager is picking a stock, They are, when managers pick stocks, they pick their best ideas first. We all do that. When we work, we do our best things first. So as more and more money flows in, they're going to worse and worse ideas. And so that drives down the alpha of the manager, the skill of the manager. And so since everybody wants a skilled manager, all the money is going to go to skilled manager. And when's that money going to stop?

It's going to stop when the manager is no longer delivering returns for investors. And so that equilibrium, that all else equal mistake, drives the return of all managers to the same, the same return, and assuming they're taking on market risk, to the market return. So all managers make the same once the market's in equilibrium, supply equals demand. But the difference is, of course, that the larger funds have more skilled managers. And since managers are paid as a fraction of the size of the fund, it means that managers of larger funds and more skilled managers make more money.

So the end result is all the skill the manager has goes to himself. He gets all the rents of the skill, which is exactly what we teach our students when they walk into their first economics course, their first microeconomics course. One of the very big insights in the first microeconomics course is that in a competitive market, when everybody's competing, only people with skill make money. People without skill, they get competed away. So it's exactly what you predict based on the standard insights in microeconomics. So I think one thing that also might be true for those managers as they get larger funds,

you can't really hunt with a pocket knife anymore. You have to hunt with an elephant gun if you're managing billions and billions of dollars. Yeah, but I mean, they're very good shots, the elephant gun. That's the way you have to think about it. I always use the example of Peter Lynch. You know, people, naive, if you don't think in equilibrium, if you make the all else equal mistake and you look at Peter Lynch's return, you'll find that in his first five years, he had a gigantic gross alpha.

And in his last five years, his gross alpha was essentially zero. A little bit higher, but essentially zero. And you might say, oh, Peter Lynch wasn't skilled. It was all luck. In fact, if you look at the size of the fund he managed, what you find is he was unbelievably skillful. The size of his fund was so much larger than any other fund at the time. It's astonishing that he was able to generate a positive alpha despite the fact that he was managing this gigantic fund. So it's a wonderful example of, yeah, Peter Lynch

had a lot of assets out of management, but he was very, very smart. And so he knew he could make money on all those assets. Whereas an average manager would never be able to make that much money on such a large fund. And I would say his portfolio grew from tens to hundreds to thousands of stocks under the Magellan Fund. And when you have thousands of stocks, it might be a little bit more difficult to follow the story for all of them. Or if you have a good pick, it'd be making a meaningful impact for the returns of a massive, massive fund. Yeah, absolutely. thing. One question I wanted to ask too, based on your study, is you found if you're an active manager and you're only looking for US equities, that's where it's going to be really hard to

compete. But is it ever worth paying for active management for international equities? Is there still room for an alpha that's worth paying for an individual investor? Well, first, let me take You step back and reemphasize. It doesn't matter. As long as you're dealing with a skilled manager, meaning a manager is managing a large fund, so you're at Fidelity, you're at T. Rowe Price, you're at Vanguard, you're at Capital Group, you're one of the big money managers, then the return you'll get from the manager will be the market return.

Maybe you're indifferent is the equilibrium. Now, you know, the question you're asking me is, well, what about international? Well, I don't see any difference. There's still going to be the same competition. I do think that it's pretty hard to invest internationally, even today. You know, there aren't that many brokers that can easily invest in international stocks. So having a manager who can facilitate that for you is good. But now, again, it's a question of do you want to index?

Do you want to get an ETF, an index ETF? Or do you want to have an active manager? The truth is, so long as you've got a skilled manager, you're going to make, on average, the same, whether you either go to the skilled manager or you go to the index. As always, people in the program may have interests in the stocks they talk about. And The Motley Fool may have formal recommendations for or against. so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.