Motley Fool Money - 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

Hi everyone, I'm Charlie Cox. Join us on Disney Plus as we talk with the cast and crew of Marvel Television's Daredevil Born Again. What haven't you gotten to do as Daredevil? Being the Avengers. Charlie and Vincent came to play. I get emotional when I think about it. One of the great finale of any episode we've ever done. We are going to play Truth or Daredevil.

What? Oh, boy. Fantastic. You guys go hard. Daredevil Born Again official podcast Tuesdays, and stream Season 2 of Marvel Television's Daredevil Born Again on Disney Plus. 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 send them. 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 in pounds 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. Berkey Moldy 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 full 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 through the podcast is directed in favor or whatever the word is. Anyway, here's the reason. We think, and I can 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. 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 increase 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 not an obvious example of a business decision, but of course, it gets much more subtle. I mean,

you know, take, for example, ways. In the beginning, ways work very well because very few people are using ways. But then as everybody else, as everybody used ways, they all change their driving behavior. And so suddenly, there isn't an easy way to get, to get from A to B. It's another a simple example. But, you know, if you, if you, and we, in the podcast series, we, 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, you know, another way of thinking about Chappelleau might be the follower, not the leader. Maybe Chappellellate looks at the other food 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 are 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 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 a, you know, 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. You know, you may think, okay, I look at Michael Jordan's record. And if you look at the astonishing as the sound, Michael Jordan is something like 150th on the all-time list of free throws. And he's the greatest players ever played basketball. How does that work? Well, of course, that's all else equal thinking. Michael Jordan is the greatest player in Boston.

Well, everybody knew that. So they double covered Michael Jordan, right? So the fact he made 150th on the list, despite the fact that he was double covered a lot of the time is 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 into 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 in that beautiful example of all our SQL thinking. Yeah, I think you've, 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, you know, for a lot of stock. 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 don't want to be, I know you invited me to the show, and I don't want to point out to you on 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, invests are short term. The problem with that thinking is not realizing that if you are short term, you have to sell the stop. to something. 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 an wonderful example of the mistake of all-seql thinking. Oh, I didn't say that investors only care about the short term.

I said the average holding time for like an American holding stocks is less than a year. And yes, and so that definitely is true. One of the things that's happened over the, you know, 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. It 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 offer? 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, you know, 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 by a well-diversified portfolio, and I hold it. And I ignore the value of that portfolio.

It's of no interest to me. You know, I can't time the market. And I, you know, 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 let's, 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 case, 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, you're also, it's an alignment game. You might be playing a different game than those short-term traders. Yes. And you're making, you're making a very, very good point. So let me explain it, as I would say. and that is, look, when you trade with somebody, that is zero-suff, 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? 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. know more about the company than the person you're trading with. You might trade with somebody knows as little as you do, in which case, you need a 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'd give is don't trade. Because every time you trade, you expose yourself to the possibility of trading with somebody more information than you, more smart a minute. 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. You know, 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. You know, 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, you know, it exposes how little we as academics and financial economists really understand about markets. Well, I think that a lot of it's the alga traders. So you have your market makers and then there's a lot of algorithm-based trading, which I think, in my opinion, explain 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, you know, I work for

the Motley Fool. So I'm sort of 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%. And the reason being is that they're holding these mega-cap tech companies in a lot of cases like Apple, Tesla, and Vida. 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 that's when they should

theoretically be buying. Okay. Let me, as you said a lot. Let me unpack as much as I can. I look 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 how investors lose money. And so you might ask why. Well, first of all, the study makes a mistake there 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 to trade.

There's basically zero. I'm talking about the bit 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, it 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 any, thing about people's return. And certainly 10 years is not enough. So, you know, for a 10-year study, finding something like that is, you know, there's just so much uncertainty. You can't say for certain whether or not individual investors are better than the market. And, you know, could have just been charged. Now, having said all of that, oh, and then, The other thing you talk about is high frequency trade is, I would disagree with you. I don't think high frequency traders are causing those big jumps.

I think those big jumps, especially in very small stocks, are individual investors, you know, paring in to a stock that doesn't have a lot of floats, and, you know, the supply of 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, right? The turnover in stocks started before high-frequency trading started. Now, obviously, high-frequency trading is a big contributor to that. But when you see, when you think about high-frequency trading, the way I think about it is it's really just replaced market makers.

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. it's not obvious that the high-frequency traders are a bad. 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, 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 as a large institutions that they can't really take a position. But more importantly, these stocks are very illiquid, and institutions like to be in liquid stocks. So you're right, these stocks would be, 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 are not a lot of people following it. The competition isn't there 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 fight a good deal, you have to be skilled in 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, you know, why did you go and compete with the big boys? Because it's fun. It's fun.

Right. That's exactly where I was going. That's exactly where I was going. So the answer is, what if you're the person who actually enjoys it? So you have a day job, but you actually love looking at companies, research in companies buying stocks. Well, then in that case, you can think about it like putting in efforts where you don't have, you don't need compensation for it, just 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 don't pay 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 that.

And I appreciate you taking the three, you know, 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, you've done research on active managers and the skill and where, we're 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 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 start

with a stock. You could say, what is the expected return I should get in the stock? And you say, I need a very long time series. Let's say it's where a stock has been around for a very long time. Your auto system. It's a hundred-year-old stock. Maybe 100 years is enough to measure the expect return. The problem is that 100 years ago, this company was so different to the company today. The data is irrelevant.

So you're stuck. You need a long-time series, but 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, what based on things other than the return of the stock, what would the model predict the expected return of the stock is? What would the model predict the skill of the manager is? Now, if the model's correct, that will work.

You don't need anywhere near as enough data. The models depend on volatility. Volatility is very easy to measure because, 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 change of something the volatility isn't changing. You don't need a lot of data to measure the volatility. But of course, there the problem is, is the model correct? and, you know, 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, you know, 35 years ago back in the heyday, and so I'm still biased towards my education, And so I am biased towards the view that the models do give us enough information to get informed estimates. But I think that, you know, a large fraction, maybe not half, but a large fraction of financial economists would disagree with me and say the models 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, 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 in academics 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 the world, would make things significantly more.

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 is a lot of, 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 perpetuated by academics, but ubiquitously 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 that's not the same thing. It's like every active manager is skill. And I'm not even the same thing that's saying, if I randomly pick an active manager, that manager will be skilled. What the data shows is that the, 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, 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 skill managers, which is another well-established fact. Investors do no better if they invest in a mutual fund with a skill manager than if they invest in a index fund where supposedly there is loan 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,

managers, when a manager is picking a stock, when managers pick stocks, they pick their best ideas first. We all do that. When we work, we do our best things first. 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 skilled manager. And so since everybody wants a skilled manager,

all the money is going to go to skill 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 management. managers to the same, to the same return and, you know, assuming they're taking on market risk to the market return. So all managers make the same once you, 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 the managers of larger funds and more skill 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 of the elephant gun. That's the way you have to think about it. You know, 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 runs a 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 mouth, but 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 fan. And I would say his portfolio grew from tens to, hundreds to thousands of stocks under the Magellan Fund. 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 at making a meaningful impact for the returns of a massive, massive fund.

Yeah, absolutely. One question I wanted to ask, too, based on your study, is you found you, if you're an active manager and you're only looking for U.S. 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's still room for an alpha that's worth paying for an individual investor? Well, first, let me take a 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 in Fidelity, you're at Tiro Price, you're at Vanguard, you're at Capital Group. If you're one of the big, big money managers, then the return you'll get from the manager will be the market return.

Maybe, you know, maybe, you know, 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, there are not that many brokers that you can easily invest in international stocks. So having a manager who can facilitate that for you is good. Now, again, it's the question of do you want to index?

Do you want to get an ETF, an indexed ETF, or do you want to have an active manager? The truth is, so long as you've got a skill manager, you're going to make on average the same, whether you either go to the skill 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.