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Don't make foolish decisions and you're already well ahead

Saturday, December 10, 2005

AVNER MANDELMAN

In his classic book What Works on Wall Street, Jim O'Shaughnessy back-tests several popular investing strategies, and concludes that successful investing is not rocket science. You simply must avoid doing what has low chances of success, and focus on actions whose success odds were found to be high.

This is both easier and harder than it sounds. Easier, because historical records of what didn't work are plentiful; and harder, because avoiding action means resisting temptation. Indeed, it often seems that money management is 90-per-cent self-management.

You want examples? Where to start?

For instance, it is well known that 90 per cent of all options (both calls and puts) expire worthless. Why then would you still buy an option? Because you think you'd be among the 10-per-cent few?

Good luck. Or how about selling short? Not only must you put up more capital than in a long, but your gain is limited, while your loss can be unbound; your short stock can be called; and long term the market goes up.

Can you still make money in a particular short? Yes. But over time, you are swimming against the tide.

Or how about buying a stock whose market capitalization is several times its sales? Jim O'Shaughnessy shows that, over time, this is a sure way to lose money.

Yes, your particular stock pick can be profitable. But why bet the low-probability odds? Over time you'll lose. In fact, the best money managers are not just those who can pick stocks better and do better due diligence -- although this is of course a large part of it. Rather, over time, those who succeed are those who avoid doing stupid things.

Only very few stocks are really worth buying, and only very few investment actions are really worth taking. All the rest are distractions.

In his book, Mr. O'Shaughnessy explains the process with a parable. Assume you live in a town that has only accountants and lawyers. Your tested database has only two facts: Eighty per cent of all lawyers (in Mr. O'Shaughnessy's town) are over six feet, and 80 per cent of all accountants are under six feet.

You are hired as a professional bettor -- you are given a stack of $10 bills, an office, and a telephone. Your job is to watch the door as a person walks in.

You can then press the "L" button if you think the person is a lawyer, or the "A" button if you think he or she is an accountant. If you are right, you win 10 bucks.

If you are wrong, you lose $10. You can also refuse to bet, but your year-end bonus depends on how your stack grows. Now, in walks a five-and-a-half footer. What do you bet? An accountant?

But wait. He is accompanied by a broker with a tip sheet whose bullet points say the following: This newcomer has won a dozen debating competitions, since language is his only passion. In fact, he failed math twice in college and had to take remedial classes to graduate.

What do you bet? Based on the broker's tip sheet and your gut feeling, you want to bet "L." Should you? Nope.

In the long run, says Mr. O'Shaughnessy, you should always bet the base-case--that is, the likeliest outcome. You should not ignore your gut -- you can, after all, avoid betting.

But betting against the base-case is foolish, no matter how convincing the presenter. The fact that you may have made money in the past in a high price/sales stock (or in options, or in a short) doesn't refute the rule.

Even in Mr. O'Shaughnessy's town there are some seven-foot accountants. But betting on them is playing the long odds. If you want to maximize your chances of becoming wealthy and staying so, a simple rule is: Don't do anything stupid with your investments -- don't take low-probability actions.

This comes close to Warren Buffett's "first rule" which says: Don't lose money. (His second rule, by the way, is: Never forget rule No. 1.)

Following this rule will in the long run save your assets.

Avner Mandelman is president and chief investment officer of Giraffe Capital Corp., a Toronto-based money management firm.

amandelman@giraffecapital.com