A Wealth of Common Sense

In his book, A Wealth of Common Sense, Ben Carlson explains why the best investment plans use simple strategies with diversification and minimal trading. But his heart seems to be in trading. Maybe this makes his book most useful for those who are currently trading themselves into losses and need to be told to form a strategy that takes their own opinions out of the mix.

The section that best illustrates Carlson’s tendency to think like a trader comes late in the book and is titled “Vetting Your Sources of Financial Advice.” After explaining the problems with most pundits who make extreme stock predictions based on oil prices and other economic indicators, he recommends that you “look for balanced viewpoints that look at both the potential rewards and potential risks.” I’d say that the average investor is crazy to trade frequently in the first place, and no amount of looking for the right talking heads will help. But, if you can’t help yourself, at least take Carlson’s advice on avoiding the worst talking heads.

The bulk of the book contains solid advice. Fifty years ago, individual investors made up more than 90% of stock trading volume, but that has dropped to less than 5% now. It’s important to understand that your neighbour is not your trading competition. “Professional investors now control the markets.”

“In most areas of our lives, trying harder is great advice. But trying harder does not mean doing better in the financial markets. In fact, trying harder is probably one of the easiest ways to achieve below average performance.” Well said. Another good quote: “Stock picking is for home-run hitters who will likely strikeout.”

In paraphrasing Daniel Kahneman, Carlson says “Even smart people need to systematically weed out their irrational impulses, because intelligent does not mean rational.” This can be hard to admit to yourself, but I now see some of my own irrational tendencies.

Carlson has a tendency to overstate things, which can be confusing at times. One example is “there’s no such thing as passive investing.” In reality there are degrees of active/passive investing. It’s only when you decide to think in extremes that you get Carlson’s statement. All he means by this is that even passive investors have to make some decisions, particularly up front.

Most investors think of diversification among stocks as roughly meaning the number of stock you own. However, Carlson seems to mix this definition with a different one: the number of different strategies you use, such as factor tilts toward small caps or value stocks. He observes that trying to follow too many strategies can leave you with an expensive portfolio that isn’t much different from the broad market. For some reason, he calls this “overdiversification.” I’d call this self-imposed closet indexing. The problem is cost, not the degree of diversification.

“Investing really comes down to regret minimization.” I couldn’t make much sense of this one. I certainly don’t want to experience more regret than I have to, but this doesn’t dominate my investment choices. Staying well diversified certainly cuts down on the regret from selling a stock too soon or buying a bad stock. However, I avoid stock picking because I believe I’ll end up with more money by indexing, not to minimize my regret.

“The perfect portfolio or asset allocation does not exist.” My first thought was that among the many asset allocations I could choose, one of them will turn out to make the most money. All Carlson means is that you can’t know in advance which asset class will perform best, so you need to diversify.

“Diversification is worthless without rebalancing.” This is just way overstated. Rebalancing is a great way to control risk, but diversification still has value even if you never rebalance.

“No one has successfully figured out a way to arbitrage long-term thinking.” I’m not sure exactly what Carlson means by this, but investing for the long term is a form or arbitrage. The risk premium is unreasonably large and I exploit it by investing in stocks for the long term. If enough others think the same way, our collective arbitrage will shrink the risk premium.

“Emotional intelligence counts for much more than IQ.” Just as you need both your heart and your lungs, you need some IQ and some control over your emotions. So, on a certain level, there is no point in trying to decide which is more important. But if I had to choose my own mix, I certainly wouldn’t go for all emotional intelligence and no IQ.

“Most investors assume that benchmarking is mainly for measuring performance against the indexes to compare over- or under-performance against the market. But in the advisor-client relationship, the main reason for measuring performance and benchmarking is to improve communication between the parties.” I disagree. Better communication could be a side benefit, but the main purpose of benchmarking is to see how you’re faring against an appropriate mix of indexes.

“The only benchmark that matters is achieving your personal goals, not beating the market.” If the goal is to get people to accept market returns and not risk going for more, I can see why Carlson says this. However, I see too many stock pickers protect their egos by not benchmarking. I recently wrote a post explaining the subtleties of when benchmarking makes sense and when it doesn’t.

Overall, this book can be valuable for overconfident investors to see some the pitfalls they’re likely to encounter using complex strategies that rely on gut feel. If it had been around 15 years ago, it might have helped jolt me sooner out of the delusion that I could be a successful stock picker.