Pomona College finance professor and author Gary N. Smith, an expert on the statistical pitfalls of investing, knows the difference between a valid financial study and hokum.
Smith, who became a multimillionaire by investing in stocks, says luck often determines a stock’s good or bad performance and is quick to point out how the concept of regression to the mean comes into play.
Citing 10 financial surprises — five resulting from sound research and five nonsensical — he recently shared his latest insights on investing with ThinkAdvisor, including the impact of President Trump’s tweets on market movement.
Smith, who has a Ph.D. in economics from Yale University and taught there for seven years, was notably early in detecting the dot-com bubble.
His newest book, “The Phantom Pattern Problem: The Mirage of Big Data,” co-written with Jay Cordes, warns readers not to let data or offbeat investing strategies trick them. (His earlier book, “What the Luck: The Surprising Role of Chance in Our Everyday Lives” focused on the ways that chance can be misleading.)
The scholar, who’s married to Margaret Smith, CFP and principal of wealth management firm Prosperity Liftoff, told ThinkAdvisor that researchers and investors who fervently seek to beat the market often find correlations based simply on chance — but “think they’ve finally unlocked the market’s secret and that they’re going to get rich.
“All that shows,” he says, “is if they spend a lot of time looking for correlations, they’re bound to find one. It’s like flipping a coin and saying, ‘I got four heads in a row — that must mean something.’ It means you got lucky.”
Here are the highlights of our interview:
THINKADVISOR: Why do the first five surprises we’re going to discuss remain valid?
GARY N. SMITH: All of them had a logical basis and didn’t disappear. That is, when they were tested with fresh data, they still held up. They weren’t just temporary coincidences.
Why do stocks going out of the Dow Jones industrial average generally outperform the stocks that replace them?
This is an example of regression to the mean. When something does really well or really poorly, there’s probably either good or bad luck involved.
Athletes that win tournaments typically haven’t gone on to do well the next time. That’s because they were lucky the first time.
But what about stocks?
Companies doing poorly that go out of the Dow are probably not as bad as they seem — they’ve just been having bad luck. Companies coming into the Dow likely aren’t as good as they seem and will probably disappoint afterward.
You did a study on this. Can you describe it?
My students and I put together a portfolio of stocks going into and out of the Dow. The ones going out beat the ones going in by about 4% a year.
Several years later, we looked at the portfolio again, and everything held up. Coincidental things tend to disappear; things that are real tend to persist.
Another surprise you’ve cited — No. 2: Stocks with the most optimistic earnings forecasts typically do worse than stocks with the most pessimistic forecasts.
It’s likely that analysts are too optimistic or too pessimistic in their forecasts. For example, if they’re forecasting 30% earnings growth, it’s more likely that the best forecast is 10%.
We did a study of stocks over a 15-year period that looked at the ones with the most optimistic and the most pessimistic forecasts in a portfolio we put together.
What did you find?
Those with the most optimistic forecasts did worse than the ones with the most pessimistic forecasts. I replicated that study last year with new data. It still held up. The explanation, again, is regression to the mean.
Things that seem to be really far from average are in truth probably not that far from average. It’s just a little bit of luck that makes them seem better or worse than they are.
Here’s a third surprise: Stocks with clever ticker symbols beat the market.
A number of years ago, a study was conducted in which people were asked which stock symbols they thought were clever or cute. [The researchers] narrowed down the list and created a portfolio of these stocks. It beat the market by about 6% a year.
Around 10 years ago, my students and I did a study in which we found that these stocks were still beating the market by about 6%. I have a couple of ideas about the reason for that persistence.
What’s your thinking?
People remember a company with a cute ticker symbol.
For instance, WOOF for a company of veterinary hospitals [VCA, Inc.] did really well [because] when thinking about investing in the pet industry, you’re more likely to remember a stock with a clever ticker symbol.
Other examples of stocks that have done better than those with boring symbols are LUV [Southwest Airlines] and MOO [VanEck Vectors Agribusiness], a stockyard company.
What’s another possible reason for the good performance of stocks with clever ticker symbols?
It may be a sign that it’s a company with clever people working for it.
Here’s surprise No. 4: Stocks that make Fortune magazine’s “most admired” list beat the market — but stocks chosen in the business books like “Good to Great” and “In Search of Excellence” did not.
The stocks Fortune has on its “Most Admired” list tend to do better than the S&P 500. They survey thousands of people – analysts, CEOs, directors — about the companies [to get input] in several categories.
So that’s pretty much the ultimate scuttlebutt. You can’t get that stuff by looking at a balance sheet. But for those two books, the authors looked back at which stocks did well in the past and then tried to make up explanations for what they had in common.
What’s wrong with this?
There are always going to be a bunch of stocks that did well in the past.