James P. O’ Shaughnessy wrote the perfect book for people who think that investing has to the risky, complex, and dangerous. It is also the perfect book for those who want to think that they can outsmart the market. This book has the academic and numerical proof that a passive or mechanical system of investing will in most cases beat a human system of investing.. . even professional investors such as fund managers. This book also explains why nine out of ten investors do not make money.
O’ Shaughnessy’s best-selling book is titled “What Works On Wall Street: A Guide to the Best Performing Investment Strategies of All Time”. O’ Shaughnessy distinguishes between two basic types of decision-making:
- The clinical or intuitive method. This method relies on knowledge, experience, and common sense.
- The quantitative or actuarial method. This method relies solely on proven relationships based on large samples of data.
O’ Shaughnessy found that most investors prefer the intuitive method of investment decision-making. In most instances, the investor who used the intuitive method was wrong or beaten by the nearly mechanical method. He quotes David Faust, author of The Limits of Scientific Reasoning, who writes, “Human judgment is far more limited than we think.”
O’ Shaughnessy also writes, ‘All (speaking of money managers) of them think they have superior insights, intelligence, and ability to pick winning stocks, yet 80% are routinely out performed by the S&P 500 index.” In other words, a purely mechanical method of picking stocks out performs 80% of the professional stock pickers. That means, even if you knew nothing about stock picking, you could beat most of the so- called well-trained and educated professionals if you followed a purely mechanical, non-intuitive method of investing. It is exactly as rich dad said: “It’s automatic.” Or, the less you think, the more money you make with less risk and with a lot less worry.
Other interesting ideas that O’ Shaughnessy’s book points out are:
- Most investors prefer personal experience to simple basic facts or base rates. Again, they prefer intuition to reality.
- Most investors prefer complex rather than simple formulas. There seems to be this idea that if the formula is not complex and difficult, it can’t be a good formula.
- Keeping it simple is the best rule for investing. He states that instead of keeping things simple, “We make things complex, follow the crowd, fall in love with the story of a stock, let our emotions dictate decisions, buy and sell on tips and hunches, and approach each investment on a case-by-case basis, with no underlying consistency or strategy.
- He also states that professional institutional investors tend to make the same mistakes that average investors make. O’ Shaughnessy writes, “Institutional investors say they make decisions objectively and unemotionally, but they don’t.” Here’s a quotation from the book Fortune and Folly. “While institutional investors’ desks are cluttered with in-depth analytical reports, the majority of pension executives select outside managers based on gut feelings and keep managers with consistently poor performance simply because they have good personal relationships with them.”
- The path to achieving investment success is to study long-term results and find a strategy or group of strategies that make sense. Then stay on the path.” He also states, “We must look at how well strategies, not stocks, perform.”
- History does repeat itself. Yet people want to believe that this time, things will he different. He writes, “People want to believe that the present is different from the past. Markets are now computerized, block traders dominate, individual investors are gone, and in their place sit money managers controlling huge mutual funds to which they have given their money. Some people think these masters of money make decisions differently, and believe that a strategy perfected in the 1950s and 1960s offers little insight into how it will perform in the future.”But not much has changed since Sir Isaac Newton, a brilliant man indeed, lost a fortune in the South Sea Trading Company bubble of 1720. Newton lamented that he could “calculate the motions of heavenly bodies but not the madness of men.”
- O’ Shaughnessy was not necessarily saying to invest in the S&P 500. He simply used that example as a comparison between intuitive human investors and a mechanical formula. He went on to say that investing in the S&P 500 was not necessarily the best performing formula, although it was a good one. He explained that in the last five to ten years, large cap stocks have done the best. Yet over the past 46 years of data, it was actually small cap stocks, companies of less than $25 million in capitalization, that have made the investor the most money.The lesson was, the longer period of time for which you had data, the better your judgment. He looked for the formula that performed the best over the longest amount of time.That is why his formula was to build businesses and have his businesses buy his real estate as well as his paper assets. That formula has been a winning formula for wealth for at least 200 years. Rich dad said, “The formula I use, and the formula I am teaching you, is the formula that has created the richest individuals over a long period of time.”Many people think the Indians who sold Manhattan Island, a.k.a. New York City, to Peter Minuit of the Dutch West India Company for $24 in beads and trinkets got a bad deal. Yet if the Indians had invested that money for an 8 percent annual return, that $24 would be worth over $27 trillion today. They could buy Manhattan back and has plenty of money left over. The problem was not the amount of money but the lack of a plan for their money.
- There is a chasm of difference between what we think might work and what really works.