Hindsight Bias Catches Up With Even The Best Of Us
By Roger Nusbaum, AdvisorShares ETF Strategist
Jim Cramer had a lot to say about ETFs the other day as recapped by Todd Rosenbluth at ETF.com. The biggest point seemed to be that Cramer isn’t a fan of the diversification ETFs offer. “Cramer questioned ETFs’ diversification benefits, noting that even an ETF could own a stock like Enron, which subsequently went bankrupt due to corrupt accounting.” Of course, he just as easily could have been talking about Worldcom from those days.
He seems to be invoking some hindsight bias as both companies were very widely owned as individual stock holdings with massive market caps before going bust. I don’t know whether Cramer ever recommended either name but a lot of people were recommending them back then. Similarly, many professional investors were recommending all sorts of “safe” financial companies in 2007 before many of them disappeared.
Cramer of course has touted all sorts of stocks in his 25 years in the public spotlight (I go back with him to the old Smart Money Magazine which he wrote for back then) including The Winners Of The New World which was his top “10 stocks for who is going to make it in the New World” from February 29th, 2000. Most of the names disappeared very shortly thereafter as the article posted less than two weeks before the NASAQ peak during the tech bubble. He also had some unfortunate timing with a buy recommendation on Bear Stearns on June 22, 2007 which of course also disappeared.
The point is not to trash Cramer or to say using individual stocks is a bad idea but the notion that anyone is perfectly infallible avoiding stocks that go on to fail is simply wrong. A modest weighting in an individual stock like Baltimore Opera Hat Company (fictitious name owned by Mr. Burns on the Simpsons) that goes on to disappear either from obsolescence, mismanagement or something else will be a drag whether it is owned individually or as part of a fund and while Cramer seems to assert failures in the making can always be avoided his track record is proof that they cannot.
To the extent Cramer is making an anti-diversification pitch, that is a valid portfolio strategy. There are many funds with 25-35 holdings, so concentrated portfolios, with excellent track records. But then there are plenty of funds that own hundreds of names with excellent track records.
Part of what Cramer is selling is the idea that you can always make some huge percentage gain every year no matter what and while a few investors do (literally a few), it is not a realistic objective and more importantly it isn’t even a necessary objective. Depending on the time frame you look at the average annual return of the stock market at 7% or 10% or whatever, which includes all the bear markets and down years, when combined with proper asset allocation, an adequate savings rate as well as minimizing self-destructive behavior is enough to get the job done.
From there, it boils down to choosing the best strategy for your tolerances and other particulars and then the best tools given what you think is your best strategy. Many investors would probably tell you their idea of best strategy includes not taking outsized risks but Cramer does not seem to be cognizant of this.