When it's hard to find a good trade, sometimes the best trade is no trade.
This is the subject of a new book by futures and hedge fund expert Jack Schwager. The title is "Market Wizards" and we sat down with Schwager recently to discuss investment strategy and new disruptive technologies.
Bobby Monks: You have written about "the importance of doing nothing" as a key component of investing successfully. For those unfamiliar with the concept, when conditions are unfavorable or when an investor can't identify opportunities for a good trade, the best bet is to do nothing. Why do so many investors, including professionals, have trouble adhering to this strategy?
Jack Schwager: Because doing nothing requires the patience of a saint. It is common for traders who develop good methodologies that signal trades infrequently to take other trades that lack the appropriate criteria because of a need "to do something."
There is a quote by Debussy that "music is the space between the notes."
Analogously, one can say that trading success is the trades not taken.
A great example is Kevin Daly, who, when I interviewed him for "Hedge Fund Market Wizards," had achieved a cumulative gross return of 870% in the 12 years since the inception of his fund in late 1999, a time interim during which the S&P  was about breakeven. And even though Daly is an equity hedge fund manager, implying a manager who trades both from the short and long side, shorts were always a very small part of his portfolio, almost invariably a single-digit percentage of the portfolio.
So how does a manager who pursues a near long-only strategy achieve a cumulative return of 870% in a net flat market? The answer is that in the two periods when equity indexes witnessed drawdowns approaching or exceeding 50%, Daly was largely out of the market.
Although Daly's stock selection contributed to his success, being out of the market when the environment was highly averse to his strategy was the key factor underlying his superior performance. Or, in other words, the trades not taken were more important than the trades taken.
B.M.: What is the biggest mistake that investors make?
J.S.: There are a lot to choose from, but perhaps the most serious and widespread mistake is to confuse future performance with past performance. Just like generals fight the last war, investors invest in the best past performers, a strategy that makes the giant and unjustified assumption that past performance is indicative of future performance.
Why is this a flawed approach? Consider an investor looking for a mutual fund with the best performance during recent years.
Odds are that the best performers will be sector funds in whatever was the hottest sector during that past time frame. But based on research detailed in my book "Market Sense and Nonsense," on balance, one would actually be better off choosing the worst-performing sectors or strategy categories for hedge funds than the best-performing ones.
Why would this be the case? The explanation is that any sector that has tremendously outperformed in recent years will tend to be overpriced and overinvested.
For example, an investor during the first half of 2014 might well have come up with energy sector funds as a great investment. By that point, however, the boom in oil prices had sown the seeds of its own destruction by spurring increased oil production, increased competition from alternative energy sources and reduced consumption.
Moreover, the very fact that investors flocked into energy funds based on recent past performance meant that the managers of these funds had to deploy the inflow of investor assets into this sector, causing energy stocks to become even more overpriced.
A similar situation exists for the market as a whole. Investors tend to shift increasingly into stocks after the market has performed extremely well for the five or 10 years and shun the market after dismal performance periods.
But the historical record clearly shows that investors would almost invariably do much better by following the exact opposite course.