Thou speakest wiser than thou art ware of.
Shakespeare, As You Like It
As regular followers know, I have been posting a series of blogs that will eventually amount to seven tips for investing based upon my foray into this world over the last decade or so. The last post was one which I knew would leave me frustrated and dissatisfied. The topic (Exploding the Myth of Buy and Hold Investing) is so vast so as to justifiably warrant treatment as a book. No blog entry (no matter how grandiloquent) could possibly suffice in adequately covering the subject. I found myself omitting point after point, for fear that each new issue would spawn several others which should logically be examined.
Reader Ruminations
I was already considering a follow-up blog attempting to fill in some of the larger gaps in my analysis, while clarifying and qualifying other points, when one of my more intellectually gifted friends posted the following comment:
Hi Mark,
Thanks to your posting, I have learned that I am a proud member of the Boglehead tribe. However, it is not because I believe the market is efficient and rational, as you suggest. In fact, I love reading the clever books by behavioral economists who demonstrate how irrational we all are. The problem is that I think it is just as hard to predict a crash as it is to predict a winning asset class (maybe harder). Thus for me, targeted short selling would likely be disastrous, especially given my lack of willingness to spend a lot of time researching. So, buying and holding low cost, diversified investments still seems like the least bad strategy (unless you have some great inside information you are willing to share!). As a way of illustrating my position, the last time I noticed your posting, it was in March, 2009 and you were giving the general advice to stay out of the market due to the pervasive financial uncertainty. Being a Boglehead who blindly feeds my 401K in all markets, I didn't listen to your advice and I now am a lot richer as a result. I am sure another crash is coming sometime and somewhere, but at this point, I am planning to continue to keep on Bogling. As a fall back, I plan to never retire.
I really enjoy your blog!
Happy Holidays! Joel Schmidt
A very thoughtful and articulate comment, thanks for the feedback, and Happy Holidays as well, Joel. Indeed, I believe there is no shame in being a proud Boglehead. He is not only one of the sharpest minds to have gained prominence on Wall Street, but he also has perhaps the purest heart (a far rarer trait in the world of finance). I have in the past referred to him as the (Living) Patron Saint of Investors. I highly recommend his books, most notably Common Sense on Mutual Funds.
Joel does bring up the most difficult element associated with NOT being a buy-and-hold-forever investor -- timing. Bogleheads correctly point out one actually has to be right about timing not just once, but twice: when to initially get in (out) of the market, and then when to get out (back in).
Let me be VERY clear about something. I do not (at least conventionally) in any way advocate market timing. Quite the contrary, I make virtually all of my investment decisions with a window of at least five, and usually closer to ten or fifteen, years. Despite making my living as an investor, I have gone almost six months at a time without executing a single transaction.
I depart from the Bogleheads in that I believe at the extremes (in terms of time, market sentiment and valuation), it behooves an investor to make discretionary buy and sell decisions. I would characterize my investing philosophy as buy-and-hold-until-the-asset-becomes-overvalued. Or maybe buy-and-hold-until-an-even-more-undervalued-asset-presents-itself. Given the unwieldy nature of either moniker, an imminent how-to book by yours truly is not in the cards.
Mania Mentality + Paltry Dividends = Market Avoidance Therapy
To specifically address Joel's comment, and while possessing no insider information whatsoever (actually resolutely classifying myself as an outsider), I think there are at least two ways in which to identify a coming market crash. The first is very unscientific, and which I have mentioned in the past - mania mentality. Investing should be about as much fun as watching paint dry. Slow, steady and relatively modest returns should be the norm. Similarly, investing in almost every normal era in American economic history is something off the radar screen of most individuals.
Conversely, when people experience stratospheric returns far in excess of long-term norms for a particular asset class, and/or when millions check the balance of their 401(k) account to gleefully take note of their capital gains more often than they check the weather forecast, these are signs that bubble mania is rampant. In times like those (say 2000 for stocks, and again with the housing market in the years thereafter), history shows us that even over the medium-term (say 5-15 years), one is better off avoiding the asset class in question.
The second, more scientific, method for identifying overvalued assets is to look at relevant quantitative data. I will admit that for the lay investor who does not want to devote much time managing her portfolio, most of these numbers will be too arcane. Specifically, as a deep value investor, I look to such metrics as price-to-book, price-to-cash flow, price-to-earnings growth, and the like. But let me give you one quantitative measure that is accessible and (hopefully) understandable to the lay investor: dividend yield.
For many decades, dividends made up half, and oftentimes more, of the total returns that investors received (capital appreciation being the other component). Between 1945 and 2001 the dividend yield for the overall US stock market averaged 4.1%. When dividend yields come down dramatically, this is almost invariably the hallmark of an overvalued market that is destined to fall.
An Illuminating Illustration
Let me use an example to help demonstrate why this is the case. Let us assume that ACME Inc. is a hypothetical company which is huge and diversified. As such, its stock price is representative of the market as a whole. At the beginning of Year 1, it is selling for $25/share and pays a dividend of $1 (hence a 4% dividend). That same year, investment fever begins to spread throughout the country (since this is a hypothetical, pretend the last 10 years never happened and that investors are not so shell-shocked) and the economy is deemed quite healthy. ACME's stock price jumps, closing out the year at $40.
Now this is an important point, and one of the reasons why dividend yield can be a helpful valuation tool for assessing stock markets -- companies do not tend to increase or decrease their dividends significantly from year to year. This is unlike almost every other investment metric that can vary wildly (stock price, PE ratios and earnings being the most notable). Even after a blockbuster year, companies are loath to significantly boost dividends. This is because dividends are generally paid from the free cash flow, and companies do not want to overextend should their fortunes quickly reverse. When a company announces a dividend cut, this is seen by the market as a sign that it must be in dire straights. The market usually punishes such an announcement with a marked drop in its stock price. Therefore, in a great year, a company like ACME might increase its dividend a fairly modest 5%, to $1.05. This leaves the dividend yield at the end of Year 1 at 2.6% (dividend of $1.05 divided by its stock price of $40).
In Year 2, market madness continues. ACME's stock ends the year at $65, and the rest of the market moves up at a similar pace. After another great year, ACME boosts its dividend to $1.10, driving its yield down to 1.7%.
Finally, in Year 3, as investors everywhere are building castles in the air, ACME's stock soars to $105. After another solid year of earnings, the company boosts its dividend to $1.16/share. But now the yield has plunged to a scant 1.1%.
So, what is an investor to do? A typical lemming would, after all the amazing returns had been already achieved, plunge as much money into stocks like ACME as possible.
The buy-and-hold-forever investor would have already achieved great returns owning ACME and other stocks like it in broad-based index funds throughout it stock price ascendancy. However, this same investor would continue accumulating the ACME's of the market (even after a 300% price appreciation) every payday in her 401(k)/IRAs/brokerage accounts.
The contrarian/buy-and-hold-until-the-asset-becomes-overvalued investor would bail, concluding that the combination of bubble mania, as evidenced by market psychology, and terrible valuations, as measured by dividend yields and other metrics, create an awful prognosis for ACME and comparable companies going forward.
Back to (Harsh) Reality
Now the dividend and price appreciation numbers used in the aforementioned example were not selected haphazardly. For simplicity purposes I condensed the time frame, but between 1990 and 2000, the S&P 500 also increased more than fourfold in price, while its dividend yield plunged from 4% to a paltry 1.1% (an all-time low). This was about as close to a clarion call for an asset bubble as one could ever expect to see.
Please note that the superiority of contrarian investing over the buy-and-hold-forever approach is not remotely based on precise market timing. I stopped buying US equities at the end of 1998, more than a year before the S&P peaked. As such, I missed out on one of the S&P 500's best years, watching from the sidelines as it gained more than 20% in 1999. But when the market tanked (which it always does after an asset bubble emerges), I and my contrarian ilk were quite happy to have forgone the final ephemeral burst of gains as the market sine curve reached its apex.
The lack of importance of market timing (at least as measured by reasonably short durations of time) for contrarians such as myself is further highlighted by the fact that even after the S&P temporarily bottomed in October 2002, I did not purchase any US equities (other than select energy and mining stocks whose performance was largely unrelated to the overall US market). Why? Even at much lower price levels, US stocks did not represent a good value proposition. The dividend yield for the market did not even rise to 2%. Moreover, as detailed in other posts below, another asset bubble was fomenting in the residential real estate market. This was artificially propping up the US economy (which from a fundamental perspective looked disastrous). Accordingly, it appeared obvious that lower lows were coming for US stocks. So long term, patient contrarians such as myself watched as the market went up more than 70% in the next five years, convinced this was the mother of all headfakes in the market.
Essentially this "ought" decade was a lost one for equity investors in all three of the major markets (US, Europe and Japan). Actually, any investor who avoided investing the the US stock market after August 1996 would have been rewarded by having a lower entry point on her investment. This again highlights how unimportant market timing is. Well, let me qualify that. A colleague of mine once coined the term "meta-market timer" to describe me after hearing my approach. I think that is fair. With a decade-long time horizon, I think a diligent and enlightened investor is able to identify both attractive and unattractive assets from a valuation perspective and act accordingly.
I should note that while I have personally engaged in the short-selling of assets I deemed to be overvalued, particularly in 2000 and 2007/2008, that it would, as Joel correctly mentions, be a disastrous approach for 99%+ of investors. Rather, the strategy I advocate for almost everyone is simply to avoid these overpriced assets if you do not have them, and sell them if you do. One only has a limited supply of money to invest, so why tolerate exorbitantly priced assets in one's portfolio? Or, looked at slightly differently, why would one not want to sell and reap the profits when asset prices are dear?
Of Automaton Investing and Lost Opportunity
This segues into my last criticism of the buy-and-hold-forever approach. It treats broad-based (generally US) stock and bond indices as the only asset classes investors should consider. Even before I disavowed my membership as a Boglehead, I recall reading in his book on mutual funds that an investor should not look any further than within our borders for investment opportunities. This is sort of like a prospective auto buyer arbitrarily limiting herself to only purchasing Jeep brand vehicles (apologies to any Jeep owners out there).
There is a huge opportunity cost associated with restricting one's investments to total market stock and bond index funds, particularly when one further limits their holdings to US based assets. For instance, while investing in broad-based equity indexes was dead money (or worse) in the last decade, it was a spectacular time to be invested in precious metals (gold in particular was up 300%+), energy, agricultural commodities, industrial metals, and companies producing all of these assets. Emerging markets also performed very well vis-a-vis more developed markets. Some of the best opportunities in currency markets also presented themselves (shorting the dollar and pound, going long the Canadian dollar and yen).
When an investor limits oneself to a narrow spectrum of investments, buying those assets every payday no matter what the cost, and then does not sell even when prices obtain dizzying heights, she will inevitably achieve suboptimal returns. These returns will almost invariably best those of the lemmings, as well as those achieved by investors relying upon expensive, fatuous financial services professionals. Hence, as mentioned in my last post, buy-and-hold-forever investing is the "least bad" approach to managing one's finances that does not depend upon some level of valuation analysis.
Now What Did I Say Again?
One problem with writing a blog with the limited intellectual resources yours truly possesses is remembering what I penned. Joel correctly noted that Bogleheads have been rewarded since the market lows in March by having money in stocks. His recollection was that at that time I was encouraging people to stay out of the market.
I looked back upon my posts during that time. I was certainly blustering invectives against the moronic policies of both the federal government and the Federal Reserve, arguing that these actions would be counterproductive to the long term health of our economy. I also contended that these policies would be largely futile in terms of affecting the real economy even in the short-term, and with unemployment at 10% and underemployment at 17%, I stand by that assessment. I also mercilessly took Wall Street to task for its rank hypocrisy in advocating government bailouts of the financial services industry, while for decades arguing that the government should refrain from intervening in the free markets when it better suited their interests.
But I could not find anything imploring investors to stay out of the stock market. Indeed, the most recent post relating to specific investment advice I could come across was from February 4, entitled Portfolio Reclamation Project. In that blog entry, I first commented upon the nature of the 45% market crash from its October 2007 peak. I then made three specific buy recommendations: TIPS (up more than 8 1/2% while comparable long-term treasuries are down almost 20%), gold (up about 23%) and (for the first time since 1998!) high quality stocks. I was specifically bullish on Microsoft (up 64% compared to a 30% increase in the S&P 500 index).
Why the change from my bearishness expressed as recently as July 2008? Attractive valuations!!! For instance, the market crash drove dividend yields for the S&P 500 up to 3%+ for the first time since 1991! To add icing to the cake, rock bottom stock prices were coupled with a contrarian's dream - horribly negative sentiment. Virtually nobody wanted to own stocks. Baron Rothschild back in the 18th century is reputed to have said, "Buy when there is blood in the streets." This investment advice has withstood the test of time, and is just an extension of my first tip -- do not run with the crowd/lemmings. It is almost without exception in your financial self-interest to zig when others zag and vice-versa (at least when sentiment extremes of despair and euphoria manifest themselves). So I was backing up the dump truck and loading my portfolio with plenty of stocks that were selling for bargain basement prices (most of them were not US stocks, but many were).
The Best of Both Worlds
So I certainly do not fault Joel's analysis that by staying in the market and adding to his positions no matter what market conditions present themselves, he is richer for it since March. But so are those of us who are contrarians and saw the market crash as a tremendous buying opportunity. An important difference is that those of us who were out of the stock market when prices were exorbitant did not see a 50% haircut in our stock portfolios between late 2007 and March of this year. Investing really is as easy as "buy low, sell high."
I do not expect to post another entry until after Christmas, so let me wish everyone a very blessed and joyous holiday season!!
Thursday, December 17, 2009
Thursday, December 10, 2009
Tip #3: Exploding the Myth of Buy and Hold Investing
"Those who live in glass houses shouldn't throw stones." American Proverb
"Gentle Reader." Now this is a term/literary device whose usage was last prevalent during the Victorian era. But in the century or so since, it has been increasingly out of favor in the world of literature. People generally find it to be bracing and intrusive to a narrative, taking them out of the moment, if you will. But I have always been rather fond of authors who make use of of it. To me, there is both an intimacy and a fondness connoted when I read it.
Why wax nostalgically upon an archaic literary device that most contemporary readers dislike while penning a blog about investing? Well, Gentle (and hopefully patient) Reader, I found a most embarrassing error several days after posting my last blog. While fulminating at the incompetency rife throughout the financial services industry, I noted that those employed therein were largely, among other unflattering nouns, "imbiciles." While being the only word that was misspelled in my last missive (and corrected since then), the irony of this particular faux pas is not lost upon me.
Now who knows? Perhaps no one made it to the eighth paragraph to even spot my blunder. I would like to think, however, there were those that saw it and refrained from sending me a rather pointed comment noting the extent of my intellectual failings. That was kind.
But on to the third tip of seven regarding the investing lessons I have learned. From my perspective this is the most important of the series and will be perhaps the most controversial.
There is a certain type of smug investor who I am sure is fully on-board with my first two investing tips (in short, they are 1) avoid following the crowd and 2) eschew expensive financial products/professionals). This investor has read the books proving most people lose money by using a "rear-view mirror" approach to investing (what was the hot performing stock/mutual fund/sector/country last year?) as well as the fact that Wall Street as a whole does not beat the market.
Accordingly, this investor resolutely advocates that the only sensible investing strategy is to simply buy a suitably comprehensive low-cost index fund (say the S&P 500, or, better yet, the Wilshire 5000), and hold it until one needs the money in retirement. Sometimes called "Bogleheads" (after John Bogle, the revered founder of the Vanguard Group and stalwart proponent of index-fund investing), these individuals are among the most stoic and disciplined investors on the face of the planet. Whether markets are deemed to be high, low or in between, they just keep contributing to their 401(k), IRA and/or brokerage accounts every payday.
Undergirding the supreme confidence these investors have in the superiority of their approach is the devotion to the concept of "efficient markets." In brief (sorry for the foray into macroeconomics for those of you who eschewed the stuff in college), the efficient markets theory posits that whatever the price of a particular asset or index is at any given time, it is the "right" price. By that I mean that it reflects all the relevant publicly available information. Hence, any attempt by naive investors (such as myself) to proclaim that certain assets might be bargains, while others are overpriced, is unprofitable guesswork.
Why? Because any information/insight that I am using (assuming I am not acting upon illegally obtained insider information) is available to everyone else in the marketplace. So if I see an asset selling for $10 that is really worth $11 based upon its intrinsic value, one of two things will happen according to those who adhere to the efficient markets theory. The price could immediately jump to $11 if my belief that the asset is undervalued is predicated on sound information and analysis, as everyone else in the marketplace would see the same opportunity. While there might be a few quick traders who make a buck as the market price almost immediately jumps to $11, the vast majority of investors would be unable to profit. Alternatively, if my analysis is incorrect due to either false information or faulty thinking, I will make no profit and the market price will stay at $10.
For those self-satisfied Bogleheads out there, the fact that every year some hot fund managers beat the market does not in any way shake their confidence that trying to outsmart the market is a loser's game. They very calmly note that any bell distribution curve representing all active mutual fund managers would have at the far right hundreds of individuals whose seemingly extraordinary performance is explained by pure chance. They are in essence the coin-flipping monkey who tosses heads eight times in a row; a rare event, but one that has nothing to do with inherent skill. After all, two, and even three standard deviation events happen all the time in the real world.
I know the psychology of Bogleheads so well you see, because I used to count myself as one of them. Between 1998 and the early part of 2000 I was supremely confident that trying the beat the market yourself, or, worse still, paying some financial adviser to do the same, was futile. However, let me assure you that after being an investor over the course of the most tumultuous decade in finance since the 1930's, I am absolutely convinced that the "buy and hold forever" investor achieves less than optimal returns.
Before considering the evidence, I want to challenge the analytical underpinnings and assumptions that form the basis of efficient-markets theory. The most important viewpoint with which I take issue relates to the market itself. As noted above, the buy and hold investors look at the market as sort of an omniscient deity; the manner in which it prices assets is always "right," reflecting the collective wisdom of all market participants, who in turn are acting both with access to all relevant information and in their own economic best interests. This last assumption means people are "utility maximizing individuals," or, more plainly stated, that we generally act in a rational manner so as to increase our own wealth. This has been a core assumption of orthodox modern economics for many years.
After being an investor for over a decade, I have a very different view of the market. Rather than the accretion of the best and brightest market participants, whose wisdom exceeds any single actor or even set of actors, I posit that oftentimes the market is more accurately an aggregation of stupidity, naivete, impetuousness, and short-sighted thinking. Quite a stark contrast to the orthodox view, I must admit. Now I should qualify this view to some degree. Specifically, as the asset markets veer to the extremes in prices, the market itself is governed less by profit-maximizing, rational thinking. Rather animal spirits (greed in the time of raising prices, and fear in the time of declining prices) grip most market actors and induce them to act in ways that are not in their own long-term economic self-interest (but is very much in the interest of contrarian investors who take the other side of their trades).
As I mentioned, I was a staunch believer in efficient-markets theory and had been so since my sophomore year in college when I read A Random Walk Down Wall Street for my Macroeconomics class. My Road to Damascus experience came in the Spring of 2000. Specifically, the day was March 10, 2000. I was sitting at my desk trying to draft a legal brief, but my mind was on the other side of the continent. In NYC, the NASDAQ had just surpassed 5000 (almost 10 years later it is trading for less than 45% of that level)! For those of you who may not have been following investing back then, this capped an unsurpassed rise for the NASDAQ from a low of 1200 less than three years previously. No major stock index had ever increased by more than 315% in 35 months.
My intellectual worlds were colliding in a most irreconcilable manner. My college and graduate economics background was telling me that the prices levels for the NASDAQ and the high-flying stocks of which it was composed must be justified and sustainable. Why? Because that is what the market was saying.
But just like Keyes (played brilliantly by Edward G. Robinson) in the film masterpiece Double Indemnity, I had this "little man" inside of me, telling me something was amiss. Nothing made sense. The vast majority of companies seeing really stratospheric increases in their stock prices were the ones that made no actual profit, much less paid any dividend. When I queried my friends who owned many of these stocks as to the nature of their businesses, I often received smug, but vacuous, remarks about how XYZ.com was using the internet to leverage its sales. But sales of what? Many of these investors did not really understand what these companies were specifically hoping to do.
This March day was largely wasted from a billing hours perspective, but was transformative for me as an investor. Eventually I concluded that, despite everything I had taken away from my academic training, it was possible to "outsmart the market." At least at that point in time, where greed and the desire for fast riches seemed to be blinding people to the fact that speculation, as opposed to investing, usually ends in tears. Hence, I placed my first short order (an investment whereby you make money if the price of a stock goes down, but lose money should the stock price appreciate) that same day.
In the decade since that time, I have found that the market has repeatedly "mispriced" a plethora of assets: the overinflated US Dollar, cheap gold, undervalued emerging market equities, overvalued real estate, overly affordable industrial and agricultural commodities, as well as expensive (October 2007) and then cheap (March 2009) stocks. Fabulous opportunities to both buy and sell various assets have consistently presented themselves throughout this most tumultuous decade.
Before closing, let me briefly examine the perils of buy and hold investing. Its proponents point to the fact that over very long periods of time, one would not have lost money investing in a broad US stock index, assuming dividends were reinvested, during any twenty-year time period in the stock market's history. I think there are many investors who find that to be cold comfort after seeing what happened in 2000, and then again in 2008. Importantly, had an investor bought the S&P 500 index ten years ago and held it through the middle of this year, she would have zero capital appreciation to show for it. Once inflation is factored in, the investor would have lost purchasing power on her investment even if dividends are considered. During that same time period gold (a most despised, and hence incredibly attractive, asset in 1999) has increased in value four-fold.
Another example showing the pitfalls of buy and hold investing relates to a question I used to pose to people in the era of the tech crash of 2000. I would ask, "What is the longest period of time one could have invested in the broad US market and received zero capital appreciation in real (inflation-adjusted) dollars?" Back in 2000 people were still very unaccustomed to sub-par returns in the stock market. Answers I received varied from as little as 3-5 years, all the way up to about 15 years. The correct answer - 55 years (1929-1984). That is a long time to be patient. While the proponents of buy and hold investing will point out that in the "long-run" people have never lost money in the markets using their approach, I am reminded of John Maynard Keynes observation that, "in the long run we're all dead."
The moral of the story? Buy and hold investing is terribly flawed and will cost you large sums of money if you are buying and/or holding over-valued assets!! Do not misunderstand. Buy and hold investing is superior to almost all other market strategies. And if you are going to make an investment mistake, this is probably the least bad one to make. But one will be far better off eschewing assets when they are being bid up beyond price levels justified by sound fundamental valuation analysis.
"Gentle Reader." Now this is a term/literary device whose usage was last prevalent during the Victorian era. But in the century or so since, it has been increasingly out of favor in the world of literature. People generally find it to be bracing and intrusive to a narrative, taking them out of the moment, if you will. But I have always been rather fond of authors who make use of of it. To me, there is both an intimacy and a fondness connoted when I read it.
Why wax nostalgically upon an archaic literary device that most contemporary readers dislike while penning a blog about investing? Well, Gentle (and hopefully patient) Reader, I found a most embarrassing error several days after posting my last blog. While fulminating at the incompetency rife throughout the financial services industry, I noted that those employed therein were largely, among other unflattering nouns, "imbiciles." While being the only word that was misspelled in my last missive (and corrected since then), the irony of this particular faux pas is not lost upon me.
Now who knows? Perhaps no one made it to the eighth paragraph to even spot my blunder. I would like to think, however, there were those that saw it and refrained from sending me a rather pointed comment noting the extent of my intellectual failings. That was kind.
But on to the third tip of seven regarding the investing lessons I have learned. From my perspective this is the most important of the series and will be perhaps the most controversial.
There is a certain type of smug investor who I am sure is fully on-board with my first two investing tips (in short, they are 1) avoid following the crowd and 2) eschew expensive financial products/professionals). This investor has read the books proving most people lose money by using a "rear-view mirror" approach to investing (what was the hot performing stock/mutual fund/sector/country last year?) as well as the fact that Wall Street as a whole does not beat the market.
Accordingly, this investor resolutely advocates that the only sensible investing strategy is to simply buy a suitably comprehensive low-cost index fund (say the S&P 500, or, better yet, the Wilshire 5000), and hold it until one needs the money in retirement. Sometimes called "Bogleheads" (after John Bogle, the revered founder of the Vanguard Group and stalwart proponent of index-fund investing), these individuals are among the most stoic and disciplined investors on the face of the planet. Whether markets are deemed to be high, low or in between, they just keep contributing to their 401(k), IRA and/or brokerage accounts every payday.
Undergirding the supreme confidence these investors have in the superiority of their approach is the devotion to the concept of "efficient markets." In brief (sorry for the foray into macroeconomics for those of you who eschewed the stuff in college), the efficient markets theory posits that whatever the price of a particular asset or index is at any given time, it is the "right" price. By that I mean that it reflects all the relevant publicly available information. Hence, any attempt by naive investors (such as myself) to proclaim that certain assets might be bargains, while others are overpriced, is unprofitable guesswork.
Why? Because any information/insight that I am using (assuming I am not acting upon illegally obtained insider information) is available to everyone else in the marketplace. So if I see an asset selling for $10 that is really worth $11 based upon its intrinsic value, one of two things will happen according to those who adhere to the efficient markets theory. The price could immediately jump to $11 if my belief that the asset is undervalued is predicated on sound information and analysis, as everyone else in the marketplace would see the same opportunity. While there might be a few quick traders who make a buck as the market price almost immediately jumps to $11, the vast majority of investors would be unable to profit. Alternatively, if my analysis is incorrect due to either false information or faulty thinking, I will make no profit and the market price will stay at $10.
For those self-satisfied Bogleheads out there, the fact that every year some hot fund managers beat the market does not in any way shake their confidence that trying to outsmart the market is a loser's game. They very calmly note that any bell distribution curve representing all active mutual fund managers would have at the far right hundreds of individuals whose seemingly extraordinary performance is explained by pure chance. They are in essence the coin-flipping monkey who tosses heads eight times in a row; a rare event, but one that has nothing to do with inherent skill. After all, two, and even three standard deviation events happen all the time in the real world.
I know the psychology of Bogleheads so well you see, because I used to count myself as one of them. Between 1998 and the early part of 2000 I was supremely confident that trying the beat the market yourself, or, worse still, paying some financial adviser to do the same, was futile. However, let me assure you that after being an investor over the course of the most tumultuous decade in finance since the 1930's, I am absolutely convinced that the "buy and hold forever" investor achieves less than optimal returns.
Before considering the evidence, I want to challenge the analytical underpinnings and assumptions that form the basis of efficient-markets theory. The most important viewpoint with which I take issue relates to the market itself. As noted above, the buy and hold investors look at the market as sort of an omniscient deity; the manner in which it prices assets is always "right," reflecting the collective wisdom of all market participants, who in turn are acting both with access to all relevant information and in their own economic best interests. This last assumption means people are "utility maximizing individuals," or, more plainly stated, that we generally act in a rational manner so as to increase our own wealth. This has been a core assumption of orthodox modern economics for many years.
After being an investor for over a decade, I have a very different view of the market. Rather than the accretion of the best and brightest market participants, whose wisdom exceeds any single actor or even set of actors, I posit that oftentimes the market is more accurately an aggregation of stupidity, naivete, impetuousness, and short-sighted thinking. Quite a stark contrast to the orthodox view, I must admit. Now I should qualify this view to some degree. Specifically, as the asset markets veer to the extremes in prices, the market itself is governed less by profit-maximizing, rational thinking. Rather animal spirits (greed in the time of raising prices, and fear in the time of declining prices) grip most market actors and induce them to act in ways that are not in their own long-term economic self-interest (but is very much in the interest of contrarian investors who take the other side of their trades).
As I mentioned, I was a staunch believer in efficient-markets theory and had been so since my sophomore year in college when I read A Random Walk Down Wall Street for my Macroeconomics class. My Road to Damascus experience came in the Spring of 2000. Specifically, the day was March 10, 2000. I was sitting at my desk trying to draft a legal brief, but my mind was on the other side of the continent. In NYC, the NASDAQ had just surpassed 5000 (almost 10 years later it is trading for less than 45% of that level)! For those of you who may not have been following investing back then, this capped an unsurpassed rise for the NASDAQ from a low of 1200 less than three years previously. No major stock index had ever increased by more than 315% in 35 months.
My intellectual worlds were colliding in a most irreconcilable manner. My college and graduate economics background was telling me that the prices levels for the NASDAQ and the high-flying stocks of which it was composed must be justified and sustainable. Why? Because that is what the market was saying.
But just like Keyes (played brilliantly by Edward G. Robinson) in the film masterpiece Double Indemnity, I had this "little man" inside of me, telling me something was amiss. Nothing made sense. The vast majority of companies seeing really stratospheric increases in their stock prices were the ones that made no actual profit, much less paid any dividend. When I queried my friends who owned many of these stocks as to the nature of their businesses, I often received smug, but vacuous, remarks about how XYZ.com was using the internet to leverage its sales. But sales of what? Many of these investors did not really understand what these companies were specifically hoping to do.
This March day was largely wasted from a billing hours perspective, but was transformative for me as an investor. Eventually I concluded that, despite everything I had taken away from my academic training, it was possible to "outsmart the market." At least at that point in time, where greed and the desire for fast riches seemed to be blinding people to the fact that speculation, as opposed to investing, usually ends in tears. Hence, I placed my first short order (an investment whereby you make money if the price of a stock goes down, but lose money should the stock price appreciate) that same day.
In the decade since that time, I have found that the market has repeatedly "mispriced" a plethora of assets: the overinflated US Dollar, cheap gold, undervalued emerging market equities, overvalued real estate, overly affordable industrial and agricultural commodities, as well as expensive (October 2007) and then cheap (March 2009) stocks. Fabulous opportunities to both buy and sell various assets have consistently presented themselves throughout this most tumultuous decade.
Before closing, let me briefly examine the perils of buy and hold investing. Its proponents point to the fact that over very long periods of time, one would not have lost money investing in a broad US stock index, assuming dividends were reinvested, during any twenty-year time period in the stock market's history. I think there are many investors who find that to be cold comfort after seeing what happened in 2000, and then again in 2008. Importantly, had an investor bought the S&P 500 index ten years ago and held it through the middle of this year, she would have zero capital appreciation to show for it. Once inflation is factored in, the investor would have lost purchasing power on her investment even if dividends are considered. During that same time period gold (a most despised, and hence incredibly attractive, asset in 1999) has increased in value four-fold.
Another example showing the pitfalls of buy and hold investing relates to a question I used to pose to people in the era of the tech crash of 2000. I would ask, "What is the longest period of time one could have invested in the broad US market and received zero capital appreciation in real (inflation-adjusted) dollars?" Back in 2000 people were still very unaccustomed to sub-par returns in the stock market. Answers I received varied from as little as 3-5 years, all the way up to about 15 years. The correct answer - 55 years (1929-1984). That is a long time to be patient. While the proponents of buy and hold investing will point out that in the "long-run" people have never lost money in the markets using their approach, I am reminded of John Maynard Keynes observation that, "in the long run we're all dead."
The moral of the story? Buy and hold investing is terribly flawed and will cost you large sums of money if you are buying and/or holding over-valued assets!! Do not misunderstand. Buy and hold investing is superior to almost all other market strategies. And if you are going to make an investment mistake, this is probably the least bad one to make. But one will be far better off eschewing assets when they are being bid up beyond price levels justified by sound fundamental valuation analysis.
Wednesday, December 2, 2009
Tip #2: Avoid being Devoured by the Parasites
Light gains make heavy purses - Francis Bacon
Well, as usual my ambition exceeded my accomplishments when it comes to this blog. I had hoped to have posted two or three more entries since Thanksgiving. But the combination of holiday travel, a new fitness/health regimen, trying to keep up with the many developments in the investment world and (admittedly) procrastination have caused me to fall behind schedule. My apologies.
Over the long weekend the financial markets were roiled by what looked to be a massive debt default (well, temporary suspension of payments is how the debtor preferred to characterize it) in Dubai. This seemed to remind investors that, while financial/asset markets have vigorously bounced since last Winter, problems continue to manifest themselves in the real global economy. Over-capacity and slack demand are ongoing issues around the world. Unemployment continues to plague the US, Europe and much of Latin America. While governments across the continents continue to engage in unprecedented deficit spending, the private sector continues to exhibit signs of economic malaise.
As a brief aside, there is a high correlation between coming asset busts and grandiose building projects. Dubai is presently constructing the Burj Dubai, slated to be 162 floors! This will eclipse the height of the current tallest building in the world (the Taipei 101 Tower) by over 1000 feet. Plans for constructing the Taipei 101 Tower in turn occurred prior to the global tech bust of 2000. Up until Taiwan's behemoth building was erected, the Petronas Towers in Kuala Lumpur had been the world's tallest building; it was built in 1998, just in time for the East Asian financial crisis that leveled Malaysia's economy. Indeed, the Empire State Building, the tallest building on earth for over forty years, was finished just as the Great Depression was decimating the US economy and would continue to do so for over a decade. Hence, one may wish to avoid investing in nations which are planning to erect the tallest man-made vista.
At some point the dichotomy between asset markets and the real economy will have to be reconciled. In my opinion, there are only three possible outcomes. First, asset markets could correct down in recognition that structural problems in the global economy will continue to plague us all. Second, the global economy could trend higher, thereby justifying the "forward-looking" asset markets' price levels. Finally, all the stimulus throughout the world could continue unabated, leading to massive inflation, the likes of which have not been seen in decades. In this last environment, non-fixed income financial assets should hold their own, if not increase further (even adjusting for inflation). Most tangible assets should see huge gains in the event of significant inflation. It will be intriguing to see how things unfold to say the least, as the investment implications of the various individual scenarios described above are quite disparate.
But on to other matters. As I mentioned last week, I thought I would try to distill some of the most valuable lessons I have learned as an investor in these series of blogs. The first blog focused on how running with the crowd/lemmings is usually the best way to achieve poor returns, particularly prior to key market inflection points. I would now like to focus on the role financial institutions play in almost inevitably sabotaging your investment returns.
One should never forget that the financial services industry is the equivalent of the "House" in Las Vegas; it always wins in the long-run, and always does so at the expense of its patrons. Since I first published a PDF financial/investment newsletter in the wake of the stock market crash at the beginning of the decade, I have been a merciless critic of Wall Street (see also blogs below). And given what they extract from investors, I think it entirely justified to place them under very close scrutiny, as Americans collectively are charged almost $100 billion in various fees by financial services firms!
Now I do not have a problem with people being paid fairly for providing some value-added service. I will gladly pay money to a mechanic that can fix my theretofore inoperable car. I have no skills in auto mechanics. And as a fan of Adam Smith and David Ricardo, I am a firm believer in specialization of labor. But the problem with the financial services industry is that it collectively not only fails to add value for the unfortunate souls who entrust their hard-earned money to it, but Wall Street actually fails to achieve market returns once their exorbitant fees are considered.
As harsh as it sounds, the vast majority of financial services professionals are imbeciles, twits, scofflaws and/or scoundrels. And let's face it, individuals working as investment professionals would be deriving most of their income from profitable investments as opposed to the fees they collect from managing your money if they could consistently obtain above-market returns. But this is not the case by a long shot.
Now the average investor under-appreciates the way in which his/her returns are savaged by bloated Wall Street fees. Many individuals I talk to have no idea what the expense ratios are for the mutual funds they own in 401(k), IRA and/or brokerage accounts. The fact of the matter is that actively managed mutual funds can charge fees that oftentimes exceed 2%. Now that might not seem like much, but compounded annually over ten years, a 2% expense fee costs an investor almost 22%, which is a significant drag on your returns. This becomes all the more brutal over a decade like the one we have experienced since 1999, where overall returns are almost flat. In that case, you have less than 80 cents left for every dollar invested, despite the market being flat. So what seem like trifling fees actually can make a huge difference in how successful one's investments will be, particularly over very long periods of time.
Accordingly, I am convinced the vast majority of investors would be best served by investing in a properly constructed portfolio of low-cost index funds. Next time - The Myth of Buy and Hold Investing. Likely to be the most iconoclastic blog of this series. My apologies for the unedited nature of this entry; I am late for a poker game.
Well, as usual my ambition exceeded my accomplishments when it comes to this blog. I had hoped to have posted two or three more entries since Thanksgiving. But the combination of holiday travel, a new fitness/health regimen, trying to keep up with the many developments in the investment world and (admittedly) procrastination have caused me to fall behind schedule. My apologies.
Over the long weekend the financial markets were roiled by what looked to be a massive debt default (well, temporary suspension of payments is how the debtor preferred to characterize it) in Dubai. This seemed to remind investors that, while financial/asset markets have vigorously bounced since last Winter, problems continue to manifest themselves in the real global economy. Over-capacity and slack demand are ongoing issues around the world. Unemployment continues to plague the US, Europe and much of Latin America. While governments across the continents continue to engage in unprecedented deficit spending, the private sector continues to exhibit signs of economic malaise.
As a brief aside, there is a high correlation between coming asset busts and grandiose building projects. Dubai is presently constructing the Burj Dubai, slated to be 162 floors! This will eclipse the height of the current tallest building in the world (the Taipei 101 Tower) by over 1000 feet. Plans for constructing the Taipei 101 Tower in turn occurred prior to the global tech bust of 2000. Up until Taiwan's behemoth building was erected, the Petronas Towers in Kuala Lumpur had been the world's tallest building; it was built in 1998, just in time for the East Asian financial crisis that leveled Malaysia's economy. Indeed, the Empire State Building, the tallest building on earth for over forty years, was finished just as the Great Depression was decimating the US economy and would continue to do so for over a decade. Hence, one may wish to avoid investing in nations which are planning to erect the tallest man-made vista.
At some point the dichotomy between asset markets and the real economy will have to be reconciled. In my opinion, there are only three possible outcomes. First, asset markets could correct down in recognition that structural problems in the global economy will continue to plague us all. Second, the global economy could trend higher, thereby justifying the "forward-looking" asset markets' price levels. Finally, all the stimulus throughout the world could continue unabated, leading to massive inflation, the likes of which have not been seen in decades. In this last environment, non-fixed income financial assets should hold their own, if not increase further (even adjusting for inflation). Most tangible assets should see huge gains in the event of significant inflation. It will be intriguing to see how things unfold to say the least, as the investment implications of the various individual scenarios described above are quite disparate.
But on to other matters. As I mentioned last week, I thought I would try to distill some of the most valuable lessons I have learned as an investor in these series of blogs. The first blog focused on how running with the crowd/lemmings is usually the best way to achieve poor returns, particularly prior to key market inflection points. I would now like to focus on the role financial institutions play in almost inevitably sabotaging your investment returns.
One should never forget that the financial services industry is the equivalent of the "House" in Las Vegas; it always wins in the long-run, and always does so at the expense of its patrons. Since I first published a PDF financial/investment newsletter in the wake of the stock market crash at the beginning of the decade, I have been a merciless critic of Wall Street (see also blogs below). And given what they extract from investors, I think it entirely justified to place them under very close scrutiny, as Americans collectively are charged almost $100 billion in various fees by financial services firms!
Now I do not have a problem with people being paid fairly for providing some value-added service. I will gladly pay money to a mechanic that can fix my theretofore inoperable car. I have no skills in auto mechanics. And as a fan of Adam Smith and David Ricardo, I am a firm believer in specialization of labor. But the problem with the financial services industry is that it collectively not only fails to add value for the unfortunate souls who entrust their hard-earned money to it, but Wall Street actually fails to achieve market returns once their exorbitant fees are considered.
As harsh as it sounds, the vast majority of financial services professionals are imbeciles, twits, scofflaws and/or scoundrels. And let's face it, individuals working as investment professionals would be deriving most of their income from profitable investments as opposed to the fees they collect from managing your money if they could consistently obtain above-market returns. But this is not the case by a long shot.
Now the average investor under-appreciates the way in which his/her returns are savaged by bloated Wall Street fees. Many individuals I talk to have no idea what the expense ratios are for the mutual funds they own in 401(k), IRA and/or brokerage accounts. The fact of the matter is that actively managed mutual funds can charge fees that oftentimes exceed 2%. Now that might not seem like much, but compounded annually over ten years, a 2% expense fee costs an investor almost 22%, which is a significant drag on your returns. This becomes all the more brutal over a decade like the one we have experienced since 1999, where overall returns are almost flat. In that case, you have less than 80 cents left for every dollar invested, despite the market being flat. So what seem like trifling fees actually can make a huge difference in how successful one's investments will be, particularly over very long periods of time.
Accordingly, I am convinced the vast majority of investors would be best served by investing in a properly constructed portfolio of low-cost index funds. Next time - The Myth of Buy and Hold Investing. Likely to be the most iconoclastic blog of this series. My apologies for the unedited nature of this entry; I am late for a poker game.
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