Investment Perspective

by havoc

This
week’s Fortune magazine has a scary black cover and says “Market
Shock 2007.” The market drop was 10%! Not very large in historical
terms, and it comes after a huge gain. But from the news (in Fortune and
almost everywhere else) it sounds like we should be freaking out.

I thought I’d post the point of view I find helpful when making
personal investment decisions and trying to keep perspective. If you
are averse to reading about financial stuff, stop reading. Like
most of my points of view, this one is really lengthy.

Disclaimer: this is not investment advice for your personal situation,
and if you plan your finances around what you read on a software
developer’s random Internet blog post you deserve what you get. Do
your own research. You have been warned.

That said, here are some thoughts, and then some elaborations.

I’ll elaborate on some of these points.

First, investing probably isn’t the most important financial
concern for you. Attempts to get abnormally high investment
performance are even less important.

Lots of media articles are about beating the market. But beating the
market is a dumb goal most of the time.

Unless you have an awful lot of money to work with, beating the market
on a consistent basis by 1% (very hard) or 5% (virtually impossible)
will still add up to much less than, say, a 5% raise in salary. If you
focused on a career change or a promotion, you could probably get 20%
more. Do the math. You’re better off worrying about your career – or
starting a business – if your goal is to become dramatically richer.

Aside from the income you earn through work, some other important
non-investing finance topics to worry about include: 1) having proper
insurance (long-term disability, life, health, liability/umbrella,
etc.) 2) running a budget surplus 3) having an emergency fund 4) taxes
5) having a will and power of attorney. All those areas probably
matter more than an extra couple percent over the market. Here
is a sensible book on all that. Or ask
for help from someone who charges an hourly fee instead of
commissions.

Second, unlike beating the market, investment risk does matter,
and you need to worry about investing at least enough to fully understand
the risks you are taking on and why.

If you need the money in a year and stocks drop 20%, you are screwed,
even if you “beat the market” by 5% since the market dropped 25%. Or if you
really can’t deal emotionally with a 50% drop (I know I can’t), but
you take that risk anyway, then even with a longer time horizon you’ll
experience plenty of angst that keeps you from focusing on more
worthwhile activities.

Here’s what you should spend time on: have a solid investment
policy that you know is right for you and that you understand.
Know when you need the money, and choose appropriate investments for
the time horizon.

Choosing a stock or fund that beats the market by 2% won’t do a lot to
change your life. Choosing an appropriate investment policy, however,
makes a very big difference.

Once you have a budget surplus so you’re saving enough, the most
important investment policy decision by far is simply how much in
stocks, how much in bonds or cash. 80/20, 60/40, etc. You should spend
as much time on this decision as you need to be 100% comfortable with
it, then forget about your investments until you need the
money.

Benjamin
Graham has a quote I keep at the top of my investment policy:

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.

He defines the terms like so:

  • thorough analysis: “the study of the facts in light of established standards of safety and value”
  • safety of principal: “protection against loss under all normal
    or reasonably likely conditions or variations”
  • adequate return: “any rate or amount of return, however low,
    which the investor is willing to accept, provided he acts with
    reasonable intelligence”

My personal risk tolerance is low. I am comfortable taking moderate,
informed risks after reading a lot and feeling I have a very good
understanding of what I’m getting into.

But this is a personal thing. The luckiest people are comfortable
taking sensible risks without having to spend a lot of time reading,
and so they can get on with their life. Other people are most unhappy
if they miss out on big gains, and don’t mind losing money as long as
everyone else is losing money too. And of course circumstances vary –
maybe you need college tuition next year, maybe you don’t need the money
until you retire in 40 years.

You have to make a personal, informed decision. Don’t let anyone else
do it for you or tell you what you should think.

But do try to vividly imagine what it would feel like to experience
the investment losses you sign up for. If you see on vanguard.com
that your plan could lose 40% in a year, then do the math: multiply
40% by your investment balance and write that number down and imagine
losing it overnight.

Third, the stock market is not just a random bouncing number; over
the long term it does relate to “fundamentals” (real economic
forces).

(Here we get into my personal need to study the risk in detail before
investing. If you have no such need you may want to skip the rest of
this post.)

The premise of every (sane) investing strategy is that over the long
term – and that means at least 10 and more like 20-30 years – on
average stock market performance will reflect economic growth, and
historically economic growth has been positive, in countries
with no major crises. The market reflects economic growth because
individual stocks reflect the value of businesses, and businesses have
a value because they make money and their owners get the money they
make.

Without this premise, index investing won’t work, value
investing won’t work, basically nothing would work reliably and
investing in stocks would amount to gambling.

With this premise, there’s a long-term upward trend line
(fundamental value), and the market’s current price bounces around it.

You probably know about the “random walk” concept, that the return on
the market tomorrow is random and unpredictable, given conditions
today. This is absolutely true over short timeframes, like a day or
even a year. But as far as I know, the theory is not intended to imply
that investment returns are truly random over the long
term. Investing would make no sense if returns were random over
30 years.

Reasonable investment strategies assume that there is a trend
upward, on average. This upward trend happens because stocks represent
something of actual value, the value increases over time due to
economic growth, and the value is roughly measurable.

(This is not a given. Commodities,
for example, do not trend upward on average, after inflation – they
are just random bouncing numbers. Unlike stocks, there’s no
fundamental reason pork bellies or metals would be worth more in ten
years than they are today, other than inflation. Oddly, commodities
can still be worth investing in, but only in small doses combined with
something that goes up, like stocks.)

Fourth, if we are willing to assume there’s a long-term upward
trend, there are a number of investment strategies that should
reflect this trend and produce gains on average over time.

What these strategies have in common is that they work for a reason,
due to economic growth, businesses producing cash profits, and just
plain math. They aren’t “magic.”

The simplest strategy is to buy a passive index fund and wait. Over 30
years, the bouncing around the trend line doesn’t matter.

It can matter a lot over shorter timeframes, though. Say you bought at
the 2000 peak, you made zero dollars since then, 7 years later. And 7
years later things are still overpriced. (That’s how insane
the tech bubble was. Ouch.)

Some minor elaboration helps a lot. The two elaborations most people
use are dollar cost averaging and asset class diversification
(combined with periodic rebalancing). Both of these reduce
vulnerability to market fluctuations.

A more complex elaboration that sells more when the market is above
the trend and buys more when it’s below is value
averaging.

Sensible active management strategies work too.

Graham/Buffett style value investing follows a discipline that hopes
to earn something close to the long-term upward trend, on average,
over time. But it can lead to very different behavior from the market
as a whole in the short term, for example many managers using this
discipline missed out on most tech bubble gains and then also missed
out on most tech bubble losses.

John Hussman’s fund, which I mentioned earlier, uses analysis based on
historical statistics to vary the amount of market risk taken from 0%
to 150%, where at 0% money market returns are expected. This fund
would have been painful to own the last three years, since it’s earned
about 5%. But then again, it destroyed the index in 2001 and 2002. The
fund’s record is too short to feel completely confident it will have
long-term returns in the same range as an index fund, but the strategy
does make sense and “should work” based on history, in the same sense
that index and value investing “should work.”

It’s controversial whether these strategies are worth it vs. an index
fund, since it isn’t clear these strategies can beat the market.

My opinion: the value of an actively-managed fund comes primarily from
risk control, and from the psychological knowledge that if there’s
another tech bubble (or mortgage bubble), there will be some stuff in
my portfolio that isn’t tangled up in it. I would generally expect the
actively-managed funds I like to lag a bull market and do better in a
bear market, but the purpose of investing in them (for me) is not to
beat the market overall.

Vanguard suggests 50% in actively-managed funds and 50% in
index funds and that’s what I use.

Tangents aside, the point is: sensible strategies are based on the
premise that there is a “fundamental value” – an economic reason that
investments will grow. This fundamental value can be captured
“actively” or “passively,” but any strategy without a basis in
fundamentals is junk. Or at least too risky for me.

Fifth, sensible investment strategies avoid predicting the future.

Strategies that work reliably make the minimum prediction: that
fundamental value will grow over the decades, roughly resembling
historical experience. Then they have a discipline which still works
even if nothing else is predictable. They can handle “statistically
impossible” events like the tech bubble or the 1987 crash and come out
OK, because they did not rely on predicting those events.

Nassim Nicholas Taleb has
a very interesting book about how unpredictable the world is. He
isn’t even willing to rely on fundamental economic value growing over
time, preferring to invest mostly in cash. I don’t see the need to go
that far – to hedge the apocalypse, buy food and guns, forget about
stocks. (The range of future situations where stocks are permanently
worthless but T-bills remain valuable seems small to me.)

Nonetheless, I like Taleb’s argument that nobody can predict any
complex event. And successful investors like Buffett make a point of
not trying to, using primarily past events – proven profits and current
prices – as input to their decisions.

Hussman emphasizes this point over and over as well, for example:

Frankly, I don’t know whether investors will drive the
market even higher in the weeks ahead. My opinion is that
whatever gains emerge (and indeed, much of what has already emerged)
will ultimately prove quite temporary. What I do know is that certain
factors have reliably identified egregiously bad times to accept
market risk, and that every historical instance similar to the present
has been a disaster. The current instance may very well prove to be
the exception, but I do not invest shareholder assets on the hope that
the future will be entirely at odds with all available historical
evidence.

Passive indexing, value averaging, and rebalancing are all based on
this same premise: they are systematic approaches that on average are
helpful, according to historical experience. In any given
instance, if you could predict future price movements, you
could do better than these strategies. But you can’t predict.

This is why it’s solid advice to “buy and hold” and “don’t time the
market.”

I’m very skeptical of mutual funds that are based on predictions, such
as macro economic analysis or guessing at which companies will have
the hot new technology. Nobody can consistently get those predictions
right, or at least I can’t tell which fund managers have this superpower.

Sixth: If you believe my first five points, and
chose your investment policy well to reflect your goals and risks, you
have no reason to worry about anything you read in the media.

To prove the point, let’s split the media into two categories.

Category One is made up of people who agree in broad outline with a
couple of my points here: that investing is about capturing a
long-term increase in fundamental economic value, and that nobody can
consistently predict the future.

Category Two is made up of short-term traders, numerologists,
economists, and the like – all trying to predict the future, or even
worse, the short-term future of market prices.

If you read Category One pundits, many are arguing that the market is
overpriced. I quoted some of them at the start of this post.

However, you, like them, should already have a disciplined plan that
produces adequate return, with acceptable risk, even if the market is
overpriced sometimes and underpriced sometimes. You don’t need to know
the market price next week or next year. Because nobody can predict
the future, there is nothing to do except stick to the disciplined
plan.

Sure, if there’s a true apocalypse or a government coup, you are
screwed. But like I said, if that keeps you up at night, buy some guns
and food to hedge your stocks.

You can ignore Category One commentators, or treat them as interesting
but not worrying, because you’re already prepared. Your investment
strategy may already include adjustments to changing market prices,
through averaging or hedging or allocation; or it may not; but in any
case you’ve already planned for market prices to fluctuate and know
what action to take (if any), or know what action your fund managers will
take. The actions you’ve planned will give you the right risk and
return over time.

You can ignore Category Two punditry because it’s meaningless
garbage. Nobody in Category Two ever relates what they say to a
sensible investment strategy, or spells out the long-term statistics
that back up their points. They’re a lot like news anchors who report
on politics “horse race” style, focused on polls, and never analyze
the substantive policy issues the elections are supposed to be about.

A month ago, there were two popular media claims about why the market
would keep going up. The first was “liquidity” and the other was “the
forward P/E ratio is in line with historical averages.”

Impressive-sounding comments, but meaningless for investing.

“Liquidity” is a short-term (and hand-wavy) property of the
market. The historical average return for stocks covers many periods
where liquidity came and went. If you say stocks can be priced more
highly when liquidity is favorable, you’re assuming that liquidity
will stay favorable permanently (or that you can “get out” in
time if it doesn’t and “get back in” at the right time after you get
out). The last month is a good demonstration that liquidity won’t stay
favorable forever.

The price/earnings argument is bogus in two ways. First, it uses the
so-called “Fed Model” to argue that because interest rates are low
now, stocks are worth more. (Hussman argues that
historical statistics don’t support this.) Like the liquidity
argument, this assumes that either rates will stay low or that
you can get out and back in if they rise, neither of which has to be true.

Second, the price/earnings argument ignores the business
cycle. Profit margins go up and down over time. Like liquidity and
interest rates, earnings can and probably will become much
worse at certain times and you will not be able to market time
when it happens. If (for example) all this housing
turmoil creates a recession, earnings will go down, and if the
price/earnings ratio stays constant, prices will go down too.

Right now, profit margins are at a record high. The price/earnings
ratio is average, but if you change the profit margins to also be
average, the price/earnings ratio is very high.

So in early July, liquidity was good, earnings were at record highs,
and the 10-year Treasury had a low-ish rate. Several favorable signs.

Investing based on this information is like saying “I don’t need
to own an umbrella because it’s not raining right this minute.”
When people who believe in long-term fundamental value say stocks are
overpriced, what they mean is that among other risks,
liquidity could dry up, profit margins will go down eventually, and
interest rates could rise. And the risk of those things happening
means that on average, stocks are likely to go down again. Good conditions
don’t continue unbroken for 30 years.

I like to read Category One media sources to keep myself from believing in
Category Two media sources. Category One is good at emphasizing that
Category Two can’t predict the future and has no sensible long-term
strategy. Here are some sources I like:

Sensible, fundamentals-based commentary keeps the focus on risk, not
return.

Again, never understand anyone’s opinion as a prediction. It is
never appropriate to try to “get in” or “get out” of the stock market,
based on today’s commentary or an emotional feeling. Only systematic
disciplines have a good chance of working.

There is no way anyone will read this post to this point, but if you
did, I hope you found some part of it helpful.

[1] A caveat about Morningstar: they are best known for
the star ratings for funds, which in my opinion are useless and often a recipe
for performance-chasing. However, their “analyst picks” and
qualitative fund writeups are very good, and they also do fundamental
analysis of many individual stocks, allowing them to analyze the whole
market by combining all the bottom-up analyses together. You have to
buy Morningstar Premium to get at some of the more useful content.

(This post was originally found at http://log.ometer.com/2007-08.html#26.2)

My Twitter account is @havocp.
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