Avoid Concentrated Stock Positions, Part 2

“Never concentrate your investments in a single company, especially the company you work for.” – Jane Bryant Quinn.

In a previous post, I talked about how investors’ familiarity with local companies can lead to concentrated positions. When an individual stock crashes and burns, the results can be devastating.

Employer Stock

Whether it happens quickly or slowly, it really hurts if you have a concentrated position in your employer’s stock, and the stock tanks. Think about the unfortunate individuals who worked for and, had a good chunk of their net worth, invested in companies that went out of business. They not only lost their jobs but suffered catastrophic losses to their portfolios. Their financial future is not at all what they were counting on.

Diversification Is the Answer

The obvious answer is to diversify, to own many stocks, so the underperformance of a single stock, or its disappearance, will have little effect on your long term results. You want to make sure that your financial future does not get derailed by events at a handful of firms. Proper diversification includes different asset classes: Large Cap Stocks, Small Cap Stocks, International Stocks, Real Estate Investment Trusts, Bonds, Money Market Funds, etc.

If you have a properly diversified portfolio, you will capture the rewards that markets have to offer. With a diversified portfolio, you are, in effect, investing in the economy, and you can reasonably expect to get a return on your investment. Short term fluctuations will not be as worrisome, because over the long term you will benefit from the dynamism and growth of the overall economy. But this is not so with any individual company’s stock. Too much can go wrong, and its stock price may not recover from a sharp decline.

Client Reluctance to Heed Sound Advice

Financial advisors deal with this issue all the time. It’s one of the most difficult to convince clients of. As mentioned before, people are familiar with their employer, they may have been with the company for a long time, and perhaps they feel a certain loyalty to it.

They know logically that you should not put all our eggs in one basket. They are just convinced that it could not happen to them. But of course, no one ever imagines that it could happen to them.

Client Reluctance to Pay Taxes

To diversify, you must sell some (or all) of that favorite stock. You may be reluctant to sell, because you do not want to pay a capital gains tax. But keep in mind that it is currently only 15% for long term gains. (This may increase in the future.) And with prices down from the highs of last year, now would be a good time to talk to your financial advisor about selling that concentrated position and investing the after-tax proceeds in a diverisfied portfolio.

Potential Underperformance

The value of your stock could easily underperform the market by 15%. In Why It’s Wrong to Hold Too Much of One Stock, Jilian Mincer reported a study finding “a third of the stocks in the (S&P 500) index underperformed the overall market by at least 15% or more at any given year.”

Moreover, in 2006, when the S&P 500 increased by 15.8%, there were 6 stocks that declined by greater than 15% in only 5 business days:

Stock	% Decline
Wendy’s International	-49.9%
Whole Foods	-28.7%
Amazon	-23.2%
Yahoo	-21.8%
Sherwin Williams	-21.6%
Goodyear Tire	-18.9%

Source: Bloomberg, Fact Set

Conclusion

Sharp declines and long term underperformance have happened so many times in the past. Why take the chance that it will happen to you?

Avoid Concentrated Stock Positions, Part 1

“Overconfidence is probably the most important of financial behavioral errors.” – William Bernstein.

Familiarity Leads to Concentration

A recent article, Why It’s Wrong to Hold Too Much of One Stock by Jilian Mincer, of The Wall Street Journal, explains that “individuals frequently overinvest in local companies.”

They think they’re reducing risk and optimizing gains by following the adage, ’Invest in that you know.’ Yet too much concentration in one stock actually increases risk as a lot of investors in Home Depot, Starbucks and Washington Mutual have discovered.

“It is a well-known phenomenon,” says Stuart Ritter, a financial adviser at T. Rowe Price Group Inc. in Baltimore, Md. “We think we know more about things that we’re familiar with.”

David Hirshleifer, a finance professor at the Paul Merage School of Business at the University of California, Irvine, says people have a natural tendency to like things with which they’re familiar.

“We treat things we’re used to as friends,” he says. As a result, investors buy local stock and donate to local charities. That same sense of familiarity also encourages people to invest too much in their own countries rather than to build an international portfolio.

Why is this a problem?

Conflict Between Concentration and Prudent Portfolio Management

When the stock market declines, we typically advise “stay the course.” Buy-and-hold is a sensible strategy for the long-term. But that applies to a well-diversified portfolio; it doesn’t apply to any single stock.

The reason is that a lot can go wrong with a single company, and it can happen very quickly. Any individual company or sector is subject to steep declines.

Weston J. Wellington of Dimensional Fund Advisors observes

“Recent events have provided an unusually harsh lesson of the importance of diversification. In a matter of days, shareholders of three financial giants—Fannie Mae, Freddie Mac, and Lehman Brothers Holdings—have seen their shares plunge into the penny-stock category. A fourth, American International Group, is scrambling for survival. “

Fannie Mae was once characterized by Money magazine as “America’s Safest Stock,” with a bulletproof business model that was “as close as you’ll get to an invincible earnings machine.”

Other “impregnable” companies include Pan Am (the premier airline of its day) Enron, “the smartest men in the room” Worldcom, etc. They went from brilliant to bust.

In the past, there have been many companies that once were considered powerhouses, but no longer are. For many years, General Motors was considered the bluest of the blue chip stocks. While GM has not gone out of business, having a concentrated position in its stock would have hurt your portfolio performance tremendously.

To be continued…

Ignore That Bear Market Headline, Part 2

 

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett.

The title of this post (and the previous one) is intentional. When market prices plummet, as they do from time to time, it is important to avoid panic. Do not discard your well-thought-out asset allocation and your long-range plan. And don’t even think of using the phrase, “In the long run, we are all dead.” That’s a rationalization for following your natural inclination of reacting to fear.

How do we avoid acting emotionally? Well, it helps if we have an understanding of investor psychology (especially our own) but also the perspective of market history. This post goes into each realm.

For an understanding of investor psychology, a great place to start is with Jason Zweig’s book Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. In this book, he discusses how neuroscience, economics and psychology explain how we make good or bad investment decisions.

Zweig’s weekly column, The Intelligent Investor, published in The Wall Street Journal is always interesting, because he is insightful and brings an independent approach to the investing scene. This weekend’s article entitled Should You Fear the Ostrich Effect? may be particularly relevant. If you don’t have access to the Wall Street Journal, here’s a summary, as well as my analysis.

Zweig observes that investors pay much less attention to their portfolios when the market news is bad. The term “ostrich effect” was coined by behavioral economist George Lowenstein of Carnegie Mellon University. Lowenstein has done extensive research measuring the phenomenon.

Zweig comments that, “Turning yourself into an ostrich doesn’t make your losses go away, but it does enable you to pretend they aren’t there.”

Moreover, Zweig maintains that ostrich-like behavior isn’t all bad.

“Experiments by psychologist Paul Andreassen have shown that the more news that investors get on their holdings, the more they trade and the lower the returns they earn. When your head is stuck in the sand, you can’t open your mouth to trade.”

Absolutely! As Eugene Fama, Jr. said at a recent NAPFA meeting, “Money is like soap; the more you touch it, the less you have.”

Of course, Zweig is not recommending that you completely ignore the news and, therefore, reality, and neither am I. But, if you have a long-term approach and a well diversified portfolio, I believe that you don’t need to follow the news day after day, nor is it even recommended. It may just get you upset at the wrong time, enticing you to react inappropriately.

“When the headlines are overwhelmingly negative, as they are now, the market tends to feel riskier than it actually is. (The time to worry is when no one seems worried, not when everyone does.)”

That bears repeating. “The time to worry is when no one seems worried, not when everyone does.” That has been a favorite phrase that I frequently use with clients.

Zweig invites us to:

“Take a few moments to go back in market history and see how stocks did after other periods of despondency like 2002, 1998, 1991, 1987, 1982, 1974 and so on. If history is any guide, your inclination to act like an ostrich is a strong indication that the market is about to turn into a phoenix.”

Well, I have done what he suggested. What follows is my analysis.

While the S&P 500 had an average annual return of 11.1% from 1970 to 2007, the numbers for the year after recent market declines are much higher.

Bear Market	% Decline	Increase Next
Bottom	in S&P 500	Calendar Year
12/06/74	-45.1%	37.2%
08/12/82	-24.1%	22.5%
12/04/87	-33.5%	16.8%
10/11/90	-21.2%	30.5%
08/31/98	-19.3%	21.0%
10/09/02	-49.1%	28.7%

Source: Standard & Poor’s, cited in Simple Wealth, Inevitable Wealth, by Nick Murray and Dimensional Fund Advisors’ Matrix book.

Be Careful How You Use This Analysis

Please note that these numbers are merely illustrative, because we are using calendar years after the decline, and the declines did not end conveniently on December 31st. Still, in the calendar year following a Bear Market, the average return was 26%. This is an impressive number and makes Zweig’s point.

However, there is another caveat. We are looking back to notice what happened after a market decline. In choosing 1974 or 2002, for example, as our ending points, we are in effect doing a bit of data mining. (We are using the proverbial 20/20 hindsight.)

Recall, though, that 1973 and 1974 were both bad years. Certainly, no one could have known that in advance. So if you were thinking about this in 1973, and you saw a decline of 14.7% for that year, you might have thought that 1974 would be a pretty good year. It definitely was not — the S&P 500 declined by a further 26.5%!

Similarly, 2000, 2001, and 2002 were all down years. If you had thought in 2001 that the worst was over, you would have been spectacularly wrong! After two bad years, the S&P 500 declined a further 22.1% in 2002!

So while I acknowledge that markets tend to do very well after a spate of declines, unfortunately, we cannot know whether the bottom has been reached, at any given point in time.

Buy-and-Hold

But we do know that if you had gotten out of the market in 2002, for example, as so many people did, you would have lived to regret it. The next year, 2003, was a very good year for the S&P 500 with a gain of 28.7%.

Numbers like that reinforce our buy-and-hold philosophy. We don’t try to use “Market Timing” to decide when to get out of the market and when to get back in. It’s impossible to know when to do that. As Jane Bryant Quinn said, “The market timer’s Hall of Fame is an empty room.”

Diversifying Beyond the S&P 500

As an important aside, many indexes did much better than the S&P 500 Index in 2003.

Real Estate Investment Trusts	36.2%
International Developed Markets	39.2%
Emerging Markets Stocks	56.3%
U.S. Small Cap Stocks	57.8%

Please note that these eye-popping results came after a very difficult multi-year Bear Market. Do not expect these results to repeat in the future. And you can not invest directly in an index.

However, these results are indicative of why we recommend diversifying in many more asset classes than just the S&P 500.

“Past Performance is No Guarantee of Future Results.” The SEC makes us say it, and it happens to be true.

Finally, read the quote by Warren Buffet at the top of this post. Do you even imagine that the “Sage of Omaha” is selling today?

The Cloudy Crystal Ball, Part 5

“The only way to make money with a (market timing) newsletter is by selling one.” - Malcolm Forbes.

Market-Timing Newsletters

No one can accurately predict the short term direction of the stock, bond, oil or any other market, but you can do quite well by charging money for those predictions. Many people buy newsletters that will help them to determine whether or not now is “a good time to invest.” Let me ask you, if you were able to do that, predict the markets accurately and consistently, would you share that extremely valuable information?

Yes, newsletter writers are very convincing, whether they quote economic reasons or technical factors based on the internal dynamics of the stock market. Yes, they use data and systems that you don’t have access to or wouldn’t understand unless you had taken classes to learn them. They talk about or refer to chart patterns, oscillation, On-Balance Volume, etc.

Oh, they speak with great conviction. And when they are wrong (and they are often wrong), they write convincingly why that happened the way it did. They may place the blame on their “system” or their (mis)interpretation of their system. Great stuff.

In fact, thousands of people subscribe to such predictive newsletters. There’s even a paid service that evaluates the newsletters for you, The Hulbert Financial Digest. As for a track record, many newsletters go out of business within a few years. Some will have success in the short term, maybe as a result of skilled, knowledgeable writers, but more likely, it’s just plain dumb luck.

One such prognosticator is the famous (or infamous, depending on your point of view) Joe Granville. I remember back in the 1980’s when his forecasts could literally move markets.

Here is a recent article from MarketWatch.com indicating that Granville had turned bullish, i.e. he expects stock prices to go up. Read more

Why You Need a Financial Planner

“An idiot with a plan is better than a genius with no plan.” - T. Boone Pickens.     

The stock market has been volatile, and the headlines have been scary. And that description has become common over the last year or more.

Given the state of the U.S. economy and the U.S. stock market, and indeed, all financial markets worldwide, how confident are you that your financial plan is on track?  While books and computer programs may help you plan your future, there are several reasons why you should seriously consider seeking the advice of a qualified financial planner.

Planners know that it’s about more than just money.

At its core, financial planning is about effectively managing financial resources so that you can lead a happier, more fulfilling life today and tomorrow. One of the very first steps in a financial planning relationship is to help clients define their life goals. Do you want to start your own company, buy a second home, retire early? How do you balance competing goals, such as saving for retirement, while simultaneously putting your children through college and helping out your elderly parents?

In our financial planning, I meet with clients periodically to reassess their goals and the strategies that will help them to achieve those goals, especially as life circumstances change. No financial planning or investment software program can effectively come up with those kinds of questions — let alone provide the right answers.

Planners see the whole, not just the parts.

Many financial specialists provide valuable services to people for a specific financial need, such as buying property and casualty insurance or drafting a will. However, a comprehensive financial planner provides the overview, in order to make sure that the various parts are working in harmony. That’s why I call myself a Personal Chief Financial Officer. A company has a CFO, so should a wealthy or moderately wealthy individual, or anyone with similar desires.

As a Financial Planner, I can often see something that is missing but is needed, something which the client had never previously considered. One example was a client who had a sizeable life insurance policy in place, but should have had it owned by a Life Insurance Trust. This would save what amounted to a lot of money on estate taxes.

Another client thought she was contributing to her employer’s 401(k) plan, but she wasn’t. She had returned from a maternity leave, and somehow the paperwork never got completed. While a computer program might provide generic investment advice (not necessarily well tailored to your individual needs), a financial planner can spot the missing ingredients.

Planners motivate.

You probably know that you need a will, more insurance, a budget, a better handle on your investments and true assessment of a host of other financial issues. Perhaps you could do some of it adequately on your own. But, there’s nothing like going to a financial planner to motivate you to finally take the actions that you’ve been procrastinating about, all along.

From my experience, procrastination is a huge problem. As part of the financial planning process, I typically use an Action Plan for clients and for me, to make sure that recommendations and specific tasks are accomplished in a timely manner.

Planners provide checks and balances.

Beyond the financial expertise and the motivation to take action, the planner can provide a much-needed objective perspective. Numerous studies have shown that investors who work with financial advisors trade less often and, on the average, get better returns than those who invest on their own. Planners can filter out the financial “noise” that so often clouds financial judgment.

Planners understand that “hot” stocks become lukewarm pretty quickly.

Financial publications frequently have lists of hot financial ideas and stocks to watch. But those recommendations change all the time. Whose list should you believe? No one’s. I encourage my clients NOT to watch CNBC news, because it will just rile them up to do something that is a mere reaction to the news. Good planning is about having a road map that anticipates various events and gives you peace of mind. Turn off the TV, and enjoy your life!

Planners allay fear.

Some clients are just too fearful to invest in the stock market at all, and they have kept their money in safe investments for years. In the long run, risk and return are related. You know the saying: Nothing ventured, nothing gained. But you need to understand that you can take on risk intelligently. We are talking about investing your money, not gambling with it. A good financial planner should be able to explain risk and return to you, and to craft a strategy that is right for you. Something you will stay with in good times and bad.

Planners save time.

It takes time to develop a personalized financial program, monitor your investments, reduce risk and keep track of it all. Perhaps more time than your busy schedule may allow. Your Financial Planner offers a professional approach to your customized financial program that will not demand a lot of work on your part, and a level of knowledge and expertise that may be difficult for you to achieve on your own.

Planners know about taxes.

Like the weather, everyone complains about taxes. Planners can help you structure your investments to take advantage of legitimate tax-saving moves.

Where to find a planner?

Does everyone need a financial planner? No, certainly not. But if you have resources — savings and investments — you have choices to make. You may not have the time, inclination or even desire to do the hard work to come up with the best answer.

You can find a professional fee-only financial planner at The Garrett Planning Network (GPN) or the National Association of Personal Financial Advisors (NAPFA). If you have determined that what you are truly a Do-It-Yourselfer, or you only need a financial checkup or a second opinion, your search should probably start with GPN. If you want to delegate the work, look for a planner at NAPFA’s web site. Most NAPFA members require that you have a minimum amount of investable assets for them to manage. GPN members have no such minimum.

Disclosure: I am a member of both organizations.

Risk Management at Investment Banks

“Risk comes from not knowing what you’re doing.” – Warren Buffett.   

Today’s news about Lehman Brothers’ large loss, and yesterday’s post on the Fannie Mae and Freddie Mac takeovers, reminded me of an old post at a blog by Rick Bookstaber, the author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.

The Wall Street Journal had this to say about his book. “Like many pessimistic observers, Richard Bookstaber thinks financial derivatives, Wall Street innovation and hedge funds will lead to a financial meltdown. What sets Mr. Bookstaber apart is that he has spent his career designing derivatives, working on Wall Street and running a hedge fund.”

In his post, Bookstaber imagines a conversation at a high-powered investment bank between a hot-shot trader of a complex financial derivative called a CDO (Collateralized Debt Obligation) and the risk manager for the firm. This conversation illustrates the conflict between generating high trading profits and the danger of taking on additional risk.

For your reading enjoyment  (and to understand the rest of my commentary) …

Talk about being the proverbial fly on the wall!

Take note of his conclusion:

…the real risk manager should not have people management and report generation responsibilities. He should be able to have the time and space to question and think. He should be able to use all the risk data as an input and demand other types of analysis he deems necessary, but then have the time to sit back and think. In this respect, his role would not look much different than any number of very successful portfolio managers.

Taking Risk Seriously

Bookstaber emphasized, that in a conflict situation, top management must back the risk manager.

It seems to me that at some firms, like J.P. Morgan Chase and Goldman Sachs for example, top management “got it” and took risk seriously. They did an excellent job of managing their exposure, prudently. Other investment banking firms, such as Bear Stearns, Citigroup, Lehman, etc., apparently didn’t understand the risks they were taking. Making things worse, it appears that they leveraged (used borrowed money) considerably more than they should have.

What a pity for their respective stockholders.

The Fannie Mae & Freddie Mac Takeover

 

“Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.” – Treasury Secretary Henry Paulson, Jr.    

Last night’s Charlie Rose TV show had a panel discussion of the Federal Government’s takeover of U.S. mortgage giants, Fannie Mae and Freddie Mac. The panel included Nouriel Roubini of New York University, Mohamed El-Erian, co-CEO of PIMCO and Gretchen Morgenson and Floyd Norris, both of The New York Times. (I faithfully record the Charlie Rose show every night, knowing that, most of the time, he will have an enlightening, or at least interesting, program. Tonight, he will have Thomas Friedman, who will discuss his new book.)

Nouriel Roubini was, as expected, the most pessimistic about the future direction of the economy. He has been called, among other things, “Dr. Doom,” but the truth is that he has been prescient about the various crises we have seen. It is his belief that, because the government “subsidized” home ownership, we invested too much in housing, instead of more productive assets.

Things are so bad, Roubini said that “we have a subprime financial system, not a subprime mortgage market.” This has led to a systemic banking crisis.

Roubini listed various simultaneous shocks to the U.S. economy:

• Consumers are “shopped” out
• Housing prices are falling and will continue to fall
• Stock prices have fallen
• Consumers are facing a large debt burden
• Banks are less willing to lend
• Consumers are dealing with rising oil and food prices

Roubini thinks that this is an unusual, if not unprecedented, confluence of events, as bad as we have seen since the Great Depression. He believes that the U.S. recession will get much worse and will last for 12 to 18 months, and that there is the strong possibility of a global recession and a “vicious circle.” He does not go so far, though, as to predict another Great Depression.

And to top things off, he commented that “Superpowers” should not be net debtors. Observing the huge and still growing U.S. deficit, Roubini said this could be indicative of the beginning of the decline of the “American Empire.” Whew! Heavy stuff.

Mohamed El-Erian’s analysis was somber, but not nearly as scary. He believes that the credit crunch had “morphed” into an economic crisis, which is in desperate need of crisis management. He sees the takeover of Fannie Mae and Freddie Mac as necessary, and as a bold attempt to change the “regime.” (Paradigm?) He believes that, in the next two years, the government will go from crisis management to an evaluation of the situation and, finally, to crisis prevention. He believes that a major reform effort will be required by 2010.

Speaking of reform, Gretchen Morgenson expressed her extreme disappointment at the failure of policy makers and regulators to address the problem earlier. Whether it was the SEC, the Federal Reserve Board, the U.S. Treasury or the bank regulators, she feels that there was a wholesale failure to recognize the problem. “Denial, upon denial, upon denial that there was a problem,” was how she described it. As a result, she sees a lack of credibility in the administration.

Morgenson commented that there was enough blame to go around, meaning banks, mortgage brokers, and consumers, in addition to the government, were at fault.

El-Erian “defended (!)” the regulators by saying that they knew that there was a problem, but they just didn’t know what the solution was, and they didn’t want to make things worse.

Somehow, this does not make me feel more confident.

Norris said that the takeover was necessary, to prevent the crisis from getting worse. He agreed with Roubini that the danger is a “negative loop,” where things just keep getting worse. He feels that we must do a much better job of regulation, especially in the “alternative financial system,” that has largely been unregulated. Norris was the only one to mention the fact that former Federal Reserve Bank Chairman, Alan Greenspan, was strongly against regulating financial markets, because he did not want to stifle innovation.

Norris highlighted the failure of top management of banks, who did not control risk. They may have thought they were making tons of money, but they weren’t, because they relied too heavily on models for reassurance that they were not taking on too much risk.

My interpretation is that they just did not think that we could have a nation-wide decline in housing prices. Bank management thought that the packaging of risky loans reduced the overall risk, through diversification. But, this could not be true if the underlying loans were extremely dicey, and in some instances, simply fraudulent. Everyone assumed that housing prices could go in only one direction – up — or if prices declined, it would be mild and temporary.

Take Home Message

One fear is that, if people are “underwater” or “upside down” with regard to their home mortgage (that is, their house is worth less than the outstanding balance of the mortgage) they will just walk away, leaving the bank to deal with a foreclosure and possibly a forced sale of the house. This is what the government is trying to avoid, or at least diminish the likelihood of it. It will not be an easy problem to solve. Roubini made the startling prediction that, of the people who have mortgages on their homes (and not everyone does, by the way), 40% will be “underwater.”

On the plus side, these recent actions by the Federal Government seem to have strengthened the confidence of foreign investors in the U.S. markets. El-Erian says that international investors view the U.S. markets favorably, because we have the deepest market in terms of liquidity, and we adhere to the rule of law. People living in the United States may take this for granted, but it is something to consider.

I would add that our dynamic, entrepreneurial “can-do” spirit is a huge advantage globally, so I am not quite ready to count the U.S. out, yet. We do have serious problems to address but, though long overdue, the Federal Government,seems, at last, to be on the case.

Postscript

For a fascinating portrait of Roubini, see this New York Times article.  In September of 2006, he was extremely pessimistic about the banking system, housing prices and the economy, and was mocked for his predictions. However, his critics dismiss his correct call because they point out that he was pessimistic about the economy back in 2004, as well. Read the article and judge for yourself whether it was “the broken clock being right twice a day” syndrome.

The Education of an Investor, Part 4

 

“The concept that all useful information has already been factored into a stock’s price, and that analysis is futile, is know as The Efficient Market Hypothesis.” – William Bernstein.

As discussed in a previous post, I appreciate Benjamin Graham’s contributions, but I do not accept his conclusions.

Times Have Changed

When Graham first wrote The Intelligent Investor, there were no online sources for information, as stock prices were seen on a paper ticker tape with a 15 to 20 minute time delay, not a CRT with near real-time quotations. It took weeks, if not months, to analyze a single company’s balance sheet, using an old fashioned adding machine called a comptometer, They didn’t have multi-function calculators then, much less a spreadsheet program. Someone as smart as Graham could find under-priced securities, even stocks selling at less than liquidating value.

Investment techniques have changed over the last 40 years, and there has been a tremendous amount of research about how markets work. Anyone attempting to identify undervalued stocks is ignoring four decades worth of research, which proved that, because of all of the competition, it is very, very difficult to find the elusive “good bargain” stock.

In an article written for the 1976 Financial Analysts Journal, “A Conversation with Benjamin Graham,” he indicated that he had reached the same conclusion, and acknowledged the difficulty in finding these undervalued stocks.

Question. “In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?”

Answer. “In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the ’efficient market’ school of thought now generally accepted by the professors.”

Since that interview in 1976, mounting evidence has continued to demonstrate that markets are largely efficient, and that the current price of a stock is the “best estimate” of what it is actually worth.

Burton Malkiel’s paper provides a detailed discussion of Efficient Markets.

Conclusion

An intelligent investor should be cognizant of Graham’s contributions to, and impact on, investing theory and practice, but should go beyond his approach to one more appropriate for 21st Century’s equity markets.

The Cloudy Crystal Ball, Part 4

“There will always be someone predicting disaster and someone predicting great fortune. At one time or another, each will be closer to correct than the other. But it won’t matter to you if you understand this and have invested responsibly. You have a long-term plan; stick with it.” – Peter Lynch.

A Recipe for a Beguiling Article

Creating a recipe for a column about the predictions of market gurus is an interesting task. You need people with a good track record, with different takes on which way the market is going. And most of all you need colorful language and good quotes.

As a recent example, take Jonathan Burton’s article in MarketWatch, The Four Horsemen of the Market: Heed the sobering investment advice of these veteran money managers.

Perhaps calling them “Four Horsemen” is a bit heavy on the sauce, but Burton serves up quite a dish. This particular column calls for two parts pessimism and a cup of caution. Add a dash of optimism for balance. Voila, a prediction column! And it really does not matter if the investment strategists are right about predicting the future. In a few weeks, get some new “experts” with different opinions. The recipe stays the same; only the ingredients change.

Well, if nothing else, the money managers certainly provide interesting, “insightful” analysis and very colorful quotes! But since they disagree on the best strategy, I am not sure how you could “heed” these “experts.” You would certainly get indigestion. I definitely do not recommend that you accept their market timing approach, or anyone else’s for that matter. A previous post explains why investing in the equity market should not be dependent on a prediction of the short-term direction of equity prices.

A Gaggle of Gurus

In any event, here are some of the best quotes:

Jeremy Grantham is “Officially scared.”

“The fundamentals have turned out to be worse than I had thought,” Grantham said. “My advice would be, don’t take any risk.”

“I underestimated in almost every way how badly economic and financial fundamentals would turn out,” Grantham wrote shareholders in a July letter. “Events must now be disturbing to everyone, and I for one am officially scared!”

John Hussman says, “Stay defensive.”

“The stock, bond and foreign-exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession,” Hussman wrote in his weekly market commentary in late August.

Investors’ consensus is mistaken, Hussman contends. He said the U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit.

“The potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact,” Hussman wrote.

Bob Rodriguez is on a “Buyer’s strike”
He declined to be interviewed for the article but was described as continuing “to focus on caution and capital preservation.”

Steve Leuthold is “Pretty positive.”

Like Hussman, Leuthold is convinced that the U.S. economy is in recession. But he points out that the stock market typically bottoms around the midpoint of the downturn. By his reckoning, the economy entered recession toward the end of 2007, and the extensive valuation criteria he uses tell him there’s now light at the end of the tunnel.

“The bottom has been made,” Leuthold said. “The economy is going to start showing some positive signs sometime in the first half of 2009.”

So he’s getting in early, loading up on shares of biotechnology and alternative-energy companies in particular, and keeping a modest amount in oil drillers and natural gas producers.

Conclusion

These “experts” disagree, which is not surprising. There is no evidence that anyone can predict the course of the market. So let’s face it: No one knows whether, in the short term, the stock market will sink or soar. But we do know that the long term trend has been up for stock prices.

Judging by his recent column on how to evaluate 401(k) choices, Jonathan Burton is a very good journalist. But this “prediction” column does not serve his readers well. It fosters the mistaken belief that in order to be a successful investor you need someone to predict the future for you. That’s just not true.

It is not necessary to try to predict market prices, since a buy-and-hold approach works quite well over the long term. Now that’s a recipe for success.

It just doesn’t make for a very scintillating column.

Buy and hold is a very dull strategy. It lacks pizzazz and doesn’t inspire much admiration at cocktail parties. It has only one little advantage: It works, very profitably and very consistently. – Frank Armstrong

Ignore That Bear Market Headline, Part 1

“Without a rock-solid belief in the fundamental principles that undergird an intelligently crafted portfolio, weak-kneed investors face the likelihood of a disastrous whipsaw.” – David Swensen

Yesterday’s Los Angeles Times online article “Another sucker’s rally? Stocks are back in bear territory” declared that a bear market has returned. This won’t be the last article you see of this kind. This is just a guess, but watch for headlines that scream, “The Bear (Market) is BACK! What should you do NOW?” These articles sell publications. So what does this “bear market” actually mean to you?

A bear market is a prolonged period in which investment prices fall, accompanied by widespread pessimism. It is typically defined as a decline in a stock index of approximately 20% or more from a previous high.

A stock market decline of that magnitude is certainly noticeable. But once it has already occurred, what should you do? Probably nothing, especially if you have a well-thought-out strategy and properly diversified portfolio based on your individual circumstances.

The Media

Newspapers, magazines, and TV programs make the declaration of a bear market sound significant. They can always find someone who will compare this decline to past ones and make predictions about just how bad things will be. But the media’s attention to a bear market may be a distraction, it may be misleading, and it could lead you to do something harmful to your economic health. It could convince you to sell.

Yes, the stock market has declined more than 20% from its high, but did you actually buy at the high? It would have been quite difficult to have such exquisitely bad timing! Were you 100% in stocks, as if you were channeling a river boat gambler? I sure hope that you weren’t borrowing money to buy stocks.

As for going forward, please realize that it is impossible to know whether the decline will continue or reverse. Magazine articles or TV commentators may talk knowingly about the causes of this bear market, and why it will continue, but my advice is to ignore them.

We’ve had them before

According to Nick Murray’s Simple Wealth, Inevitable Wealth, not counting the current decline, we have had 12 bear markets since World War II. So these declines are actually quite common. And they have all been temporary.

In the past, we’ve had steep stock market declines caused by wars, high inflation, OPEC embargoes, credit crises, over-speculation, corporate overreaching and fraud. We’ve had assassinations, an impeachment and a president resign. We have had hedge funds implode, and seemingly great institutions disappear. Each time, while living through the terrible stock market, it seemed like that was the first time that such a negative constellation of events had ever occurred. But that wasn’t so. Our economy survived and stock prices recovered, as investor confidence returned.

How long withh this bear market last? No one knows! No one. Talking about the “average” decline is not particularly useful. Some bear markets have been short, some very steep, some unnervingly long and relentless.

Seeing your wealth decrease day by day is no fun. But a bear market is something you have to accept in order to get the long term (higher) returns associated with stocks. At least that is the way it has been in the past.

Feel the Fear But Don’t Act on It

With prices declining, and everyone talking about it, fear takes over, quite naturally. The L.A. Times companion article Investors flee as fear factor swamps markets worldwide is all about fear. In a relatively short piece, I counted the word “fear” 8 times, not to mention “worried” “nervous” and “hammered.” And what a litany of terribles. We’re doomed, doomed!

The final quote, “You tell me — why would you want to buy something now?”

I don’t know, maybe because stocks are on sale with prices reduced?

If you act on the fear, and sell in panic, you have lost. You may think that you will buy back, when things look safer, but the odds of your actually doing so are very small.

Conclusion

It is not easy to have the courage to ignore the pessimism, but over the long term, returns from stocks have more than made up for the periodic (and temporary) bear markets. Will the future look like the past? My guess is Yes.

To be continued …

« Previous Page — Next Page »