Intelligent Investing, Part 1

“Instead of concentrating on the central issue of creating sensible long-term asset-allocation targets, investors too frequently focus on the unproductive diversions of security selection and market timing.” – David Swensen, chief investment officer of Yale University.

To many people, investing can seem a bit like a game of chance. Tracking the daily fluctuations in the equity markets can make it difficult (some might say impossible) to make any sense of investing.

Turn on the television to learn about the stock market, and too often, what you will find is talking heads.  They are no help; they are misleading, because they generally  speak only of the short term. These TV stock market commentators are always predicting future prices for stocks, bonds, currencies, etc.  It doesn’t matter if they disagree (which they regularly do, since it makes for more interesting conversation) or whether one or another turns out to be correct or way off. You never hear how their predictions turned out.

A Better Way

Modern Portfolio Theory (MPT) is a very different approach to investing. It does not depend on predicting the future or analyzing individual stocks. It is based on decades of academic research. In fact, several individuals have won Nobel prizes as a result of their discoveries related to the way securities markets work. MPT has also influenced the way many pension funds and college endowments are invested, including Yale’s.

Think of Modern Portfolio Theory’s message as the opposite of what Wall Street wants you to believe, which is that their analysts have the secret to successful investing through superior stock selection.

For a good solid introduction to the practical implications of Modern Portfolio Theory, you can view Henry Blodget’s recent interviews with Ken French, Professor of Finance at the Tuck School of Business at Dartmouth College.

The first video is Buy and Hold Versus Timing the Market.

The second video is Stock Picking Versus Index Investing.

Each video is about 5 minutes long.

Dimensional Fund Advisors

Ken French is not merely a prolific academic researcher; he is also the Director of Investment Strategy for Dimensional Fund Advisors (DFA). DFA applies academic research on capital market behavior to the practical world of managing investment portfolios. The firm maintains close ties with the University of Chicago and other research centers for financial economics.

DFA’s approach is firmly rooted in the belief that markets are “efficient,” and that investors’ returns are determined primarily by asset allocation decisions, not market timing or stock picking. DFA has no economists forecasting business cycles or interest rates, no investment strategists shifting allocations between stocks and bonds, and no analysts seeking “underpriced” stocks.

With $140 billion under management, Dimensional Fund Advisors is the leading provider of structured investment strategies in the world. DFA funds are carefully constructed to capture the returns of a well-defined asset class that has historically provided investors with a substantial premium for the risks those investors took.

DFA funds are only available to institutional investors and through a select group of fee-only financial advisors who subscribe to the passive asset class investment philosophy.

Along with other select funds, I recommend DFA funds be included in my client portfolios.

The Economy and the Stock Market

“Something that everyone knows isn’t worth knowing.” – Bernard Baruch. 

Baruch was referring to individual stocks, but I take his meaning to include the economy and “the stock market” as a whole. If something is already known, it will have no further influence on individual stocks or the stock market. It is only something new that will affect prices.

Larry Swedroe is the co-author of The Only Guide to Alternative Investments You’ll Ever Need.

In a recent interview with HardAssetsInvestor.com, he talked about commodities, portfolio construction and investing strategy. He also related his outlook for the U.S. economy as a whole to his view on future returns in the stock market. Surprisingly, he is optimistic.

I know, firsthand, that a great many investors are discouraged and/or disgusted with the downturn in the economy, in general, and the decline in the markets, specifically, over the past months. Some investors have fled the stock market for safer investments. And, yes, I realize that it is difficult to find any silver lining in the current dark clouds of the economy.

Certainly, the volatility of the stock market cannot make anyone feel peaceful. It’s clear that optimism is in short supply.

Nevertheless, Swedroe thinks this may be a good time to invest in stocks. Please, consider his logic, which I personally find very persuasive.

HardAssetsInvestor.com: What are your general thoughts about the economy and the stock market here?

Swedroe: The big picture is simply this: Clearly, this is the worst economic crisis we’ve seen since the Great Depression. But wait … did I tell you anything you didn’t already know? The markets know that too. This is the worst market since the Great Depression.

We all know the economic news is going to get worse. Unemployment is going to go up; retail sales are going to go down. But while everyone’s focusing on the bad economic news, they’re forgetting that the market has already understood this.

People are saying, why can’t this be another Great Depression? And it could; you can’t rule that out. But what people fail to understand is this: In the Great Depression, the policy responses were all in the wrong direction. We raised taxes and raised interest rates, increased margin and reserve requirements, and started a trade war. The policy responses this time, whether you agree with them or not, have not only been in the right direction – cutting interest rates, flooding the markets with liquidity, etc. – but they have been the most massive effort ever.

The effort is coordinated around the globe, and countries are pledging to maintain free trade. Every major country is enacting fiscal stimulus programs, all the central banks are cutting interest rates, etc. So while we have had a massive economic crisis, offsetting that are the largest policy responses in history coordinated around the globe. Policy responses take a while to work through the system, while the economic news will continue to look bad for a while.

Remember: Just when things look darkest, stocks tend to have good returns. Prior to this year, when consumer confidence has fallen below 50, the average return for stocks the next year was 16%.

Or consider this: When the unemployment rate is below 4.3%, the average return to stocks is 2%. When the unemployment rate is over 6%, the average return to stocks is 15%.

In the 11 recessions in the post-war era, the cumulative return to stocks is up 7%, and T-bills are up 5%. Returns were positive and better than the risk-free rate. Every time an investor sold stocks and paid taxes, they would have been better off sitting pat in stocks. The only way to do better would have been to forecast the recession, and who can do that?

I cannot guarantee that we will get out of this crisis, but we have gotten out of every other crisis quite well.

(Emphasis added)

Conclusion

Certainly, there is no shortage of bad economic news: Home prices are falling, unemployment is rising, the stock market has had one of its worst years on record, and the automobile industry is asking the federal government for bailouts, like the financial services industry before them. Where will it all end? Is there any good news?

Indeed. Unfortunately, we do not know when the good news will arrive. But, what we do know is that whatever negative that can be said about the economy is already known. If it is widely known, then the bad news is already reflected in current stock prices.

If history has any relevance, and I think it does, after a stock market decline, when pessimism is commonplace, is a very good time to expect stocks to have higher returns.

This may be counterintuitive, but it is true, historically.

Financial Experts?

 

 

 

 

 

 

 

 

 

 

 

 

This cartoon is courtesy of Nick Anderson, the Editorial Cartoonist of the Houston Chronicle.

I think it captures beautifully the irony of banks and brokerage companies still holding themselves out to be “experts”even though they have imploded due to poor risk management.

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